Keep This Hybrid in Mind If You’re Seeking Income

An overlooked source of income in the Canadian market that you should stick in your tool kit.

The Motley Fool

With bond yields bouncing along at historical lows, credit spreads reasonably tight, and dividend paying stocks bid into the top valuation tier, Canadian investors are running out of attractive ways to get their income fix.  An option that is often times overlooked is the convertible debenture.

What’s that?

A convertible debenture is sort of a hybrid between a corporate bond and a stock.  When first issued, they look like a bond.  There is a regular coupon, a maturity date, and the issue price is typically par.  However, strapped to this ordinary looking bond is an equity-linked conversion option.  This gives the owner the option to “convert” the bond into the company’s stock at a pre-determined exchange ratio, if the price of the stock climbs to a certain level.

The security effectively blends the security of a bond with the upside of an equity.  As long as you’re buying into a financially sound company, the worst that you will do with a convertible debenture is receive a regular coupon payment and get your money back at the maturity date.

However, if the company’s stock takes off and exceeds the conversion price, you will participate on the upside.  The debenture’s price will tend to move with the stock once the conversion price is cleared.  This is known as being “in the money”.  Limited downside and upside optionality are welcome attributes with any investment.

Sounds too good to be true

Theory and practice aren’t necessarily aligned in the Canadian convertible bond market.  The downside protection is legit, again, as long as you’re dealing with a financially sound entity.  The optionality provided by the conversion feature is slightly less so.  Many of the convertibles in the Canadian market trade with a very wide gap between their current stock price and the conversion price.  On average, this gap is 112%, however, outliers have a significant impact on this figure as the median difference is only 32%.  Selection is important if you want that upside kick.

How do I buy these things?

Convertible debentures trade on the TSX just like an ordinary stock.  There is no magic involved with transacting in them.  Typically they have a “.DB” added to the ticker symbol of the underlying equity.  XYZ.DB for example.

There is some magic involved in knowing which companies offer this kind of security, but the National Post appears to offer a comprehensive list here.

The Foolish Bottom Line

Canada does not have a very well-developed corporate bond or high yield debt market.  Income trusts served this purpose for many years.  With the disappearance of trusts, convertible debentures are likely to play an increasingly important role in this country’s capital markets.  You’ll be ahead of the game and ready to profit if you begin following these hybrids before they truly go mainstream.  In our next post, we’ll have a look at 2 convertible debenture ideas to help get you started. 

Follow us on Twitter and Facebook for the latest in Foolish investing.

Fool contributor Iain Butler does not own shares in any of the companies mentioned in this report at this time.  The Motley Fool has no positions in the stocks mentioned above.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

More on Investing

Sliced pumpkin pie
Dividend Stocks

2 Delicious Dividend Stocks I Plan to Add to My TFSA in October

These dreamy dividend stocks can provide you with endless dividends in your TFSA. And it's why I'm considering them right…

Read more »

The letters AI glowing on a circuit board processor.
Tech Stocks

Is Nvidia’s Growth Sustainable?

Nvidia stock soars 1,069% in 2 years. Is this AI chip titan's growth sustainable, or are we witnessing a bubble…

Read more »

Canada day banner background design of flag
Investing

3 Growth Stocks to Buy Now and Hold Forever

These Canadian growth stocks have delivered stellar returns but still have room for growth and can deliver solid capital gains…

Read more »

Hand Protecting Senior Couple
Dividend Stocks

TFSA Pension: How Couples Can Earn $9,500 per Year in Tax-Free Passive Income

This investing strategy can reduce risk and boost returns.

Read more »

calculate and analyze stock
Investing

If You Had Invested $1,000 in Dollarama Stock 5 Years Ago, This Is How Much You’d Have Now

As Dollarama's share price consistently grows year over year, here's how much long-term investors are making owning the top stock.

Read more »

shopper buys items in bulk
Dividend Stocks

9.9% Dividend Yield? I’ll Be Buying This TSX Passive-Income Stock in Bulk

Why make investing complicated? This ETF makes earning monthly income easy.

Read more »

worker holds seedling in soybean field
Investing

Got $10,000? Here’s How It Could Become $100,000

Investing in smart small cap-stocks could be a faster way to multiply your wealth.

Read more »

Canadian dollars in a magnifying glass
Investing

2 High-Yield Dividend ETFs to Buy to Generate Passive Income

These two high-yield Hamilton ETFs pay monthly and offer exposure to real assets.

Read more »