At a time when government bonds yield less than 1 per cent, it may be a surprise to discover that it is possible to invest in a basket of Canadian convertible bonds issued by companies listed on the TSX with yields to maturity in excess of 20 per cent. Clearly, these astronomical yields are telling us that investors place a low probability on the bonds paying off in full at maturity. Although it is true that these bonds are extremely risky, recent work in behavioural finance tells us that investors feel greater pain from a loss than pleasure from a comparable gain. So it is possible that the risk is overstated and the bonds, as a group, are inefficiently priced. In other words, a bargain for well-diversified investors.
The year to date has provided a crash course in all the things that can go wrong when investing in high yield bonds, which may be a good starting point before getting behind the wheel. But first, a quick description of a "busted convertible."
A convertible bond provides the holder with the option to receive payment at or before maturity in the form of shares in the underlying company at a fixed conversion rate or price, typically a small premium to the stock price at the time of issue. This option is valuable if the stock price rises over time, but if the company faces hardship and the stock price craters, the option has no value and the bond price usually deteriorates because investors are concerned that the problems facing the company will spill over into the balance sheet. At that point, we have a busted convertible bond.
In thinking of what can go wrong, the worst-case scenario is for the company to simply default and there is no recovery for the investor. It is true that you own a bond, but after the bank and secured creditors have been paid, there will be nothing left for those lower down on the totem pole. This outcome unfolded for holders of convertible debentures in Armtec Infrastructure Inc. in April of this year when it filed for protection under Companies' Creditors Arrangement Act (CCAA). It is difficult to believe that a company involved in basic infrastructure services could go out of business at a time when governments see this as a priority, but high financial leverage and poor bidding discipline are problematic in every industry.
The remaining scenarios are not necessarily fatal, but will almost certainly result in a change in the terms of initial investment.
In order to stave off a looming maturity, the company may try to negotiate a deferral. In order to do so, management will likely offer sweeteners such as an improved coupon rate, a lower conversion price or some other bonus. IBI Group Inc (IBG) followed this route when it extended the term of its 2014 bonds to 2019, cut the conversion price to $5 from $19 and threw in a bonus coupon. Those bonds have subsequently rallied in price as the company appears to be in a recovery mode.
Almost all convertible bonds permit the issuing company to pay off the principal at maturity in common stock rather than cash. The value of the shares to be issued is based on the price prevailing at maturity, not the much higher conversion price, so there will likely be huge dilution for the common shareholders. The good news is that you receive shares worth the full face value of your bond, the bad news is that everyone else is in a selling mode, too. Just this month on Nov. 9, Anderson Energy (AXL) proposed to redeem both issues of convertible debentures at a conversion price of 4 cents a share. If approved, the share count will go from 172 million to a staggering 2.8 billion.
This option does not require the company to redeem the entire issue in the form of shares: On Nov. 13, Data Group Ltd. (DGI) announced that it would redeem with shares 75 per cent of its outstanding 6-per-cent convertibles due in June, 2017. The result will be a share count in excess of 500 million, up from 23.5 million currently, but the transaction will presumably make the balance of the issue more viable.
Finally, there is an outside possibility that the company's fortunes will be reversed: It will return to financial health and pay off the bonds in full at maturity. At present, the odds look slim, but no one expected the reversal that trashed the stock in the first place so it should not be dismissed out of hand. IBI Group, mentioned above, announced on Nov. 18 that it would redeem for cash its entire issue of 5 3/4-per-cent convertibles due June 30, 2017. For a bond that had been trading at $65, this redemption at par came as a pleasant surprise.
With this range of possible outcomes, it is understandable that investors impose a high risk premium when valuing busted convertible bonds. It is also no accident that in the opening paragraph I referred to a "basket" approach to investing in this sector. No matter how much homework you do, there will be unpleasant surprises, so diversification is key. If you have the temperament and financial resources to pursue this strategy, here are some suggestions for further research:
– IBI Group (IBG) is a consolidator of architectural consulting firms with headquarters in Toronto. It has several issues of convertibles outstanding with yields ranging from 18 per cent to 22 per cent. The 7 per cent of June 30, 2019, yield only 18 per cent because the conversion price at $5 is a feasible target over the next four years while the other issues have higher yields to compensate for a conversion price closer to $20.
– 5N Plus (VNP) produces very high purity metals for technology and pharmaceutical applications. The 5 3/4-per-cent convertibles of June 30, 2019, have a conversion price of $6.75 compared with the current stock price around $1.20, which accounts for the yield to maturity of 16 per cent.
– Fortress Paper (FTP) is struggling to achieve profitability at its dissolving pulp specialty paper mill in Thurso, Que. The bonds are convertible at $37.50 and come due in December, 2016, so the yield to maturity of 28 per cent suggests this is not going to happen.
– Zargon Oil & Gas (ZAR) represents the confluence of two of the most-hated sectors in the market today – energy and busted convertibles – so it is a contrarian's dream investment. This oil and gas junior has an issue of 6-per-cent bonds maturing in June, 2017, with a conversion price of $18.80 and a current stock price around $1. The board is currently exploring strategic alternatives. No wonder the yield to maturity on the bond is 46 per cent.
Investment articles usually end with a reminder to do your own research before investing and that certainly applies here. Based on the indicated yields, at least one of the four companies listed above will default before maturity and you should be mentally prepared for that. In addition, it should be obvious that investing in busted convertibles is not for the faint of heart, so part of that research should be a little self-examination of your own tolerance for risk.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.