Convertible Debentures: Trade-off a little less upside for a lot less downside
Paul Borisoff - Mar 05, 2019
Convertible Debentures: Trade-off a little less upside for a lot less downside
Last month I highlighted a few convertible debenture positions which we bought in our Private Investment Management Diversified Income Portfolio recently (December 2018). This is our primary income mandate which I manage on behalf of clients on a discretionary basis – and represents our best “income ideas”. If you recall a convertible debenture has some of the features of both a bond and equity. Convertible debentures are issued by corporations. They have a set coupon rate (interest rate), maturity date and maturity value, along with a built-in conversion option to equity at a pre-determined price (at the holder’s option) - which can provide significant upside potential above the maturity value (face value).
A key point I made in my last update was that 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. Our two Chemtrade Logisitics Income Fund convertible debenture positions which I highlighted last month are a great example of this statement.
Between December 7th and December 17th Chemtrade Logistic Income Fund’s underlying units traded in the $10.19 to $11.38 per unit range - and finished the year at $10.48 – valuing the company at ~$1 billion. In my December 20th update I mentioned that that average consensus twelve-month price target was $16.75 per unit (Bloomberg) – and that “after taking a little closer look at the firm’s balance sheet, and some of the expectations around the business as per the various analyst comments, Chemtrade does look interesting to us as a possible equity investment.”
As previously described though we chose to focus on the company’s convertible debentures – which in my opinion represented a significantly lower level of risk - yet still offered a very attractive rate-of-return. On December 14th we bought a new position in the Chemtrade Logistics 5.25% 30JUN21 convertible debenture (convertible at $28 per unit) at a price of 91.07 - which equated to a 9.3% yield-to-maturity (average return each year for two and a half years). We also added to our position in the Chemtrade Logistics 4.75% 31MAY24 issue (convertible at $26.70 per unit) at an average price of 81.06 between December 7th and December 17th - which coincidentally also equated to a 9.3% yield-to-maturity.
On February 13th, 2019, Chemtrade Logistics reported the company’s full year 2018 and fourth quarter financial results. Unfortunately, reported results and management’s outlook did not meet investor expectations by a wide margin – which immediately sent the company’s equity units lower (they closed at $9.39 on February 28th – down 11.4% from their January 31st close of $10.60 per unit).
On February 14th the Raymond James analyst nicely summed up the markets’ new sentiment towards Chemtrade Logistics after their latest update: “While we’re inclined to believe 2019 will bring improvement, we’re also of the view that persistent missteps over the past 18 months leave the company firmly in the ‘show-me’ camp at this stage.” Most analysts covering the company immediately lowered their price targets – and as of February 28th the average consensus twelve-month price target (Bloomberg) is now $12.38 per a ~26% reduction from what they had in mid-December.
In contrast to the recent sell-off experienced by equity holders our convertible debenture positions moved higher in February – and are now significantly higher than where we acquired them in December.
While Chemtrade Logistics equity units fell 11.4% in February – our 5.25% 30JUN21 convertible debenture moved up 1.8% in February (from 95.00 to 96.75) and is now up 6.2% from our December purchase – excluding accrued interest. The 4.75% 31MAY24 convertible debenture which we last added to at 81.06 in December (average) also moved up 1.8% in February (from 84.00 to 85.50) and is now up 5.5%. Based on its February 28th closing price the Chemtrade Logistics 5.25% 30JUN21 convertible is now offering a yield-to-maturity of 6.8% per year (for just over two years) while the 4.75% 31MAY24 issue is offering 8.2% per year – which we continue to view as attractive in both cases.
Note, while the company’s latest results were not great - we do not believe that the company is at risk of becoming insolvent or going out of business in the foreseeable future. There are many things the company could do to improve their finances if required – including reducing or eliminating their current dividends being paid to equity holders -which we do not think is being considered at this time.
We buy convertible debentures for one of two reasons: 1) they represent what we believe to be good value – and an attractive rate-of-return based purely on a yield-to-maturity basis or 2) they represent a safer way to gain exposure to the underlying common shares based on both the yield-to-maturity on offer – and the “optionality” provided by their built-in conversion feature. In all cases we do not initiate positions if we are concerned about the company’s solvency, and ability to remain in business over the time horizon of our convertible debenture exposure.
Our recent Chemtrade Logistics convertible debenture purchases were an example of “Buy” reason #1 highlighted above – as we were definitely not expecting to see the units appreciate anywhere close to the $26.70 to $28.00 range – never mind above these levels where we could see additional upside. In both cases we viewed the yield-to-maturity on offer very attractive (9.3% per year at the time) – with the optionality provided by the debentures built-in conversion features a non-issue. For our convertible debenture investments to provide the return expected we simply need to have Chemtrade Logistics remain in business and solvent – which we fully expect.
This recent experience with Chemtrade also highlights our statement last month: “I have often found that investing in convertible debentures issued by good quality companies at opportune times provides a much higher degree of “return certainty” than relying on the future value of a stock or the stock market.” There are of course no guarantees when dealing with equity investments. Things happen. Company’s “miss” quarterly earnings expectations – as Chemtrade just did, economies go through cycles, politicians tweet, weather events happen, etc., etc. etc. And there is nothing wrong with that. That is what the market is all about: Risk and Reward.
Note, we do regularly buy equity positions in our managed portfolios when they offer what we believe is an attractive risk/reward ratio – and fit within our mandate parameters. We always look though to see if there is possibly a better way to be exposed to any company or situation based on what other alternatives are available in the firm’s capital structure – i.e. bonds, preferred shares and convertible debentures.
If you would like to see our recent Diversified Income Portfolio comments - including details on recent changes to our convertible debenture positions, please let me know. I spend a great deal of time monitoring this asset class – and would be happy to discuss any current opportunities which we see.
As always please do not hesitate to contract me directly if you any questions – or would like to discuss your current portfolio and investment strategy.
Paul J. Borisoff BBA, CIM, FCSI, AIFPTM, RIAC
Senior Vice President, Portfolio Manager
Senior Investment Advisor
Canaccord Genuity Wealth Management
609 Granville Street, Suite 2200, Vancouver, BC V7Y 1H2
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