The Canadian Convertible Debenture Market: Exploiting Opportunities in an Overlooked Asset Class
Paul Borisoff - May 18, 2017
Convertible Debentures can provide extremely attractive risk/return opportunities for investors
The Canadian Convertible Debenture market in particular is one of our favorite “asset classes” in which to hunt for compelling investment opportunities for our discretionary Diversified Income Portfolio which is currently ~ 36% exposed to this area.
A convertible debenture is a hybrid security which has some of the features of both bonds and equities. It is essentially an issuer unsecured debt obligation which comes with a set maturity date, maturity value, and a built-in conversion option to equity that can provide significant upside potential.
A convertible debenture is almost always a safer way for an investor to be exposed to a particular company compared to buying its common or preferred shares directly. However, if you do not like the nature of a firm’s business (i.e. a highly cyclical resource issuer), the state of the firm’s balance sheet, or have questions about the firm’s expected profitability, overall direction and/or management quality should probably stay away from its convertible debentures as well.
You will often see the terms convertible bond and convertible debenture used interchangeably – with the distinction being that some convertible bonds are secured debt obligations but most convertible debentures issued in Canada are not secured. To further confuse matters “debentures” often have different definitions in different countries - i.e. U.K. issued debentures are usually secured1 while in the U.S. debentures refer specifically to an unsecured corporate bond2. With any investment it is important to understand what you are buying, how it works and what a reasonable return expectation is for the investment under a variety of scenarios. It is important to have an appreciation of the issuer’s financial stability. Complicating matters for investors researching convertible debenture opportunities in Canada is the fact that most issues are not rated by any credit rating agencies. The risk profile of individual convertible debentures varies greatly as they are regularly issued from a wide range of companies - from very small micro-cap “start-ups” right up to large, multi-billion dollar firms.
Only investors that are comfortable picking their own stocks should consider buying their own convertible debentures. Convertible debentures are not a “guaranteed investment” like a GIC which has CDIC coverage. They are however safer than buying the issuing company’s common shares or preferred shares.
Convertible Debenture Example: Cargojet 5.50% 30JUN19 Convertible Debenture
Cargojet describes itself as “Canada’s leading provider of time sensitive overnight air cargo services.” The company currently has a market capitalization of ~ $475 million, ~700 employees and utilizes a fleet of 20 all-cargo aircraft. On April 8th, 2014 Cargojet’s shares closed at $20.50 (2.9% yield). The company then announced that afternoon that it was raising $60 million via a 5-year convertible debenture financing coordinated by RBC Capital Markets. This new debenture offered 5.50% per year (coupon interest payments) until its maturity date on June 30th, 2019, and could be convertible into the company’s shares at $28.75 per share at any point at the option of the debenture holder - subject to being “Called” early by the company (more information on this below). The settlement date for this issue was April 29th, 2014 (the day it was listed onto the Toronto Stock Exchange for trading and started to accrue interest).
Convertible debentures are issued in multiples of $1,000 – which also the debentures “face value.” In our example each $1,000 face value of the Cargojet 5.50% 30JUN19 debenture is convertible into 34.7826 shares ($1,000/$28.75). Note, convertible debentures are quoted on the market as a percentage of par value (100) – so a price of 96 equates to $960 for each $1,000 of convertible debenture, while 104 equates $1,040. Interest that accrues after a semi-annual coupon payment is added to the transaction contract – so the seller of a convertible debenture does not have to worry about missing out on coupon interest by selling it prior to a coupon payment. The buyer and holder always receive a full 6 months of accrued interest on the next scheduled coupon payment date (except possibly for newly issued debentures).
Evaluating Convertible Debentures
The key questions that we ask when deciding whether or not to buy a new convertible debenture issue for the Diversified Income Portfolio are: 1) Do we like the issuing company and would we be comfortable owning the underlying shares directly?; 2) Do we like the specific terms of the convertible debenture being offered via a “New Issue” or otherwise trading in the market?; and 3) Do we believe that a particular issue will be liquid enough for our clients and trade well in the secondary market? Note, on point 3) most Canadian convertible debentures are listed on the Toronto Stock Exchange which is a significant plus as it increases transparency and liquidity. In comparison most U.S. and international convertible debentures are not listed on an exchange – and instead trade primarily in the more opaque “Over-The-Counter” market.
