Time to 'convert' to convertible bonds

A convertible bond can be converted into a predetermined amount of a company's equity at certain times during its life, usually at the discretion of the bondholder. They are hybrid products, offering the relative safety of bonds with the potential upside of equities in the long run, and now may be a time where such attributes hold high merits.

The fundamentals are in place to support the convertible bond market, as equity prices have reached the lows that allow investors to get themselves a bargain convertible premium whilst securing a strong yield – put simply if equity markets rise out of the recession and one can lock into a convertible bond now, they can secure a yield and an option to later convert into equity when the stock price meets its conversion price.

Convertible bond investments are particularly attractive in these uncertain times as they protect against downside risk, given that bond value doesn’t fall below the bond’s straight value – meaning there is a floor that an investor can always expect as the minimum value of their investment.

Although convertible bonds have performed poorly over recent months, one can attribute most these losses to forced sales and redemptions in hedge fund markets – the main players in convertible bonds.

Nevertheless the environment that this activity has created is one in which convertibles are trading at well below straight value bond floors and cheap equity conversion premiums – an opportunity in the right market conditions, making convertibles certainly an asset class that should begin to see more interest in impending months.

Outlook

Interest rates are set to fall as the Government pursues economic stimulation policies to combat recession, and convertible bond yields will look attractive on a relative basis despite being lower than conventional bonds.

Convertible debt is seen as a riskier investment due to its equity component, and has already priced in twice the default levels of their comparable straight bonds, thus they are trading at relatively cheaper prices.

Forced selling from hedge funds in the convertible bonds market is also providing a huge opportunity for bargain prices – albeit for those who can tolerate a low degree of liquidity.

Convertibles remain less risky than equity investments, ranking higher in capital structures in the event of default, and as corporate profitability is set to reduce by 25-35 per cent over 2009, the discretionary dividend payments are first to get slashed, making yields on convertibles relatively more appealing.

Some of the top fund managers in the UK Equity Income space too have sought an exposure to this asset class – Invesco Perpetual’s Distribution and Monthly Income Plus fund, along with the Trojan Income fund, are examples of those funds opting for convertibles in recent months.

If one were to seek a fund that focuses greatly on this asset class, they should draw their attention to the New City High Yield Investment Trust which maintains a high 29 per cent exposure to convertibles.

New fund launches are also tapping into this opportunity during the recessionary phase, with RWC Investors launching its Distressed Convertibles fund posing a good example.

Overall the investment climate that now exists, coupled with cheap convertible bond prices, makes this an exciting asset class offering a great opportunity for those seeking a more tentative play on rising stock levels in future, whilst securing themselves a yield better than they could expect from a bank deposit – as equity prices can only go up over the longer-term, why not earn a comfortable yield until then?


How convertible bonds work

Corporations issue convertible bonds and carry the right to convert the bond into a specified number of shares of common stock. At the time of issue, the bond issuer decides:

1. The number of shares that can be converted
2. The stock price at which conversion can occur
3. The time frame

Convertible bonds usually earn a lower interest rate than regular bonds because the price of the bond will rise as the value of the underlying stock rises.

The bonds benefit in a rising stock market, but still pay interest if the underlying stock doesn't rise. Furthermore the value of the bond will not go below its straight value, meaning they protect against downside risk.

Key considerations for investors

Before investors get involved, some things to consider before buying convertible bonds are that:
 
• Almost all convertible bonds are callable, meaning the corporation can redeem the bonds at its discretion. You get the face value back, but may have to reinvest the money in a less attractive investment.
• The stock price has to hit a certain number before you can convert. This number may be quite high, and called the conversion premium. If you want to own the stock, you may be better off buying it at the lower current price rather than waiting for it to hit this premium.
• They are more illiquid than equity investments, once a convertible is bought, you’d generally only prosper to hold it until the bond reaches the conversion price.
• You receive a lower interest rate on the bond and if the stock declines, the bond price drops. In the worst of all worlds, interest rates rise and the stock falls.


*Source of data: Financial Express Analytics