What the heck is a convertible debenture?

Posted on April 10th, 2012.

There are many options for investors seeking income. I have written posts summarizing these options and also a fair bit of specific info about some of them. I think it is important that investors have an understanding of the basic types of investments so that they can try to decide if an investment choice or the advice they are receiving is right for them. That is a huge part of the battle for an investor and the more knowledge you have, the better position you will be in to determine if the advice you are receiving is sound.

Where there is complexity there is often opportunity since the more complex an investment is, the less people will take the time to try to figure out where those opportunities lie. I have seen this phenomenon quite a lot throughout my long career in finance.

One of the more complex but not extremely complex income producing investments are convertible debentures. A convertible debenture is a debt instrument that has some of the features of an equity investment. These instruments, due to their link to equities, provide income and the potential for capital appreciation.

A debenture itself is a debt instrument similar to a bond. The investor is essentially lending money to the issuer, the money is meant to be returned on a certain date – the “maturity date”. The key difference between a debenture and a bond is that a bond is generally secured by an asset, whereas a debenture is generally not and is therefore based on a promise of repayment only. An investor who has a debenture in default will likely find there is little recourse.

So are debentures riskier than bonds? Generally yes although bonds have varying risk levels that range from extremely safe, to extremely unsafe-these often being referred to as “junk bonds”. Debentures often have no available “rating” that would be helpful to gauge risk, so there is an advantage for those willing to roll up their sleeves and do a bit of research.

So what is the draw? Well the fact is that the majority of available debentures in Canada are convertible into another type of investment – generally a type of equity. The reason that this is advantageous is because the conversion price is generally set from the outset and so if the investment that the debenture is convertible into – the “underlying investment” goes up in value – the value of the debenture based on the conversion feature will rise and the price of the debenture will likely also rise more or less in proportion. Here are some possible characteristics of debentures:

  • Redeemable, where the issuer has the right to redeem under certain conditions before it had matured.
  • Extendable, where there is a provision to extend the debenture under certain conditions.
  • Retractable, where the holder has the option, under certain conditions, to cash in their debenture at a certain price (usually par) prior to maturity.
  • Convertible, where the debenture is convertible into another type of investment, usually an equity investment, under certain circumstances.

I realize these instruments are a bit more complicated…but knowledge is power so I would encourage you to learn more about debentures and other available investment choices. In my acclaimed book “InSync Income, The Must Read Guide to Investing for Income in Canada” I wrote a great chapter about debentures and also wrote a more in depth Appendix called a closer look at convertible debentures for those who really want to roll up their sleeves.

Here is some key terminology to get you started learning more about convertible debentures:

  • Issuer: The name of the company or other entity that originally created the debenture.
  • Symbol: The letters that the debenture uses to trade on the stock exchange, generally the Toronto stock exchange.
  • Maturity: The date that the debenture holding period ends and the principle investment is due to be returned.
  • Last Price: This is the last price at which the debenture has traded.
  • Parity: The price of the underlying investment, multiplied by the conversion ratio.
  • Premium: The amount, as a percentage, that the market price exceeds the parity value as calculated above. It is also possible for debentures to trade at a discount. This would be a negative premium.
  • Conversion Ratio: The number of shares of the underlying investment that each debenture is convertible into.
  • Underlying symbol: The letters identifying the underlying investment.
  • Share price: Last market price of the underlying investment.

 

I would encourage you to learn more about convertible debentures by reading chapter 5 of InSync Income. Reading books and articles online is not a substitute for professional advice. I recommend seeking the advice of an appropriate financial professional prior to implementing any new or making any changes to an existing strategy. Invest with advice for best results.

Frank Weiler

The Income Investor’s Advocate

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