In regard to the Cargojet 5.50% 30JUN19 convertible debenture announced on April 8th, 2014 we quickly decided to secure a position as: 1) We liked the underlying shares of Cargojet - it had been on our “Watch List” for a while; 2) We liked the terms of the convertible debenture offered - 5.50% for five years, with the right to convert into the underlying shares at $28.75, and the other terms, including the “Call-Dates”, were satisfactory; and 3) at $60 million this particular issue was large enough and expected to be liquid enough for us to participate in on behalf of our clients. Note, the “Order Book” for “New Issues” is sometimes open for only a very short period of time from the Underwriters – i.e. one hour or less in some cases.
Another key question when evaluating whether or not to participate in a particular “New Issue” convertible debenture is: What is the company raising the money for? In the Cargojet example the company was raising money to finance an expansion of their domestic air cargo network (including the purchase of a Boeing B767 freighter) related to a recently awarded contract with Canada Post and Purolator. Generally speaking, cash raised to take advantage of a specific growth opportunity with the intention of increasing the overall profitability of the company is treated favorably in the market. This particular convertible debenture offering was “Upsized” the next day to $67 million due to significant demand in the market (this is always a very good sign) and the underwriters were also given an option to raise an additional $7 million – which was also fully taken up. All told the company raised gross proceeds of $74 million. In the “Convertible Debenture World” the Cargojet 5.50% 30JUN19 convertible debenture was a “Hot Issue” – and we were pleased that we were successful acquiring a substantial stake for the Diversified Income Portfolio at the convertible’s original issue price of 100 (par value). On its first day of trading (April 29th, 2014) this convertible debenture opened at a price of 102.00 – and closed that day at 102.50 (up 2.5%). For reference, Cargojet’s shares closed that same day at $20.60.
Convertible Debentures Can Provide Significant Upside
The Cargojet 5.50% 30JUN19 convert moved up 17% its first year (from April 29th, 2014 to year-end 2014) while Cargojet’s shares (underlying the debenture) moved from $20.60 to $27.50 over the same period (up 33.5%) – excluding interest and dividends respectively. This is a good illustration of how the “optionality” embedded in a convertible debenture can provide significant upside – even prior to the convertible’s conversion price trading “In-the-Money” (underlying shares trading above the conversion price). Note, the convertible debenture’s “optionality” erodes overtime as the clock runs out as the debenture’s maturity date approaches or as the possibility of a “Hard-Call” looms (see below). In year two Cargojet moved lower and closed 2015 at $25.81 (down 6.1% – which was offset by $0.60 of dividends – so off 4.1% net). In comparison the convertible debenture closed 2015 at 111.00 (down 5.1% - which was almost fully offset by the 5.50% coupon interest payments that year). Note, as of December 31st, 2015 the total return for a convertible debenture holder that had acquired the position on its original issue date of April 29th, 2014 at 100 was ~20.2%. In comparison, the common shareholders would have been up 29.6% including 6 dividend payments.
In 2016 it got exciting though. Cargojet’s shares moved up sharply that year closing at $45.74 (up 77%). The debenture, convertible at $28.75, followed the stock higher – and closed the year at 170.00 (up 53% in 2016 – and up 70% from its original issue price. Note, the intrinsic value of this debenture at year-end 2016 was $1,590.96 (34.7826 conversion ratio x $45.74) – a price of 159.10 - so this convertible debenture closed at a premium to its intrinsic value at year-end 2016. As of December 31st, 2016, the total return for the convertible debenture holder, including paid and accrued interest, was 84.7% since the original launch date on April 29th, 2014. In comparison, common shareholders would have been up 129.9% over the same period, including 10 dividend payments over the period.
Convertible Debentures Often Trade at a Premium to their Intrinsic Value
Convertible debentures often trade at a premium to their intrinsic value due to the “optionality” provided by their embedded conversion feature for the remaining term of the debenture (maturity or “Call Date”). They are also influenced by the same forces that influence regular bond prices such as the general movement of interest rates. Additionally, a convertible debenture’s trading price may be favorably impacted by the fact that the convertible debenture may offer a higher Current Yield in comparison to the underlying shares which may not pay a dividend, or only pay a very small dividend (i.e. at year-end 2016 the convertible debenture in our example had a current yield of 3.2% (5.50%/170.00) while the shares were yielding 1.5% ($0.70/$45.74). A convertible debenture’s price can also be influenced by the fact that a convertible debenture offers a higher degree of protection in the event the company’s share price corrects in a company specific set-back or general market correction (a correction back to 100 being the “Floor Price” at maturity for a convertible debenture outstanding issued by a solvent company), while there is no “Floor Price” for a stock.
