How do debentures work
Convertible Debentures- Information, Description & Examples
Convertible Debentures for Income & Growth
There are three basic avenues for investing capital in a company. One is by way of debt obligation, the second is as a shareholder. A third method is a combination of the two, referred to as convertible debt, or more commonly as convertible debentures. This combination results in the convertible debenture retaining some features of a debt obligation, as well as the common shares or equity. Convertible debentures are a hybrid security. Debentures without the conversion feature are only a debt obligation, and do not fall into the hybrid category.
Convertible debentures provide the security associated with earning interest, and the opportunity to benefit from increases in share prices of the issuer. Convertible debentures and convertible debenture funds are popular with investors who need income, but don't want to give up the potential for capital growth.
We start with a description of convertible debentures, then consider the main reasons to own them. This is followed with information about the debt and equity aspects of this hybrid security, then some closing comments on risk and two recommendations.
A convertible debenture is an interest bearing, debt obligation which the debenture holder may, at their discretion, exchange for common stock in the company issuing the debenture. The number of shares which the debenture holder is entitled to is based on an exchange ratio that sets the number of common shares that will be received for each debenture held. This is generally expressed as the number of common shares per $1000 (face value) debenture. The terms and conditions applying to convertible debentures are set out in the prospectus and trust indenture. The number of shares which the debenture holder is entitled to receive for each debenture, and the price per share paid by exchanging the debenture for those shares, are set out when the convertible debenture is initially issued.
These term include; the security position generally described as secured, unsecured, senior or subordinated; the maturity date, interest rate, how the debenture is repaid at maturity, i.e. shares and/or cash; and change of control provisions in the event of a takeover. The issuer might also have the right to retract the debentures, usually after a specified date, providing the shares are trading at a premium to the exchange ratio. While the terms for each debenture can vary, it is typical for them to be unsecured and subordinated debt obligations, with maturity dates of 5-10 years. The conversion prices are initially set at between 30-60% of the value of the share price when the convertible debenture is issued.
Why Own Them?
There are approximately 180 investment grade convertible debentures trading on the TSX. A single company can have multiple issues, each with different terms. On average the interest yields for convertible debentures average around 6% paid semi-annually.
The rationale for owning convertible debentures is to earn interest income in expectation the share price of the issue will exceed the stated conversion price for the debenture, causing the price of the debenture to rise. If the share price exceeds the conversion price, the relative amount by which it exceeds the conversion price should increase the value of the debenture. When this happens the debenture is said to be trading 'in the money.' If the conversion price exceeds the share price then the debenture is trading out of the money, however the interest income is still earned until either the debenture matures, or it begins to trade 'in the money' and the holder elects to convert it into common shares.
Ideally, the goal for both issuer and the holder of a convertible debenture is for the price of the shares to appreciate above the conversion price. This allows the issuer to exchange shares for the debenture to eliminate their debt obligation and increases that number of shares outstanding. The increased number of shares outstanding also improves the debt to equity ratio. Everything works out best when the share price rises past the conversion price. If the share price does not rise past the conversion price the holder of the convertible debenture still receives the interest payments until maturity.
From the holder's point of view, a convertible debenture provides interest income that is paid in priority to dividends. The interest income is well suited to registered accounts, plus provides exposure to share price appreciation. From a tax perspective, the interest income is tax deductible to the issuer and there is no tax deducted prior to payment into either registered or non-registered accounts. If the debenture appreciates in price, once converted or sold this amount is taxed as a capital gain in non-registered accounts. Any capital gains from convertible debenture price appreciation are not immediately taxed in registered accounts.
The bond-like similarities include possible elevated priority of interest payments over common and preferred share dividends, and for the return of principle at maturity. Maturities for convertible debentures are typically in the 5-10 year range. The main difference from a bond is the security which backs the debentures. Bonds are typically backed by a specific charge over assets or some type of senior ranking. Convertible debentures generally have no assets backing them and are almost always unsecured obligations of the company issuing them. The strength of priority right to interest is measured by the number of times the earnings cover the total interest the company pays.
This aspect is comprised of the right to exchange the debentures for a specific number of shares based on the exchange ratio. This ratio is set out in the debenture agreement and is fixed as of the date of the debenture issue The exchange ratio is usually expressed in numbers of shares exchangeable per $1000 of debenture value. The difference between the market price of the shares and the price at which the debenture can be converted is referred to as the discount or premium. The amount of the discount or premium very much influences the price of the debenture.
Know the Risks
Convertible debentures are not guaranteed investments; the prices vary with the financial condition of the issuer and trends in financial markets. The best way to invest in convertible debentures is to learn about how they work and to know the financial condition of the companies that issue them. For those that take a bit of time to learn, and have access to the right information, convertible debentures provide an excellent income alternative, while still retaining the opportunity for capital growth. Two issues currently on our recommended list trade under the symbols CHE.DB and EIF.DB.C.
Using the following as an example, we will explain the terms used as column descriptions in our convertible debentures listing with two different prices for the common share. The date to maturity and the general level of interest rates are assumed to be constant. The debenture is assumed to have been bought at par or $1000. The first example will price the debenture out of the money; the second will be in the money.
A $1000, 6% convertible unsecured subordinated convertible debenture maturing in five years, with an exchange ratio of 50. The common shares into which the debenture is convertible have traded in a range of $10-$30.
