Convertible bonds - Fixed Income Investing

Convertible bonds are like other bonds except for one special feature: they give you the privilege of exchanging the bonds for a specified number of shares of the company before a certain date. Because of this attractive feature, the interest rate on convertibles is usually lower.

For example, Hudson's Bay has a convertible bond that pays a fixed interest rate of 7.5% and is trading at $845.00. You can exchange this bond for 5.75 shares of Hudson's Bay. Hudson's Bay as of mid-December, 2002, is trading at $8.71.

Suppose the price of these shares moves up to $10.00. Since you can convert your bond into 5.75 shares, they will now be worth at least $57.50 ($10.00 x 5.75). In fact they will be worth more because the bond pays interest as well. Thus when share prices rise, convertible bonds automatically benefit.

On the other hand, suppose the stock goes down to $5.00 per share. Then, the share value of your bond will be only $28.75 ($5.00 x 5.75). But the price of the bond will not decline that much simply because, unlike the shares, convertible bonds pay interest. Thus when share prices decline, convertible bonds will decline only to a point.

To summarize, when the share price increases, convertible bonds behave like shares with unlimited profit potential. When the share price decreases, convertible bonds are partially protected against corresponding declines because of their interest-yielding feature.

When to buy convertible bonds

The convertible feature is of no great benefit if the total value of the share per bond is too low relative to the cost of the bond. This would mean that the shares have to move up significantly before you can make a profit.

Therefore, when you buy a convertible bond, you should make sure that the premium is not too high. (Higher premiums will be asked for when the underlying stock is expected to move up and when the bond has a high coupon.) Premium is calculated as: % premium = [(100 x current bond price)/

(# shares per bond x current stock price)] - 100

You also have to look for the actual rate of interest. This is calculated as: % current interest = (100 x interest specified on the bond) / current bond price.

You should look for convertible bonds with low premiums and high current yield. Bonds trading close to (or below) their par value are more desirable than bonds that trade at a price that is much higher.

A convertible bond is a good buy when:

* the current interest rate on the bond is not too low compared to regular bonds;

* the conversion is relatively low (under 20%) and there is enough time until maturity for the stock to appreciate;

* there are reasons to believe that the underlying stock will rise before the bond's maturity date;

* rates are falling, but the stock is rising; and

* the bond is not trading above its par value.

The last feature is particularly important because many convertible bonds have a 'call feature' that gives the corporation the right to buy the bond back at a specified price on or after a specified date. Once a bond is called, you will get only the specified price, no matter how much you paid to get it.

You should be careful investing in convertible bonds when:

* the bond price is much higher than its face value;

* conversion premium is high, but current yield is low;

* the call features are due soon;

* the interest rates are rising but the share price is falling;

* the share price is not likely to go up; and

* the underlying company is not sound.

Examples of some convertible bonds are given on the previous page.

How the gain is taxed

The interest paid on the bond is fully taxed as interest income. If the bond goes up in price and you sell it, the profit will be treated as capital gains and taxed accordingly.

Note: Buying convertible bonds requires expertise. Please make sure that you understand the features of these bonds before investing.

Some Canadian convertible bonds that have premiums under 18.5%

                                               Shares/
                     Coupon   Bond    Yield *   $100    Common
                      (%)     ($)      (%)     of bond  price

Superior Propane      8.00   112.02   5.06      6.25    18.40
George Weston Ltd.    3.00   163.40   0.00      9.52    16.95
Pembina Pipeline      7.50    10.3    6.72      9.52    10.79
Pembina Pipeline      8.25   119.60   2.08     11.11    10.79
Provident Energy     10.50   100.10  10.47      9.35     9.91
Cdn Hotel Income      8.50    98.75   8.82     10.42     9.05
ACS Freezer Inc Tr   12.00   123.80   0.00     10.53     8.50
Rogers Sugar Income   9.50   102.00   8.95     21.05     4.71
Revenue Properties    7.00    97.00   7.88     51.47     1.58

Prices as at mid-December, 2002. Many of these convertibles have call
features. Check all features before investing. Do not invest unless the
risk involved is acceptable to you.

* Yield = Yield to Maturity. For convertible bonds trading much above
the issue price, the yield to maturity is 0 or close to 0.