Please note that convertible debentures will occasionally receive additional buying pressure from investors employing sophisticated trading strategies (i.e. hedge funds going “long” the convertible debenture, and “short” the underlying stock – which we are not going to get into in this paper in an effort to not further complicate the discussion…).
It should also be noted that “attractive” convertible debenture issues tend to be quickly snapped up by buyers that recognize their unique features. Many convertible debenture buyers tend not to “trade” their positions, but simply hold them for the long-term. While we have quickly booked gains on many past positions, we have also bought many issues over the years for the Diversified Income Portfolio and held them to maturity, the “Call Date,” or until we were forced to convert. Many issues will therefore trade with a very wide “Bid/Offer” spread over time, with many issues going “No Offer” for periods of time.
Also, it should be noted that there can be a lack of liquidity in times of market stress which can result in exaggerated moves lower as buyers retrench to the sidelines and panicked investors “hit the bid.” Market sell-offs can provide extremely attractive opportunities to accumulate positons as unlike buying a stock during a sell-off a convertible debenture has a set maturity date and maturity price. If the issuing company is solvent on the maturity date the convertible debenture has to “snap back” like a stretched elastic band eventually (back to par value (100), and until it does, you collect the coupon interest payments.
The “Default Scenario (or “Base Case”) for Buying a Convertible Debenture
The “Default Scenario” or “Base Case” when buying a convertible debenture is the expectation of collecting the set coupon interest payments for a few years - and then getting your principal back on the maturity date. If the company does well though and the share price takes off, or if the shares rise for some other reason above the conversion price (i.e. the company is acquired by another company), convertible debenture investors may get to participate in significant additional gains.
If on the other hand the company hits a rough patch and gets into difficulties of some sort, and the stock price plunges, convertible debenture investors still have the expectation of being paid back 100% of their capital at the debenture’s scheduled maturity date – as long as the company remains solvent. If the company finds itself in extreme difficulty though and initiates a restructuring process, or is insolvent, convertible debenture holders are almost always in a much better position compared to shareholders in regard to recovering their capital.
Convertible debenture holders often have a “Second Opportunity” of getting back 100% of their capital, or most of their capital back, if a company runs into problems. We have seen situations in fact where a company’s shareholders have been effectively “wiped-out” and yet convertible debenture holders have received back 100% of their capital in a short period of time (a few months). More on this below.
We maintain that for investors needing to generate a required level of income off of their investment portfolio, selecting and holding a group of “high quality” convertible debentures issued from companies that simply need to remain in business and solvent for the expected “Default Return” to be realized is a lot easier and more predictable than buying a basket of common shares. Both are subject to fluctuations based on company specific developments and the general market. Convertible debentures though have a set maturity date and an expected maturity value – unlike common shares.
Convertible Debenture “Soft-Call Dates” and “Hard-Call Dates”
Most Canadian convertible debentures are issued with a “Soft-Call Date” - which typically kicks-in at 3 years for 5-year issues and allows the issuer to essentially force holders to convert their debenture to stock if the shares have risen to a certain level above the convertible price (usually 25% above for at least 20 days). This isn’t necessarily a bad thing as it means your convertible debenture has delivered a significant gain up and above your interest payments. In this situation the company will redeem all remaining outstanding debentures at par value (100), or slightly higher, on the specified date if they have not otherwise been converted to shares. Since walking away from a 25%+ capital gain does not make any sense…investors will either sell the debenture on the market before it is actually redeemed by the company or convert to stock at the conversion price. If converted to stock, the stock can then be sold or kept depending on what one’s view is. In all cases though convertible debenture holders are “forced” to do something.
