An income investment for greater fun and profit
Bonds, GICs and other income investments are so low that it’s time to find a better way, says this Canadian expert — convertible debentures.
How dull are income investments these days?
Here’s how one expert in the field puts it.
“The Canadian government has a deal for you. Loan them $1,000 for a year, and they will pay you enough interest to buy a cup of coffee and a donut; maybe two donuts.”
The words are those of Mr. David Baskin, head of his own financial services firm and a frequent guest on business TV. He’s talking about the latest Canada savings bond, which offers the low, low rate of 0.4 per year, which pretty much rounds down to zero.
“It is amazing to me that the government is even bothering to spend the money to advertise these remnants of the past,” he writes in The MoneyLetter. “It is even more amazing that anyone would consider buying them.”
So he goes in search of a more exciting form of income investing. And finds it in convertible debentures. He explains the nuts and bolts of these investments, and recommends three of them.
A far better return
Canadians have over $1 trillion locked up in low-yielding brokerage accounts, savings accounts and money market funds, says Mr. Baskin.
It’s perfectly understandable that many investors are wary of stocks — even the dividend-paying variety — after the market mayhem of 2008, he realizes. “Nonetheless, it does not take much imagination or work to get a far better return.”
Better returns only come with the assumption of greater risk, he admits. But prudent investors must learn to evaluate risk.
“They must be able recognize those securities which are truly dangerous to their financial health compared to those which may look a little shaky, but are in fact solid and relatively safe.”
In fact, safe can turn into sorry, he points out. A retired couple with a nest egg of $1 million who purchased a three-year GIC in 2006 would have received interest of about three per cent a year, or $30,000. Roll that over today, and they get 1.5 per cent, cutting their income substantially.
Priority over dividends
Now consider convertible debentures, Mr. Baskin says. They are simply bonds issued by companies. They pay interest regularly, usually twice a year.
The interest payments on debentures take priority over dividends. No dividends can be paid until the interest on debentures has gone out. By the same token, if the company fails or has to reorganize, debenture holders must receive their principal before shareholders get anything.
Debentures are usually rated by one of Canada’s big bond rating agencies. They will be rated lower than government bonds, of course.
Institutional investors rarely buy anything with less than a BBB rating, so you’re taking a greater risk with debentures under this level. Naturally smaller companies will get lower ratings than blue chips.
Convertible debentures are often traded on the exchange under the company’s symbol with “db” or “d” affixed to it.
That’s what they are. Here’s how they work.
In and out of the money
There’s a bonus with convertible debentures that makes them attractive beyond the interest rate, says Mr. Baskin. This is “the opportunity to participate in the growth of the issuing company.”
The holder can swap his or her debentures for shares of the company at a pre-determined price.
When the conversion price is higher than the price at which the shares trade, the debenture is said to be “out of the money.” Debentures can still trade over par if the stock is expected to rise, or if there is a long period before the eventual conversion.
When the stock price rises above the conversion price, the debenture is “in the money,” and will start to trade in sync with the stock price.
At this point, Mr. Baskin says, it is not unusual to see debentures trading at twice their face value, or more. (But be forewarned, he adds — once the conversion price has been met, holders of some debentures can be forced to convert into shares at a pre-set target after a certain date.)
Now he gets down to specifics, with three debentures he likes.
Yield and conversion
Aecon Group (TSX-ARE.DB), the construction and engineering firm, has debentures convertible at $19.00 a share until September 30, 2014.
The shares are trading around $14, so the conversion price is 35 per cent higher than the price. This is the conversion premium. The coupon sets the interest at 7 per cent, the debenture is priced at $105 and the yield to maturity is close to 6 per cent.
“Currently the company is benefiting from government infrastructure spending, a growing order backlog and a strong balance sheet.”
Thus this Aecon debenture is a buy for both yield and possible conversion, says Mr. Baskin.
Cinexplex Galaxy Income Fund (TSX-CGX.UN.DB) has about 66 per cent of the box office business in Canada and more business on the way in 3-D movies.
It has a debenture with a 6 per cent coupon, priced at $104.50 and yielding 5 per cent to maturity. Due December 31, 2012, its conversion price is $18.75.
That’s not far above the current unit price of $17.95. Cineplex is a buy for probable conversion and yield.
Crombie REIT (TSX-CRR.UN) is one of eastern Canada’s largest commercial landlords and is owned by Empire Corp. (which also owns Sobeys). It has a debenture with a 6.25 per cent coupon due June 30, 2015, priced at $103 and yielding 5.7 per cent to maturity.
The conversion price is $11.00 and the units are trading at just above $10. This is a buy, Mr. Baskin tells his readers in The MoneyLetter, for a likely conversion as well as for yield.
Safety first is no bad principle, this author admits. But when safety means principal and not much interest, it’s time to put a little more excitement in your income investments.
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