Lately I got friends asking me about what to put in their fixed-income portfolios. When I recommended Convertible Debentures, many did not know what they are and how to invest in them. So I decided to write an article on what I think of them and how I select convertible debentures.
I started noticing Canadian convertible bonds about a year ago and since then, I've purchased them for my own registered accounts and for others. I believe they are a terrific fixed-income play with a 'free' call option.
What is a Convertible Debenture/Bond?
In pure terms, a convertible bond is a bond with an option to convert the bond into shares of the company. Check out wikipedia for detailed explanation.
Okay, so what? What are the benefits over just a Bond?
These are reasons why I choose Convertible Debentures:
1. It is a source of passive income while providing a 'free' option to convert. The optional agreement value is set up front. The maturity date, and coupon rate (income) are also setup from the start. No speculation work.
2. The minimal investment is low compared to preferred shares and bonds. ( min for CV is $1000, bond min is 5000, preferred shares min is 2500) There is more room to diversify your portfolio.
3. You can purchase them as a stock, and you can purchase them in registered accounts (RRSP/TFSA), unlike other income plays (covered calls, selling puts ).
4. Lower risk, rest better. Convertible Bond (Debentures) have lower volatility than their underlying stock. The payment isn't going to get cut like dividends or distributions and you will get your money back at end of the term. (unless the company goes under) So you can sit back and collect the cashflow.
Cons:
1. liquidity: less people know about them, thus less trading volume, stick with big name companies and you'll be fine. Make sure you are using "limit order" when acquiring.
2. Most of the Canadian issues are not secured against company asset. unlike the conventional bond. again, do your research on the company and you should be fine.
3. That's really it, can't think of anything else. put a comment if I missed something
Where and how to acquire?
I only elect convertible debentures/bonds from Canadian REITs in that I understand real estate and REIT provide great cashflow and hard assets. That helps me relax at night.
I came across a good list of Canadian convertible bond/debentures from Financial Post which shows all the information you need to pick the right one for you. (well, not all the info. still need to do research on the company financial statements)
This is what I do:
* step 1. from the Financial Post website, I copy the table into Excel sheet for sorting
* step 2. sort based on 'yield to maturity'
* step 3. delete the companies that I don't comprehend, (again, I only look at Canadian REITs)
* step 4. look at the convert price vs current price, closer the better
* step 5. look at the top 5 and see if you are comfortable holding it till maturity. (some could be more than 7 years)
* step 6. purchase them
* step 7. figure out when you will get paid: go to http://www.sedar.com and search for the company you are interested in. Each company is required to file prospectus with the Canadian government.
Example Exit Strategies
Let's say you purchased a CV (convertible debentures) today at $104. This CV is maturing in dec 21, 2015. The conversion price is 25 dollars and today's common share price is 20 dollars.
* case 1: at any time you can sell the CV back to the market just like a stock
* case 2: the price of the common stock went to 26 dollars before dec 21, 2012. you can convert into common stock, sell the common stock or keep the common stock after convert.
* case 3: the price of stock went to 26 dollars and the issuer calls (force conversion into common stock) you can then either sell them or keep the common stock
* case 4: by dec 21,2012, the price of common stock is below 25 dollars. you get your principal back.
* case 5: company go bankrupt. you lose your initial money :p that's why it's important to pick good company to start with, the one with predictable cashflow and hard assets.
That's it! I hope this helps to provide you with more options for your investment portfolio.
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