In a timely example, Cargojet announced on May 15th, 2017, that they were forcing conversion of their 5.50% 30JUN19 convertible debenture as of the upcoming June 30th, 2017, “Soft-Call Date.” As per the company’s right (detailed in the Indenture) all of this debenture outstanding on July 5th, 2017, (along with accrued and unpaid interest) will be satisfied by delivering common shares to debenture holders based on a formula representing 95% of the share price that day (a slight premium over par value assuming that the shares could be sold at that price (the share closed at $44.17 on May 17th). The “Soft-Call Trigger Price” was $35.94 (25% higher than the $28.75 conversion price) and the shares have been trading above this level for several months. Holders of this convertible debenture should therefore either convert their debentures into common shares at $28.75 (notice has to be received by the “Trustee” by 5:00 p.m. in Toronto on July 4th, 2017), or sell their debenture on the market prior to the deadline. If they don’t do either they will likely leave a lot of money on the table. For example, if the share price on July 5th is $44.17, 95% equates to $41.96 – and each $1,000 of debenture outstanding on that date would therefore be exchanged for 23.8322 shares ($1,000/$41.96) – setting aside any additional interest due. However, if converted before the deadline at $28.75 per share the debenture holders would have received 34.7826 shares ($1,000/$28.75). At $44.17 this represents a position valued at $1,052.67 versus one valued at $1,536.35 – a very large difference. As of May 17th, 2017, we held a ~2.4% position in this convertible debenture in the Diversified Income Portfolio acquired at par value (100) in April of 2014.
Many convertible debentures are also issued with a “Hard-Call Date” which typically kicks-in one-year after the “Soft-Call Date.” This feature allows the issuer to redeem the debenture early, usually at par value (100) or sometimes slightly higher, whether or not the underlying shares have risen to any particular level. This feature allows the company to preemptively prevent the possibility of unwanted equity dilution, and/or to take advantage of refinancing opportunities in the market prior to the debentures scheduled maturity. While investors receive their capital back early, losing the remaining coupon payments and optionality of the conversion option for the remaining term can be frustrating as it is often a sign that the company is confident in its future, which often precedes or coincides with a rising stock price. The “Hard-Call Date” for the referred to Cargojet debenture was June 30th, 2018, but in this case it is now irrelevant.
The Canadian Convertible Debenture Market
Canaccord Genuity’s Canadian Convertible Debenture Weekly Summary Report currently lists 143 convertible debenture issues listed in Canada - issued by 92 separate issuers (many issuers have more than one convertible debenture issue outstanding).
Deloitte LLP published a brochure in November 2014 titled “How to avoid the death spiral of converts – The Canadian convertible debentures market” targeted at Canadian public companies looking for advice on how to best refinance previously issued convertible debentures with as little damage to the issuing corporation as possible. Deloitte estimated that the Canadian Convertible Debenture market was approximately $14 billion in size at the time – and aptly pointed out that “few issuers or investors truly grasp the long-term risks associated with these complex products.”
We previously pointed out convertible debentures are issued by a wide range of companies in Canada (size and quality) and they have a correspondingly wide range of risk levels associated with them. They are also issued with terms specific to each individual issue – and it is important to understand what the relevant terms are, and the investment implications. This is one area where it is important to do your homework.
Worst Case Scenario for Convertible Debenture Investors
Convertible debentures are not guaranteed, and in a worst case scenario can go to zero if a company becomes insolvent. However, investors can mitigate this possibility by doing their research and hopefully proactively selling a position before it deteriorates to such a state. Diversification is always important. The Deloitte LLP brochure referred to above summarizes the options available to corporations that find themselves in financial distress. From the perspective though of an investor invested in a “troubled issuer’s” convertible debenture there is often a “Round Two”, or “Second Opportunity,” to recoup their invested capital. These financing options are usually at the expense of the company’s current shareholders to a significant degree.
Often the first choice from the corporation’s perspective is to try and come to a consensual arrangement with the convertible debenture holders to “Amend and Extend” the convertible debenture at issue. These offers typically include lengthening the maturity of a particular debenture, increasing the coupon interest rate and/or lowering the embedded conversion price.
We have also seen issuers invoke an often embedded right to pay-off a maturing outstanding debt issue by issuing stock in-lieu of cash - at some formula reflecting the company’s current stock price (probably severely depressed in this situation). This is called a “Debt/Equity Swap” and typically results in a severe dilution to a company’s common shareholders (prior to the Swap) – and in some cases effectively wipes them out as the convertible debenture holders (prior to the Swap) end-up inheriting most the company’s equity. If a significant amount of debt is converted to equity in this situation though, the overall risk profile of the firm may improve significantly, and the “new” shares and shareholders might see a significant improvement – possibly to a level that fully compensates previous convertible debenture holders for their original investment. Outright capital gains are also possible, as outlined in our example below. Note, also that a “Debt/Equity Swap” is sometimes the result of a formal process to reorganize a company’s debt obligations if a consensual arrangement cannot be reached.
