Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
Looking for higher bond yields? Forget Portugal or Greece – shop the TSX.
Investors in the bond market know that as they stretch for higher income, they take on additional risk. With Government of Canada two-year bond yields at 1 per cent, there is so much stretching going on that the bond market looks like a yoga class.
If you are willing to move aggressively up the risk spectrum in search of higher yields, you could check the yields available on debt of some European countries that are often in the headlines for the wrong reasons. For example, two-year Greek government bonds yield 7.6 per cent while Turkey delivers a yield of 10.8 per cent. They reflect the risk assessment of professional traders at multinational banks and mutual funds, but I am not seduced.
Not when you can buy a basket of a dozen Canadian convertible bonds listed on the Toronto Stock Exchange with yields to maturity in excess of 20 per cent.
Here are three of my sample holdings with increasing degrees of scariness – a non-technical term for risk.
6.5 per cent due Dec. 31, 2016.
Price: $66, yield to maturity 24.5 per cent
Not long ago, Fortress was a glamour stock, which is why the bonds are convertible into common shares at $37.50 – a far cry from the current price of $3.35. More recently, it has been struggling to achieve profitability at its dissolving pulp specialty paper mill in Thurso, Que. On a positive note, Fortress sold a wallpaper-backing paper mill last April for $212-million. As a result, it had $115-million in cash on Sept. 30, 2013 – a healthy cushion of liquidity for nervous bondholders.
Data Group Ltd.
6.0 per cent June 30, 2017.
Price: $52, yield to maturity 31.0 per cent
The company is moving from an old-economy document-management printer to a Web-based solutions provider. The balance sheet is quite leveraged, but the company recently renewed its borrowing facility, so that lender at least was willing to stay the course.
IBI Group Inc.
7.0 per cent due Dec. 31, 2014.
Price: $58, yield to maturity 105.0 per cent
The promised yield on this bond is twice that of short-term Ukraine government bonds. In contrast to Kiev, however, you can actually visit this company’s head office on Richmond Street in Toronto to ensure that the lights and heat are still on. I did, and they are.
We all know that there is no such thing as a free lunch, so what can go wrong?
First, the company could simply declare bankruptcy. Yes, you own bonds, not shares, but your position is so low on the totem pole that there will be nothing left after the bank and secured creditors are paid. There is a non-trivial probability of this occurring, which is why you need a basket of bonds.
Second, the company may try to negotiate a deferral in the maturity date. They will likely offer sweeteners such as an improved coupon and a more attractive conversion price on the stock. Depending on your outlook for the company and its industry, this may be a satisfactory outcome.
Third, many of these bonds permit the company to pay off the maturity value in common stock rather than cash. The value of the shares to be issued is based on the price at the maturity date, not the much higher conversion price, and this would result in huge dilution.
Fourth, some of the bond indentures provide that in the event of a change in control, such as a takeover, the bonds must be redeemed at par. Many of these companies are struggling, so they may be attractive takeover candidates, although the need to cash out the bondholders in full could represent a poison pill to an acquisitor.
Finally, the company could successfully revive the business to its former glory and simply pay off the bonds in full at maturity. This seems highly unlikely right now, but the current disaster scenario was equally unlikely a few years ago when these bonds were first issued.
There are about a dozen similarly priced convertible bonds listed on the TSX. Clearly, they could go bankrupt tomorrow, which is why the yield is so high and why I own a basket of the bonds as only a small part of my fixed-income portfolio. They trade with a wide bid-ask spread and exhibit alarming volatility, so they are not for the faint of heart. You don’t need to be a lawyer, but you really must read through the prospectus that accompanied the bond issues so you understand the payment and redemption options open to the company.