Friday, 21 February 2014

Convertible Debentures: the Certs mint of investments

Many years ago a famous TV commercial for Certs featured a debate as to whether it is a candy mint or a breath mint.
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The answer was that it is both at the same time - "two, two, two mints in one". 

Step forward the investing equivalent, the convertible debenture, a hybrid security that has features of both debt and equity. It is a debenture debt which promises to make fixed regular payments and has a defined maturity date. But it also is convertible into equity of the company under certain conditions. When it works well, it provides the steady income of debt repayment with the potential for capital appreciation if the common stock rises in the market.

Our simple description above inadequately describes the many details and variations possible with convertible debentures. To ease into the subject, we suggest reading:
1) A Primer on Convertible Debentures - by Hank Cunningham, author of the book In Your Best Interest: The Ultimate Guide to the Canadian Bond Market; includes a brief intro to assessing convertibles
2) Convertible Debentures for Income & Growth - on the Income Research website, which charges a subscription for access to its ratings and ratio calculations for the various issues on the market  
3) Convertible Debenture Overview - by ScotiaMcLeod
4) Convertible Bonds: Combining the Advantages of Stocks and Bonds in One ETF - by Barrry Gordon of ETF provider XTF in

List of Canadian Convertible Debentures
The Financial Post publishes a freely available list under Market Data. The screenshot below shows part of the list of almost 190 issues on the market.
(click image to enlarge)

The detailed conditions for each issue may be found on the company website, though the authoritative comprehensive source is the relevant Prospectus that issuers must file on Click on Search Database then Public Company Documents, then enter the Company name in the search box and Prospectus in the drop down box.

USA Convertibles
An easy way to get a list of convertibles of US companies is to download the holdings of an ETF focussed on that segment, such as the SPDR Barclays Convertible Securities ETF (NYSE symbol: CWB), which holds 100 of the largest issues.

Canadian ETFs, Closed End Funds and Mutual Funds
A few examples of debenture price action
1) Far out of the money, a "busted convertible" - Debenture price behaves according to bond value
Advantage Energy's conversion price is far below the current stock so the convertible AAV.DB.H hardly budges , there's no reaction to stock price movements and its value to an investor is the yield to maturity of 4.30% as the TMX Money chart below shows.
(click image to enlarge)

2) At the money, where stock and conversion price are quite close - Algoma Central's common stock price is slightly above the conversion price. In the last few months especially as ALC has risen, the price of its debenture ALC.DB has moved a lot more in sync with ALC. 

3) Deep in the money, where the stock price is far above the conversion price - Just a few days ago Cargojet (CJT) announced a huge contract and the stock price skyrocketed. So did the debenture's price, as seen below, to the point that the yield to maturity on the debt is a big negative 8.09%. That doesn't matter since debenture holders are now making a large capital gain based on the stock price. From now on till conversion into equity, CJT.DB.A will bounce up and down in tandem with the stock price.

Bad things can happen
If a company begins to get into financial difficulty, the stock price will go down, not increase, eliminating any possibility of capital appreciation. If the difficulties get too bad, the risk of default may impair the value of the debenture. As the primers above point out, an investor needs to assess credit risk among other things. And as the type of companies that issue debentures are usually smaller and not rated by the credit rating agencies such as DBRS, the self-directed investor must do more work him/herself. The provisions of each issue can vary considerably so it's a very good idea to check the Prospectus on SEDAR.

Nevertheless, convertible debentures can offer a solid way to invest in a security that offers the dual properties of equities and fixed income. The analogy with CERTS isn't perfect however, since you cannot be sure in advance whether it will be a candy mint, a breath mint, a bit of both, or even at times a possible sour taste.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Anonymous said...

If all you are looking for is the interest income and a possible capital gain most fit the bill if they are from a strong company.

Anonymous said...

this paper shows you why convertibles make profit.

CanadianInvestor said...

Anon, thanks for the link to the paper. It does show how and why hedge funds like doing convertible arbitrage profitably.