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Convertible Debentures – a Primer

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Portfolio Advisory Group May 12, 2011 Convertible Debentures – A Primer A convertible debenture is a hybrid financial instrument Convertible debentures offer some advantages over that has both fixed income and equity characteristics. In investing in common equity. As holders of a more its simplest terms, it is a bond that gives the holder the senior security, investors have a greater claim on the option to convert into an underlying equity instrument at firm’s assets in the event of insolvency. Secondly, the a predetermined price. Thus, investors receive a regular investor’s income flow is more stable since coupon income flow through the coupon payments plus the payments are a contractual obligation. Finally, ability to participate in capital appreciation through the convertible bonds offer both a measure of protection potential conversion to equity. Convertible debentures in bear markets through the regular bond features and are usually subordinated to the company’s other debt. participation in capital appreciation in bull markets through the conversion option. Unlike traditional Convertible debentures are issued by companies as a bonds, convertible debentures trade on a stock means of deferred equity financing in the belief that exchange but generally have a small issue size which the present share price is too low for issuing common can result in limited liquidity. shares. These securities offer a conversion into the underlying issuer’s shares at prices above the current VALUATION level (referred to as the conversion premium). In A convertible bond can be thought of as a straight return for offering an equity option, firms realize both bond with a call option for the underlying equity interest savings, since coupons on convertible bonds security. Therefore, there are two lower boundaries are typically lower than those on straight bonds to below which the bond should theoretically never account for the call option, and tax savings as coupon trade: expenses are deductible for income tax purposes whereas dividends are paid from after-tax cash flows. • the straight bond value & • the conversion/intrinsic value Professional Wealth Management Since 1901 The intrinsic value of the bond is the current price of the money and as such the risk of losing capital the common stock multiplied by its conversion ratio under a soft call provision is lower than a hard call (the number of shares that each bond is convertible provision. into). • HardCall:The hard call feature allows the bond to CONVERTIBLE DEBENTURES TRADING IN THE MONEY be called at par, or slightly higher, regardless of the price of the underlying security. A convertible debenture will normally trade at the intrinsic value, or a small premium above the intrinsic Why should you be aware of these call options? All value, when the underlying equity security is trading else being equal, a convertible debenture with a above the strike price, or commonly referred to as higher coupon should trade at a higher price. In the trading in-the-money. current low interest rate environment, companies can use their hard call option to redeem an outstanding When a convertible is trading deep in-the-money, convertible and issue a new convertible at a lower it will take on the characteristics of the underlying coupon. In order to preserve capital, investors need to equity as opposed to a debt obligation. As a result, be careful when owning a convertible debenture with the yield-to-maturity can become negative and the a hard call option that is significantly lower than the cash-on-cash (ie. coupon divided by prce) yield current trading price. can be lower than the underlying dividend yield. If these conditions exist and the convertible debenture In addition to these redemption clauses investors need to be aware of any soft redemption clauses which allow the issuer to repay the principal amount Market Price of at maturity/redemption by payment of common Convertible Bond Convertible Instrinsic shares, as opposed to cash. Most frequently, the Bond Value clause will state that the corporation may satisfy its Price obligation to repay the principal amount by issuing Straight Bond and delivering that number of common shares or Value units obtained by dividing the principal amount by 95% of the weighted average trading price of the Common Equity Share Price common shares during a specified period of time right before maturity. In most cases, receiving units/ was originally purchased as part of a fixed-income shares instead of cash is not an issue since you can portfolio an investor should reconsider holding this usually sell them into the market relatively easily. security. However there are certain situations which could cause a concern: REDEMPTION CLAUSES • Suitability: some accounts cannot hold equity so Prior to buying a convertible, investors should you may be forced to sell the convertible before investigate whether a debenture can be redeemed maturity. prior to maturity. Convertibles typically have a non- call period, followed by a soft call and/or a hard call • Lowshareprice:where the underlying security to maturity. The non-call period prohibits the issuer trades at a low price and is lightly traded, the bid- from redeeming the bond without the consent of the ask spread may be sufficiently wide that it may be bond holders. difficult to sell the shares/units and recoup the full face value. • SoftCall: The soft call period allows the issue to be called but provides investors with a capital Convertible debentures that are far out-of-the- gain to offset the loss of interest income. The most money (i.e. the current stock price is well below the common soft call stipulates that the underlying conversion price) will normally trade at or near their equity instrument must trade for a specified period straight bond value, unless the company is under of time above a certain price level in order for the financial stress. Key pricing considerations include bond to be called. Usually, the soft call is set at a standard fixed income criteria such as the current level that allows the convertible bond to trade in yield, yield to call, yield to maturity and credit rating (if applicable). Investors should also consider the balance sheet of the company in question as convertible debentures tend to be subordinated debt and clients should note what debt ranks senior to the debentures. Investors need to also be aware that convertible debentures are not generally rated by credit agencies and due to the subordination would likely be rated and few notches below other bond or debentures of the same firm. Many currently outstanding convertible bonds would be considered below investment grade. Convertible bond pricing becomes most interesting when dealing with issues that are at-the-money. It is here that the bond’s call option value becomes fundamental in determining the bond’s fair value. Key considerations when evaluating an at-the- money convertible include conversion premium (the lower the better), and call protection (the longer the better). Unfortunately, no rule of thumb exists about what constitutes an attractive conversion premium. Comparative analysis of at-the-money debentures of similar credit quality will highlight attractive issues. The information contained in this report has been compiled by RBC Dominion Securities Inc. (“RBC DS”) from sources believed by it to be reliable, but no representations or warranty, express or implied, are made by RBC DS or any other person as to its accuracy, completeness or correctness. All opinions and estimates contained in this report constitute RBC DS’s judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Additionally, this report is not, and under no circumstances should be construed as, a solicitation to act as securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. This material is prepared for general circulation to Investment Advisors and does not have regard to the particular circumstances or needs of any specific person who may read it. RBC DS and its affiliates may have an investment banking or other relationship with some or all of the issuers mentioned herein and may trade in any of the securities mentioned herein either for their own account or the accounts of their customers. RBC DS and its affiliates may also issue options on securities mentioned herein and may trade in options issued by others. Accordingly, RBC DS or its affiliates may at any time have a long or short position in any such security or option thereon. Neither RBC DS nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. This report may not be reproduced, distributed or published by any recipient hereof for any purpose. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member–Canadian Investor Protection Fund. ®Registered trademark of Royal Bank of Canada. Used under licence. RBC Dominion Securities is a registered trademark of Royal Bank of Canada. Used under licence. ©Copyright 2011. All rights reserved..
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