Best way to invest with convertible bonds
There are so many options for investing your hard-earned money. There are mutual funds, stocks, bonds, real estate, and plenty of other more sophisticated investments. It’s likely that you’re very familiar with the more common investments. But are you familiar with convertible bonds?
You might be in for a pleasant surprise.
The principal advantage to the investor is the lower level of volatility and risk found in a bond along with the potential upside of a stock.
However, convertible bonds are commonly referred to as a hybrid security. It combines features of both equity and debt investments. It’s a bond that can convert itself into common stock, if the right circumstances exist. It’s a bond with a call option on the stock that’s issued by the same company that issued the bond. Similarly, Companies with a low credit rating that are attempting to avoid paying higher interest rates typically issue these bonds.
It is referred to a convertible debenture if the maturity is greater than 10 years.
It can be helpful to understand why a company would want to issue a convertible bond in the first place:
1. It allows them to lower the coupon rate of the bond and keep the investment attractive to investors. Most investors are willing to accept a lower coupon rate if the bond is convertible. The conversion feature is attractive enough to investors that the lower interest rate is acceptable.
‣ The lower interest rate can save the issuing company a lot of money. There are examples of large companies saving well over $1 billion in interest payments over the lifetime of a bond issuance.
2.Converting the bond to stock instantly eliminates the debt associated with the bond. Therefore conversion of the bond to stock dilutes the shares of the existing shareholders. This is a negative consequence for the shareholders.
3. It delays dilution to the equity holders. In the short and medium term, many companies would rather issue a bond, since the interest expense is tax-deductible. But in the long-term, the same company might be comfortable with dilution if it believes that the stock price will climb significantly during that time.
Convertible bonds allow companies a way to raise capital without harming the current stock price and upsetting current stockholders. It also lowers their costs by reducing the amount of interest paid. And companies can still deduct the interest paid on the bonds.
These three benefits make convertible bonds highly attractive to companies, especially if they expect the stock price to rise in the future.
There are several types of convertible bonds:
1. Vanilla convertible bonds are the considered to be the simplest form of convertible bonds. It allows the bondholder to convert the bonds into a certain number of shares according to a predetermined conversion ratio.
‣ The conversion ratio or conversion rate is the number of shares of stock that the bondholder would receive per each $1,000 worth of bonds held (par value). This value can be found in the bond prospectus.
‣ The effective price of the stock is referred to as the conversion price. The conversion price is equal to $1,000/conversion ratio. There can be adjustments to the conversion ratio due to dividend payments
2. Mandatory convertible bonds have a maturity date and require the bondholder to convert the bond to stock on that date. This variety usually has two conversion prices.
3.Think of packaged convertible bonds as a bond with a call option. Another term used to refer to these is “warrant bonds”. One can trade the option portion separately. Institutional investors are the most common purchasers.
4. Reverse convertible bonds are essentially the opposite of a vanilla convertible bond. As the actual stock price drops below the conversion price, the par value of the bond will drop. Due to this extra risk, this type of convertible bond has a higher coupon rate.
Like other types of investments, convertible bonds have their own unique terms.
Add these terms to your investing vocabulary:
1. Cashflow payback. The term is always expressed in years. It measures the number of years needed to recover the premium compared to investing in the common stock.
‣ A= annual interest income on $1,000 worth of the bond.
‣ B= the annual dividend income on $1,000 worth of the common stock.
‣ Cashflow payback = A – B conversion premium (in dollars)
2. Call features: The list of circumstance under which the issuer of the convertible bond can call and convert the bond. An example of a call feature would be: If the stock price has been at least 135% of the conversion price for at least 20 trading days during a 30-trading day period, then the bond issuer can call the bond and the bondholder can convert it into common stock.
As you can see, convertible bonds are a little more challenging to understand than the common bond. Doing the additional research necessary to educate yourself more fully about these bonds could be very beneficial to you!
‣ HOW DO INVESTORS USE CONVERTIBLE BONDS?
Investors often use convertible bonds as part of an arbitrage strategy. An investor purchases the convertible bond and shorts the related common stock. What does this accomplish?
One can harvest the difference in yields between the stock and the bond. Shorting the stock hedges most of the risk. This is a common strategy of hedge funds and other sophisticated investors.
Most conventional investors that want a debt investment with more potential upside also use convertible bonds. Convertible bondholders also have a claim to company assets should the company go bankrupt, similar to regular bondholders. This isn’t true for holders of common stock.
The main draw of convertible bonds is that they potentially perform very well in bull markets but still provide income in bear markets. Convertible bonds will have less overall risk than comparable regular bonds.
Most convertible bonds in Canada trade on an exchange, making it straightforward to purchase them.
In the US, brokers typically trade convertible bonds over-the-counter. If you don’t already have an OTC trading account, it will be necessary to establish one to purchase a convertible bond. Most bonds trade over the counter as well, so if you’ve purchased bonds in the past, you should have access to convertible bonds, too.
While convertible bonds are not well known by the common investor, they have a place in the portfolio of nearly any investor. The combination of both debt and equity features can be the best of both worlds in uncertain economic conditions.
Consider your investment time horizon and the addition of convertible bonds to your portfolio. In Contrast some point in your life, convertible bonds are likely to be the perfect investment