Start with a bond, end up with an equity

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A convertible bond is a unique corporate debt instrument that behaves like a bond, with a fixed payout on a regular basis (called coupon payments) and a stable maturity. What makes them "convertible" is the option, upon maturity, to switch over to shares of the company's common stock if the investor so chooses.

"In essence, it is a bond with an embedded call option," explains Lee Goldman, senior vice-president and manager of the convertible bond portfolio at First Asset.

Experts like Mr. Goldman acknowledge that the convertible bonds market in Canada has not been overly active in the past two years, but now might be the time for curious investors to take a look at this hybrid financial asset. However, there is still a lot to consider about a convertible bond before diving into this market.

The investor

So who should take notice of convertible bonds?

The hybrid nature of this bond makes it appealing to two types of investors – on very different ends of the risk spectrum, says Mike Reed, portfolio manager at BlueBay Asset Management, a part of Royal Bank of Canada's RBC Global Asset Management.

The first is the fixed-income investors who are looking to dip their toes in the stock market but still want to benefit from the capital protection characteristics seen with a corporate bond, as well as the coupon payments. But with the current low-interest, low-yield environment seen with government bonds, investors' interest is piquing as they want a bit more for their money with a little added risk.

"It allows people who may want to try out the equities market but aren't quite ready to take on all the risk associated with it," says Mr. Reed. "They're looking for opportunities to take on a little bit more risk to try and get some more upside potential."

He adds: "We see a lot of those investors from Canada."

Mr. Reed explains that the motivations are very different on the international side, especially in places such as Britain and Australia. There, investors are used to a more equity-based portfolio and so they may look to convertible bonds to de-risk their investments and have a financial vehicle that is a little more predictable.

Liquidity

Over all, the reputation for liquidity in convertible bonds is fairly poor, explains Joey Mack, director, fixed income, at GMP Securities.

"You do not get a lot of liquidity in these securities," says Mr. Mack. "It's also very small issue sizes, as well, which doesn't help the matter for the most part."

Mr. Goldman agrees that these investment vehicles should not be looked at as high sources of liquidity.

"I would say, as a general rule, issues which are $50-million or less are generally not that liquid," he explains. "It is also somewhat a factor of the underlying equity, as well. If the equity price is relatively close to the conversion price, there tends to be more interest from hedge funds, thereby increasing liquidity of the issue."

Risk

While the risk in convertible bonds is much less than in the equity markets, it is far from zero, as there are several aspects to consider.

The main risk to the convertible bond buyer is whether it will be paid back upon maturity. If the company goes bankrupt then you could find yourself in a long procedure to see your invested funds again.

Indeed, Mr. Mack cautions investors to look before they leap, as some convertible bond issuers are declaring bankruptcy in the energy market.

"The downturn in energy prices has seen many convertible bonds plummet in value," says Mr. Mack. "Since convertibles rank after the senior debt in terms of priority of payment in the event of default [bankruptcy], and many companies are approaching default with their senior lenders and unable to pay them back, many are going to zero."

But there is an upside – if only a small one – in the case of issuer default, explains Mr. Reed.

"If you end up in a credit situation, and the company declares bankruptcy … as a convertible bond holder you are then higher up the pecking order because you are higher up the capital structure than equity [investors]," he explains.

There is also the risk you acquire if you choose to convert your bond into shares as, like any other equity investor, you are then exposed to the ups and downs of the equity market. But it might be worth the risk if the company's share prices have seen an increase.

"What we effectively do is we work on probability," Mr. Reed says. "Obviously, if the share price goes up, it is more likely that you, as the holder of the convertible bond, are going to want to take shares because it's more likely … that the exchange value will be above the redemption value."

So is there a way to limit one's risk?

Limit risk

All of the experts agree that doing some homework on the company that is issuing the convertible bond is the best way to limit risk. A great resource is the company's balance sheet, which will give a better idea of the debt load and potential bankruptcy risk.

But despite the cautionary tone, the experts still say there is the opportunity for good upside if the right bond is chosen.

"Over all, there are some interesting opportunities in the industrial space, so yes, convertibles are worth consideration, but you have to be very selective," cautions Mr. Mack.

He follows up with an old trader adage to illustrate his warning, "Bulls make money, bears make money, but pigs get slaughtered," he recalls. "Don't look at the super-high yields on some of these convertibles as the opportunity; they trade there because the likelihood of receiving your principal back is low."

Convertible bonds can be purchased through a financial adviser or individually on the stock exchange.