“Reorganization” or “Arrangement” under the Canada Business Corporations Act (CBCA)
Deloitte’s brochure does a good job of outlining the options that a company can undertake if a consensual arrangement with convertible debenture holders cannot be made. A company can file for a either a “Reorganization” under section 191 of the Canada Business Corporations Act (CBCA) - often in conjunction with the Bankruptcy and Insolvency Act (BIA), or the Companies’ Creditor Arrangement Act (CCAA) whereby the debt and equity of a corporation can be amended.
Alternatively, if “not insolvent”, a company can file for an “Arrangement” under section 192 of the CBCA as outlined by Deloitte, which is a potentially streamlined restructuring process.
In these situations secured lenders are usually made whole after outstanding taxes are paid, and payrolls made current. Unfunded pension obligations also enter the mix if applicable. Next in line are the unsecured lenders including convertible debenture holders - which in almost all cases rank ahead of both the preferred shareholders and common shareholders. If you are concerned about getting your money back in a “worst case scenario” it is important to know where a particular issuer’s convertible debentures rank in its capital structure.
An Example of a Successful “Debt/Equity Swap” Convertible Debenture Restructuring
In late 2011 Holloway Lodging REIT announced that company was going to issue new equity units to holders of the company’s 6.50% 30JUN12 convertible debentures in-lieu of cash. This decision effectively wiped out the company’s current unit holders. Each $50,000 of outstanding convertible debenture was swapped for 765,394 units in the company at an average deemed price ~ $0.065 in January 2012. The company then did a 1 for 40 share consolidation – which meant if you were a previous convertible debenture holder your break-even price to get back your original $50,000 of capital was $2.61 per unit. By November 2012 Holloway’s newly consolidated units were trading in the $3.75 range. If an investor had bought their convertible debentures on the original issue date in June 2007 at par value (100) – and went through the reorg process described above, they could have realized ~ 44% capital gain on their original investment after a few months after the Debt/Equity Swap plus would have collected 6.5% per year for ~ 4.5 years prior to the conversion to equity. In comparison the original unit holders (equity owners) saw their capital pretty well wiped-out over the same period, off-set by dividend payments for a few years.
An Example of a Successful “Amend and Extend” Convertible Debenture Restructuring
In September 2009 we purchased a position in the IBI Group 7.00% 31DEC14 convertible debenture in the Diversified Income Portfolio – convertible at $19.17 per share. For reference IBI Group traded between $14.50 and $15.49 that September – and closed the month at $15.00 per share. IBI Group was one of the larger Canadian architectural and engineering firms at the time, but subsequently ran into problems coming out of the financial crisis related to an overly aggressive prior acquisition strategy and sluggish business prospects. On July 16th, 2014 IBI Group received approval from holders of this particular convertible debenture to re-set the terms of the debenture as follows: the maturity date was moved out by five years to June 30th, 2019, and the conversion price was lowered to $5.00 from $19.17 per share. The debentures 7.00% coupon rate was left unchanged though. At the time, this refinancing was viewed as a good result for the company - and the underlying shares moved up 57.7% from July 16th to July 31st 2014 – closing at $2.05 per share. The restructured convertible debentures closed at a price of 66.00 that month.
Fast forward to September 29th, 2016, and IBI Group had improved to such an extent that they announced the “forced conversion” of this particular convertible debenture – effective as of October 31st, 2016. We then sold the position on the market within a few days at an average price of ~120 – which translated into a ~ 40% capital gain in the portfolio as our average cost was ~86 (we had added to our position as low as 59). In this case if someone had bought the debenture when it was first issued in September of 2009 – and held it right through to the restructured forced conversion in September 2016 – they would have realized ~ 20% capital gain over the seven years – plus would have received coupon interest payments of 7.00% per year for seven years. In comparison, IBI Group’s common shares were valued at $6.08 per share as of September 30th, 2016 – and investors that maintained exposure since the original convertible debenture issue date in September 2009 would have been down ~ 59%.
The Canadian Convertible Debenture Project
Felix Choo, a Chartered Financial Analyst working in the financial service industry in Alberta, recently launched the “The Canadian Convertible Debenture Project” Blog in his spare time which can be found at: https://convertibledebentures.blogspot.ca/. Note, we do not have any relationship with Felix Choo and are not responsible in anyway for the information on his Blog. Having said that we think his site can be a useful resource for individual investors researching their own convertible debenture investments.
