Convertible bonds are an intriguing option for those among your clients who are worried that government issues are not worth their low yields and that corporate bonds at every credit level have reached the point at which they are fully priced.

In fact, during 2009, Vanguard Convertible Securities Fund, a widely followed portfolio that indexes convertible bonds, rose by 42.6%. This gain beat the Salomon corporate bond index’s 18.4% rise and the MSCI world index’s 30.8% gain. (All gains are in U.S.-dollar terms.)

Convertibles’ gains have been spectacular, not only because of the bullishness in all parts of the bond market last year but also because of the leverage built into convertible bonds that boost performance when their related stocks thrive.

“This is a good time to buy convertibles,” says John Calamos, president of Calamos Asset Management Inc. in Chicago, which manages US$6 billion in convertibles. “In an inflationary environment, governments will raise interest rates. And while conventional, investment-grade bonds will lose value, the equities component of convertibles will tend to sustain these bonds’ prices.”

Convertible bonds bridge the worlds of equities and debt. Often issued by companies that do not have the credit rating to issue conventional bonds, convertibles are really IOUs with an equities kicker: the promise that the bondholder will get bond interest plus potential capital gains on the company’s stock. It’s a combination of bond security with participation in equities growth. In the present bull market, the hope of conversion to stocks with rising prices have only added to the allure of these bonds.

Recently, there has been increased issuance of convertibles in Canada, as many income trusts have issued convertibles to provide funding for their reversion to corporations next year. Like conventional bonds, convertibles pay interest twice a year, have a maturity date and are usually callable.

And this upswing not just happening here. There has also been a surge in the issuance of convertibles around the world. As Calamos notes, “The equities kicker in convertibles allows issuers to pay a lower coupon than they would have to pay on straight debt.”

The main difference between convertibles and conventional bonds is that a convertible has a specific option to switch the bond into a defined number of the issuer’s common shares at a given price. The number of shares per $100 of bond face value is the “conversion ratio” — a critical factor in figuring out what the bonds are worth on the market. Most of the time, the underlying stock’s price sets the market value of the convertible. Market interest rate trends matter less for convertibles, which are subordinated debt, than for senior bonds of investment-grade issuers.

The downside of convertibles is that in exchange for the potential equities gain, the investor must accept a rate of interest that is lower than the bond’s general risk level would justify. Today, the average yield on convertibles is 5%-6%; although, for speculative securities, the rate could very well be higher.

The idea of having the best of both worlds — a bond yield packaged with an option to convert to common stock that can participate in higher earnings — is a straightforward component in the basic conversion calculation.

In a very basic case, if a $1,000 bond is convertible into 10 shares of stock, the parity stock price is $100. If the stock price rises to $150, the bond has to rise to $1,500 for the stock and the bond to be in parity. Thus, the bond trades on its merits as corporate debt as long as the stock price is below $100. Once that rises above $100, the bond will take off, much like a stock option — which, in fact, the bond will have become. If the convertible’s gain lags the stock price’s rise, it will show what amounts to a charge for downside insurance embedded in the bond’s price.

There are some downsides to convertibles. The underlying stock price may decline. As well, if the stock price rises to, or above, the conversion price, some investors will convert, diluting the stock, which in turn reduces each stockholder’s share of corporate earnings.

As well, the convertibles market is retail-oriented, notes Chris Kresic, senior vice president and head of the fixed-income team with Mackenzie Financial Corp.in Toronto: “In general, with convertibles, you have to pay too much for subordinated debt. On the other hand, if you expect the stock to be flat for a long time, they are a good way to get paid for waiting for a price gain.”

@page_break@Convertibles’ prices have risen sharply recently because of the strong recovery in stock prices, which means investors are paying for the right to convert the bond to common shares. And as interest rates rise, a bond’s value should decline, in theory. Expectations of rising corporate earnings should sustain a bond’s price. That expectation is a valuable embedded premium.

So, should your clients pay the premium for a bond packaged with a stock option? After all, you can often buy options separately. Nigel Roberts, a chartered financial analyst and president of Bluenose Investment Management Inc. in Oyama, B.C., suggests that you “look at the value of the payback based on the yield to maturity of the bond vs the yield on the underlying security. I want the yield to maturity of the bond to be higher than the running yield on the stock.”

Currently, Roberts likes convertibles issued by H&R REIT. Its most recent issue, HR.DB.C, has a 6% coupon with a maturity date of June 30, 2017, and a conversion price of $19. Recently, the common units of the REIT have traded at $16 — which means that when they hit $19, the bond, with a recent price of $100, should shoot up. If the stock hits $25, Roberts estimates, the bond would be $131.

In other words, a 56% increase in the current $16.50 common unit price would turn into at least a 32% bond price gain. It looks like a bad deal, but, as Roberts says, “With the bond, you have the security of a fixed redemption date and interest that ranks ahead of interest due on the common. For now, the stock must rise by 19% to hit the conversion price.”

Roberts also likes Russell Metals Inc.’s 7.75% issue due Sept. 30, 2016. “It’s a good play on a formerly high-flying stock,” he notes. As well, he likes grain-handling equipment maker AG Growth International Inc.’s 7% issue, due Dec. 31, 2014. Both have a good yield and play on an underlying stock with prospects for strong appreciation.

The difficulty with convertibles is that analysis is complex: you have to compare rates of return; adjust for the different risks of bonds and stocks; check call dates and the effects of conversion on stock dilution; evaluate the different levels of volatility of the two asset classes; and examine the liquidity of the assets in their underlying markets.

If that’s too much research, then you can consider closed-end convertible funds, managed by convertible-bond experts, for your clients. There are not many offerings in Canada, but among them are Lazard Global Convertible Bond Fund, a closed-end fund that had its initial public offering on Dec. 9, 2009; and Middlefield Group’s closed-end fund, Pathfinder Con-vertible Debenture Fund.

In the U.S., there are 11 closed-end funds devoted to convertibles, all available to Canadians. This list includes Calamos Convertible Opportunity Income Fund and Calamos Strategic Total Return Fund. IE