The debenture would then be convertible at the rate of $20 per share. ($1000/50=$20)
In the money-
If the common shares were trading at $30 and the debenture holder had the right to convert at $20 per share then there is a $10 benefit per share that would be added. The $1000 face value debenture could then be exchanged into 50 shares worth $30 per share or $1500. In theory the debenture would then trade at $1,500 and the holder would continue to collect interest at the rate of 6% on the $1,000 face value debenture.
Out of the money-
If the common shares dropped in value to $10, then the debenture would be exchangeable for 50 shares worth $500. The exchange would not occur since the holder would lose $500. The reason to hold the debentures would be to receive the 6% interest payment, and the debentures would be trading out of the money and be valued based on the security and amount of the interest payment.
Description of Key Terms Used in IncomeResearch.ca Debenture Listing
Price – market price of the debentures based on TSX exchange prices for the date specified
Interest Rate – interest rate based on the face value of the debenture
Unit Price – current price if the common share into which the convertible is exchangeable
Conversion Price - based on the exchange ratio, it is the price at which the debenture will be exchanged for the common shares of the issuer of the debenture. i.e. the number of common shares that will be received for each debenture
Maturity - maturity date of the convertible debenture
Effective yield – this is the yield based on the current market price of the debenture
Conversion Premium – this is the current share price minus the conversion price, divided by the current share price. This is a measure of how far the conversion feature is ‘in’ or ‘out’ of the money.
Determining Under, Over or Fair Valuation
Undervaluation could exist when the conversion ratio is positive i.e. in the money and the value of the debenture does not reflect this, i.e. trading below par or not far enough above par to properly reflect the positive conversion ratio. This would also be dependent on the interest rate, effective interest rate, the time to maturity and the outlook for the value of the common share.
Overvaluation may exist when the conversion ratio is negative and the current price of the debenture is above par, or not far enough below par to properly reflect the amount of the negative conversion ratio. This would also be dependent on the interest rate, effective interest rate, the time to maturity and the outlook for the value of the common share.
Taxation of Debenture Interest
Interest is tax deductible when paid, and this applies to both corporations and trusts. Trusts will not have to pay a 31.5% tax on interest payments as this interest is a tax deductible expense for them. Accordingly RRSPs and RRIFs will receive the interest without tax being deducted. Interest income is taxable to individuals at personal tax rates.
The Canadian convertible debenture market, like the bond markets is a dealer market. This is in contrast to an exchange traded market on which shares are traded. The major securities firm own inventories of debentures and bonds and act as principle in the transaction since they are the party from which the debentures are traded. Consequently, buying and selling cannot be done electronically, which can reduce liquidity.
Guidelines for Valuing Convertible Debentures - Investors
The factors to consider when valuing convertible debentures are the maturity date, interest rate, conversion price and the market price of the debenture. It is also important to asses the business conditions unique to the business, the sector in which the business operates and the economy in general.
The interest rate, conversion premium or discount and debenture price constitute the first checkpoints. The value of the shares should ideally be less than 5% below the conversion price and not more than 5% above. The price of the debenture should be at or under par and the effective interest rate should exceed the 10 year Government of Canada yield by at least 1%. The effective rate is the interest rate based on the current price and is not necessarily the same as the stated yield as of the new issue date. Because they have a lower security position or ranking, subordinated debentures will usually command a higher interest rate than more standard debt instruments. This may not apply if the market price of the shares exceeds the conversion price. The maturity date should be distant enough to provide opportunity for the value of the shares to increase, making the conversion feature more attractive. Industry and economic conditions should also be considered. A recovering or growing sector is preferred.
New Debentures - Issuer Objectives
Companies can issue convertible debentures either alone or in combination with shares. The objective of the issue is to minimize the interest rate and set the conversion price low enough to make conversion attractive and remove the obligation to repay the debt. The company also wants to minimize its overall cost of capital and if they set the conversion price too low the value of their shares will be diluted. Because the buyer has the ability to convert the debenture into stock under certain circumstances, the seller is able to borrow at a lower cost than if the convertibility feature was not present. Conversion prices are generally 20% above the market price of shares as of the new issue date. The initial interest rate is something less than it would cost the company to raise a comparable amount of capital without providing the conversion feature.
Convertible debentures are usually offered by companies that are already generating sufficient debt-service cash flow, hence, a portion of the all-in return is expected to come from the equityÂ’s capital appreciation between the debentureÂ’s conversion price and the ultimate liquidity value.
As an example, a convertible debenture may have an interest rate coupon of, say, 8% per annum. The all-in annual return target may be 25%. If the debenture is convertible into common shares at a price of $2.00 per share, the shares would have to be worth $4.39 by the fifth year to generate the expected 17% annualized return from the equity. Combining the 17% equity return with the 8% interest rate would yield an overall return for the financial instrument of 25%.
The math is: 2 x 1.17 = 2.34, 2.34 x 1.17=2.74, 2.74 x 1.17=3.20, 3.20 x 1.17=3.75, 3.75 x 1.17 = $4.39
In theory, the market price of a convertible debenture should never drop below its intrinsic value. The intrinsic value is simply the Number of Shares Being Converted at Par Value times the Current Market Price of Common Shares.
Note: The term shares and company can be used in place of units and trusts respectively.
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