Diversified Income Portfolio: Exploiting Convertible Debenture Opportunities
We established the Diversified Income Portfolio in March of 2008 (prior to the financial crisis) as a discretionary mandate within Canaccord Genuity’s Private Investment Management (PIM) program. As of April 30th the Diversified Income Portfolio was up 5.4% in 2017 and 17.1% over the last 12-months after all fees, for all clients. Since inception, March 4th, 2008, the Diversified Income Portfolio has returned 5.9% annualized per year, after all fees for all clients.
As of June 30th, 2017, we will be reporting returns for this mandate as “Gross of Fees, net of transaction charges” going forward to provide more transparency. On this basis the Diversified Income Portfolio is up 5.9% in 2017 as of April 30th, and 18.9% over the last year. Since inception, March 4th, 2008, the Diversified Income Portfolio has returned 7.2% annualized per year “gross of fees, net of transaction charges” for all clients. Management fees range from 1.00% to 2.00% depending on account size. Our minimum account size is $100,000.
The primary portfolio objective of the Diversified Income Portfolio is to provide a high level of sustainable, tax-efficient, monthly distributions generated from a diversified portfolio of cash generating investments.
The Diversified Income Portfolio provides diversified exposure to a wide range of income generating securities with capital preservation being paramount at all times. While this portfolio can hold Government Bonds, Investment Grade Corporate Bonds, Preferred Shares, and dividend paying Common Shares, when it makes sense to do so, the Diversified Income Portfolio specifically targets attractive investment opportunities that are often not available to large institutions due to size constraints and liquidity limitations. Specifically, this portfolio looks to exploit opportunities in the Canadian Convertible Debenture market, discounted Closed-End Funds (with upcoming redemption dates at 100% of Net Asset Value) and a number of other areas. While Government Bonds have an important role to play in many portfolios today for safety of capital and diversification purposes - relying on them for “income” does not always make a tremendous amount sense. Additionally, relying solely on the stock market for “income” introduces too much uncertainty for many investors relative to their comfort level.
The Diversified Income Portfolio seeks out the easiest and safest ways for retail investors and small institutions to generate income and attractive returns - in any environment.
The assets in the Diversified Income Portfolio are currently sitting at ~ $18.5 million – very small in the investment world. Based on the current size of the Canadian Convertible Debenture market, and also opportunities available to acquire discounted Closed-End Funds, we are planning on reevaluating the capacity of this mandate to accept new client assets once we hit $50 million. If the market grows significantly, we could possibly go a little higher in the future, but this is not the sort of market that investors with large pools of money can easily exploit. We don’t expect to be competing with the Canada Pension Plan for issues for example.
Currently the Diversified Income Portfolio is 36% exposed to Canadian convertible debentures: 20 separate issues from 15 different issuers with an average Current Yield of ~ 5.2%. Two examples below:
Convertible Debentures Recently Added to our Diversified Income Portfolio – Two Examples:
Just Energy 6.75% 31DEC21 Convertible Debenture
In late 2016 we added a ~5.2% position in the Just Energy 6.75% 31DEC21 ($9.30) convertible debenture to the Diversified Income Portfolio. We acquired this position an average price of ~99.00 – and the debenture closed at 107.50 on May 17th, 2017 (up ~8.6% from our acquisition cost). Just Energy sells natural gas and electricity contracts to over 4 million residential and commercial customers via fix price contracts across North America and the UK and currently has a market capitalization of ~ $1.2 billion. The company’s largest shareholders are billionaire(s) Jim Pattison with a ~16% stake and Ron Joyce (Tim Hortons) who own ~14% of the company (and had added significantly to his positon in the past year). Additionally, the CEO has as substantial portion of net worth tied up in the company with a ~4% stake - another encouraging sign.
A key “Rule of Thumb” with Convertible Debentures is that if you are comfortable owning a company’s common shares you should be comfortable owing a company’s convertible debentures as they have priority over shareholders - both preferred and common - in the event of a restructuring, or dissolution in a worst case scenario. If you are not comfortable owing a company’s underlying shares you should probably stay away from its convertible debentures -unless you are proficient at credit analysis. In this case we take comfort in the fact that Jim Pattison, Ron Joyce and the CEO would need to see their equity stakes effectively wiped-out prior to our convertible debenture position being at risk. This adds to our expectation that at a minimum this investment will generate the coupon interest payments of 6.75% per year for five years and then return of 100% of the capital invested by the maturity date. Just Energy closed at $8.26 on May 17h, and the current consensus 12-month price target is $9.05 per share (Bloomberg). This debenture’s embedded conversion option provides significant further upside.
