General Strategies

As they say, investing is as much art as it is science, and convertible debentures (convertible bonds) aren't any different. Both quantitative and qualitative factors influence pricing of the market, and ultimately risk and return.

Investing your hard-earned money isn't easy.  To better the odds of success, I'm of the opinion that one's investment approach should be grounded in clear objectives. The next step is formulating sound strategies to achieve those achieve those objectives.  Finally, implementing on the strategies in a cost-effective manner and instilling the discipline to stick with the overall approach over the long-term are essential.  Successful long-term investing is like shampoo: lather, rinse, and repeat.

In this post, I discuss a few of the high-level strategies I follow to invest in the Canadian convertible debentures market.  As usual, my disclaimer is that these opinions are my own - your mileage may vary, and it's always a good idea to speak to a qualified investment professional before undertaking any investment actions.  

Diversification

Diversification is really the only "free lunch" in investing.  This is, of course, the don't-put-all-of-your-eggs-in-one-basket principle. Generally, one's wealth should be well-diversified among the major asset classes - bonds, equities (stocks), real estate, and the like.  Although portfolio-wide asset allocation isn't the focus of the Canadian Convertible Debentures Project, diversification, as a key principle is undeniable if one wants to achieve superior risk-return outcomes.

As a hybrid security, I'm of the belief that convertible debentures are a good fit for a portion (only a portion!) of the fixed income allocation of a portfolio.  And within the portion of one's portfolio that's earmarked for convertible debentures, I'm also strongly of the belief that any convertible debentures that form a part of the allocation should be diversified by issuer, industry sector, currency denomination, and maturity.  Diversification! And just so you know I'm being serious - diversification.

Capital Preservation

At the end of the day, a convertible debenture is a bond, and when in investing in a bond, your #1 priority is getting your money back. In other words, capital preservation is a key consideration, and key to capital preservation is knowing what credit risk you're taking.

Although there are currently some 130 different convertible issues, not all are good credit risks. Thus, it pays (or, saves) to have knowledge of the balance sheets and business prospects of the issuers of debentures that you are interested in.  To get your money paid back, the company has to at the very least stay solvent until your convertible debenture matures. Know the potential risks.  Investing in convertible debentures is not the same as investing in a GIC or term deposit whose principal is guaranteed by deposit insurance.  

Like the Equity

My general rule is this: if you don't like the prospects of the underlying shares of the issuing company, then don't buy the convertible debenture either.  Out-sized gains in convertible debentures are primarily driven by increases in the underlying common shares and, specifically, beyond the conversion price. In other words, if the common shares have potential, then the convertible debentures will have potential as well.

Look for Value

The Canadian convertible debentures market is relatively small and illiquid, and doesn't garner a whole lot of attention.  This means this isn't the most efficient market and, as such, offers potential for returns above market returns.

What you pay for a particular convertible bond issue matters.  I use the Peanut Power Rankings and the quantitative model which supports it as an indicator for absolute and relative value.

Important: cheap does not necessarily mean good value.  We'll cover the concept of "busted convertibles" in a future post, but for now, know that if the debenture price is well below par value and yields are abnormally sky-high, there are special risks to consider. 

Read and Research

When investing in inefficient markets, information is valuable.  Read company annual reports, financial statements, and investor presentations on investor relations websites.  Know the business before investing in the business - looking before you leap is just common sense. 

Also, read prospectuses for convertible bond issues.  To find a given prospectus, get familiar with the Canadian Securities Administrators' SEDAR website, which has an accessible database of all regulatory filings (in PDF format) of all Canadian public issuers.  Although prospectuses are filled with legal jargon, they are an invaluable of source of information that describes the exact terms of the issue, risk considerations, and company considerations.  

Tax Efficiency

Coupon payments from convertible debentures are fully taxable as income and, currently, 50% of any capital gains earned on sales of a debenture are also taxable.  As such, an ideal place to hold convertible debentures for investment is in registered plans such as a TFSA or RRSP, where interest and capital gains are sheltered (in the case of TFSA) or effectively deferred (in an RRSP) for the purposes of income tax.  

Limit Orders

When placing an order to buy or sell a convertible debenture, never use a market order.  Bid-ask spreads can be wide given the illiquidity of the market and placing a market order can commit you to paying (or selling at) a price that could drastically affect your ultimate rate of return.  Instead, know your price and set a limit order instead.

Take Profits

One of the main potential benefits of convertible debentures is equity-like returns.  When I'm fortunate enough to have equity-like returns in what is effectively a type of bond, I don't hesitate to sell the debentures and take the profits.  As the old adage states, no one ever went broke taking profits.

Picture of the Day

 
Avoid frustration by having a strategy for investing in Canadian convertible debentures.  A female sea otter (Enhydra lutris) at the Vancouver Aquarium in Vancouver, British Columbia, Canada.  Copyright © 2016 Felix Choo / dingobear photography.  Photo is available for licensing at Alamy Images. All rights reserved. Photo may not be reproduced without permission.

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