Convertible bonds: A less risky equity play

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Two articles featuring bad advice today - Convertible Bonds are less risky? Huh I would think most companies which issue CB are lousy, therefore they cannot borrow outright from banks and thus have to resort to CB!

The Straits Times
Dec 11, 2011
Convertible bonds: A less risky equity play

They offer security of traditional bonds, while allowing investors to benefit if the share price rises

By Jonathan Kwok

Many people may be unfamiliar with convertible bonds as an asset class, but some experts say that they could fit into investors' portfolios.

A convertible bond refers to debt issued by a company that may be converted into the firm's shares at certain times during its life, at the discretion of the bondholder.

These bonds offer the security of traditional bonds, while allowing the investor the chance to benefit if the share price rises - by converting his holdings into equity.

Hybrid between bonds and stocks

'The difference is that you get the security of the bond, but at a lower coupon on average than typical corporate bonds,' said Mr Dorian Carrell, analyst of convertibles at Schroders. 'In return, you get the upside of companies including small and mid-caps.'

He added: 'From the companies' point of view, it gives them a cheaper cost of financing and there's a potential dilution of their shares, but only if things go well.'

Like typical bonds, convertibles can have credit ratings, pay interest and have their market prices change over time as they are traded.

At the time of issuance, they will contain an option for the bondholder to convert the debt into shares, at a 'conversion price'.

This option is typically exercisable from a specified date until the maturity of the instrument.

If, over this period, the share price is higher than the conversion price, the investor can make money by converting his holdings into stock, effectively paying a price lower than the market value.

If the share price is below the conversion price, the investor can keep his bonds and continue to receive the coupon payments. This helps to limit the downside of the investment.

Convertible bonds tend to pay lower interest than typical corporate bonds. The coupon on convertibles can vary according to the credit strength of the issuer and the tenure of the debt.

Convertible bonds issued by Singapore blue chips have coupons ranging from 0 per cent - where the bond acts mainly as an option to buy the company's shares in future - to 6 per cent.

Investing via funds

Convertible bonds are typically sold by companies in large tranches of $100,000 or $250,000. There is often little liquidity for convertible bonds, so investors can instead look to invest via funds of these convertible bonds.

Schroders has a convertible bond fund registered here that deals with Asian companies outside Japan. The yield of the fund is about 4 per cent, said Mr Carrell, and investors can choose to be paid regularly or have the interest payments re-invested, to receive a total return when they finally cash out.

Schroders also has another fund holding convertible bonds of companies all over the world.

French bank BNP Paribas runs its Parvest Asian Convertible Bond fund for Asian holdings outside Japan. The bank also runs separate funds for exposure to European or global companies.

There are also selections offered by Aviva, JP Morgan and Lion Global, which are similarly recognised by the Monetary Authority of Singapore for sale here.

Fundsupermart general manager Wong Sui Jau points to another benefit of investing via funds. 'Convertible bonds entail credit risk - there is risk of default by each issuer,' he said.

Since unit trusts hold convertible bonds issued by a large number of issuers, a default by an individual issuer will have less impact on the investor's portfolio.

Risks and rewards

'The convertibles segment has often been considered a less risky way to gain exposure to equities,' said Mr Wong. 'If equity prices rise significantly, the embedded call option gains in value, allowing the investor to gain from capital appreciation.

'Should equity markets tank and the convertible bond is not likely to be converted, the convertible bond will still have some form of capital protection as it is still a bond.'

Risks include the chance of default from companies going under, said Mr Wong. Also, some convertible bonds have terms that require mandatory conversion to shares after a certain period of time, which could turn out to be unfavourable for the investor.

He said that it is not advisable for the investor to have his entire portfolio in convertible bonds, but the segment could be used alongside other bond and equity holdings.

Mr Carrell from Schroders described the risk-reward ratio of convertible bond funds as similar to that of high-yield bond funds or holdings of defensive stocks.

The performance of bond funds will also depend on the 'investment decisions made by the fund manager and how he views the direction of the market', said Ms Mah Ching Cheng, head of investment communications at DBS Bank.

She said that due to the weak equity market, there has hardly been any convertibles issued recently.

'An improvement in market behaviour and sentiment has to take place to provide issuers an opportunity to source for funding via launching convertible bonds,' she added.
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