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Look for Value in Convertible Debt

In some of my previous posts, I discussed the value available in the Canadian preferred share and investment grade corporate bond markets. Over the last couple of months, typical preferreds have risen 20% – 25% while investment grade corporates and Tier 1 Capital Trusts have increased 10% or more.

An area to consider for some decent value right now is the convertible debenture market.  A convertible debenture of a publically traded company usually trades on the TSX so pricing is very transparent. The debentures are usually unsecured so they are based solely on the creditworthiness of the underlying company.

The debentures pay a fixed rate of interest with coupon payments being made semi-annually in most cases. Unlike trust units or commmon stock, the interest payment is fixed on the debentures which gives a level of comfort to investors as companies will do whatever it takes not to go into default.

The debentures are convertible into common shares at the investors option at a pre-determined price when issued. This provides the investor not only the interest but an opportunity for capital gains as well should the underlying share price of the company rise over the term of the debenture.

At maturity, the corporation usually does one of two things. It can pay the investors back in cash or shares. If the payment is made in shares, the price used is usually 95% of the average trading price over the 20 days prior to maturity.

Typically speaking, you dont want to be faced with this scenario as the share price will drop continuously over those 20 days. I will get into this in more detail on another post.

Currently most convertible debentures are yielding in excess of 10% with some yielding in the 20% range. The lower yielding convertibles have been able to raise capital in these markets to shore up their balance sheets reducing the risks of holding them. A company like Cominar REIT has a 2014 debenture yielding in excess of 10%. Primaris REIT has one yielding 12%. Debt laden Harvest Energy has debentures yielding in excess of 20%. The debt looks considerably more attractive than their trust units and the debt has increased in value by 30% in the last month.

Look for institutional investors to start picking away at them as the yields on other fixed income investments continue to drop and money markets with all time records amount of cash flow out to find higher yields.

Your comments are always appreciated.


2 Responses

  1. 1) If I am understanding your comments about how the company can repay your capital, the investor doesn’t have a choice on how to reveive the capital. The company can chose to return capital to a share offering.

    2) How safe can an investment returning 20% be?

    • In response to your questions, the company will pay in cash if it has the cash to do so or it can refinance the debt in the marketplace. If it can’t do either, it will return the capital in shares rather than cash.

      With regards to the second question, the debentures paying 20% are more secure than most trust units paying 12%. With billions of dollars parked in money market funds starting to move into corporate and high yield bond funds right now, the demand for convertible debt is increasing while supply is remaining constant. As such, prices are trending higher offering capital gain potential in the short term along with a very attractive yield.

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