Tricon Capital 5.75% 31MAR22 USD Convertible Debenture
In March 2017 we bought a new ~4.5% position in the Tricon Capital 5.75% 31MAR22 $10.46 USD Convertible Debenture on the market at 102.42 USD – which closed at 106.00 on May 17th. The company had recently announced a “Transformative Transaction” to acquire 100% of Silver Bay Realty Trust in an all-cash accretive deal valued at ~ $1.4 billion which closed in May. This transaction positioned the company as the fourth largest public company owner of Single Family Residences in the U.S. with 16,809 homes, enhances the company’s market density in key markets and also provides a number of other advantages. We have followed Tricon Capital since April of 2012 and have booked significant gains in both the company’s shares and other series of convertibles in the in the Diversified Income Portfolio in the past. Additionally, we continue to hold a ~1% position in Tricon’s 5.6% 31MAR20 $9.80 convert in this portfolio since it was issued in Feb 2013 at par value (100) – which closed May 17th at 121.13 (up 21.3%). Tricon Capital’s shares closed at $11.06 (Canadian) on May 17th, and the current consensus 12-month price target is $13.69 (Bloomberg). The embedded conversion options on both of these Tricon Capital debentures provide significant further upside potential over the next few years.
Most retail investors are not familiar with convertible debentures and bonds – and get somewhat intimidated by the sheer volume of unfamiliar terms related to the asset class as discussed above and as they dig deeper. Note, we have left out references to the most “sophisticated terminology” used in the market to discuss convertible bonds and debentures including the “Greeks” - i.e. “Delta”, “Gamma”, “Theta” references – and also sophisticated convertible debenture strategies such as “Delta Hedging.” For most investors there is no need to further complicate the analysis and identification of attractive convertible debenture opportunities.
Recognized convertible bond authority Bill Feingold concisely summarized the attractiveness of convertible bonds [and debentures] in a November 26th, 2013, CNBC article titled: Convertible bonds: Best of both worlds?
When most people think of investments, they want three things: significant appreciation potential, current income and safety of principal. Neither stocks nor traditional bonds offer all three. Convertible bonds do, and it’s a hard combination to beat.
Ben Feingold has been a recognized authority in convertible bond market for over twenty years and regularly appears in major financial online, print and broadcast media. His firm Hillside Advisors LLC advises institutional and individual investors and corporate issuers on convertible bonds and related investments. Previously, he has served as a portfolio manager for Wellesley Investment Advisors, a leading manager of convertible bonds. Before Wellesley, Bill served as Managing Director and Convertible Strategist at BTIG LLC in New York, having also traded convertibles for the firm. Bill has also traded convertible bonds for Goldman Sachs, and has been visiting lecturer at Yale University, along with writing a few books – one of them titled: Beating the Indexes: Investing in Convertible Bonds to Improve Performance and Reduce Risk.
In Canada I have been investing in convertible debentures personally and on behalf of clients for over twenty years – and our Diversified Income Portfolio, which I manage directly, has been exploiting opportunities in this area since March of 2008. My team and I strongly believe that the Canadian Convertible Debenture Market regularly offers extremely attractive risk/reward opportunities which are being overlooked by most investors or are completely off of their radar.
Investing in the Convertible Debenture Market may not be suitable for all investors as there are unique characteristics and risks involved with these securities. Please contact us if you would like to find out if convertible debentures are suitable for you, or if you would like to know more about them.
In regard to our Diversified Income Portfolio please let us know if you would like to receive a copy of our latest Quarterly Commentary and Quarterly Summary. Additionally, please let us know if you would like us to add you our email distribution list to receive regular Monthly Updates on the portfolio.
Paul J. Borisoff BBA, CIM, FCSI, AIFPTM
Senior Vice President, Portfolio Manager, Senior Investment Advisor
Canaccord Genuity Wealth Management
609 Granville Street, Suite 2200, Vancouver, BC V7Y 1H2
T: 604.643.7083 | TF: 1.800.663.1899| F: 604.601.5942
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