5 things to know about convertible bonds

By: Sound Choices • February 8, 2019 • Personal Finance

Convertible bonds offer the best of both worlds.

Convertible bonds are designed to give investors the opportunity to participate in a rising market and offer protection when equities are sinking. Historically, their returns tend to be higher than corporate bonds, according to Morningstar Direct data. This even though they offer a lower interest rate.

However, perhaps due to their complexity, many investors may not be aware of how they can fit within a diversified portfolio. Here’s what you need to know.

 

1. What is a convertible bond?

They are the shapeshifters of fixed income securities because at different stages in their lifecycle, they can be either a bond or a stock. That’s why they are called convertible bonds.


2. How does a convertible bond work vs. a traditional bond?

All bonds are essentially IOUs, with the company issuing the debt promising to pay investors a set rate of interest in exchange for their loan. Typically, convertible bonds pay a semi-annual coupon like a conventional corporate bond, but with a lower interest rate.

Convertible bonds differ from corporate bonds in that they include an option to convert the bond at a specific price (the “conversion price”) into the company’s common stock. Each bond entitles the investor to a predetermined number of shares (the “conversion ratio”).

 

Convertible bonds vs. traditional bonds
Source: UBS, October 2008. For illustrative purposes only.

3. What are the opportunities of convertible bonds?

(a) Enhanced return potential vs. conventional bonds

Even though rates are lower than with conventional bonds, the option to convert from bond to stock in a rising market provides the potential for upside participation with the underlying equity. In other words, if the stock price has risen higher than the conversion price, you may be better off converting the bond into the company’s common stock.

(b) Decent downside protection

Unlike stocks, convertible bonds have a specific maturity date at which time investors will receive their principal. In this sense, convertible bonds have more limited downside than common stocks.

(c) Lower sensitivity to interest rates

Convertibles have historically performed more like stocks than bonds during rising-rate environments. Globally, convertibles have generally proven more resilient than bonds when interest rates have risen, as well.

(d) Enhanced diversification without the typical equity-related risk.

Convertible bonds have a less-than-perfect correlation with equities and an even lower correlation with traditional bonds. This provides an extra layer of diversification and protection within a portfolio – and reduces the overall volatility of the overall portfolio.

Convertibles have historically performed strongly in rising rate environments
Source: Bloomberg, Barclays Capital, February 9, 2018. This historical perspective is not intended to predict future analytics. Past performance is not an indicator of future results.

4. What are the risks of convertible bonds?

Convertible bond default rates have been exceptionally low and consistently better than the high yield category over the past several years, according to Moody’s Rating Service data. However, if an issuer does go bankrupt, convertible bond investors have a lower priority claim on the company’s assets than investors in non-convertible debt (but rank higher in the capital structure than equity).


5. Why are so many convertible bonds unrated?

Non-rated issues are quite common in the convertible bond market, but that doesn’t necessarily equate to a poor-quality investment. More often than not, the cost of the ratings process simply outweighs the benefit to issuing companies.

 


To find out more about convertible bonds, talk to your financial advisor or visit www.AGF.com/income.


 

The information contained in this article is based on material believed to be reliable and is provided as a general source of information and should not be considered any personal investment or tax advice. Every effort has been made to ensure accuracy at the time of publication, however AGF Management Ltd. and its affiliates cannot guarantee 100% accuracy of this information, and is not responsible for the development and creation of this material. It is important for investors to consult with their financial and tax advisors before making any investment or tax planning decisions.

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