Convertible bonds give the best of both worlds – here are three to buy now

Each week, a professional investor tells MoneyWeek where he’d put his money now. This week: Maxime Perrin, senior analyst, Lombard Odier Convertible Bonds Fund.

Investors in stocks – particularly those who have favoured developed markets – have done well over the last two years. Most will be sitting on handsome gains generated by recovery in the US, a reinvigorated Japan and a stabilising Europe.

Combine this tidy profit with the apparent calm in markets, and low – some would say ominously so – volatility, and you can see why many wise investors are looking to reduce their risk. However, given that there is no obvious catalyst for a market crash looming, they still want exposure to any further gains.

For these investors, convertible bonds – corporate bonds that convert into shares of the issuing company at a certain price – may fit the bill nicely. In many respects a convertible bond investor enjoys the best features of a bond and a share. The bond pays interest – albeit at a lower rate than a non-convertible bond.

It has a maturity date at which point the capital is repaid to the investor, if the bond is not converted to a share before then.

However, if the company’s shares rise above a specific ‘strike’ price, the bond can be converted into a share (hence the name). So in effect, a convertible bond is the same as holding a non-convertible bond issued by that company, but with a ‘call’ option on the equity attached. This gives the investor the reassurance of the bond ‘floor’ if the share price falls, but also offers exposure to any upside in the share price.

US and European companies are big issuers of convertibles, but Asia is catching up fast. Companies like convertibles as a way to raise money because the interest payable is lower than on a plain bond. They also don’t have to persuade shareholders to accept dilution, or to buy more shares, as they would if they decided to launch a rights issue instead.

Convertibles have traditionally been bought mainly by specialist bond investors, but they can also be useful for everyday investors wishing to reduce their risk while keeping some exposure to markets.

UK commercial property is one interesting area. UK property company Derwent offers a convertible bond with a coupon of 1.125% and a maturity date of 2019 (ID No. EJ7611316; ISIN XS0954745351). This bond has a ‘sensitivity’ to the underlying share of 36%. So if the share price rises by 1%, the convertible price will go up by 0.36%.

The higher the share price, the higher the sensitivity, and vice versa. So as the share price climbs, the bond behaves more and more like an equity – which is what an investor would want, which is what makes such convertibles so attractive.

But if the share price falls, the convertible still maintains its bond floor, which in the case of Derwent is 18% below the bond price. As the share price falls towards this floor the convertible’s sensitivity drops – the bond price would fall more slowly than the share price.

For those who want exposure to the continuing success story of the US west coast tech industry, convertible bonds issued by SanDisk Corp, a $22bn market cap microprocessors and storage solutions company, are worth a look.

These convertibles have a coupon of 0.5%, mature in 2020 (ID No. EJ9011143; ISIN US80004CAE12) and have an equity sensitivity of 54%. The bond floor is 24% below the current bond price.

Alternatively, for those who are impressed by Europe’s ongoing recovery, German engineering giant Siemens offers a convertible bond rated ‘A’ by credit-ratings agency Standard & Poor’s, with a coupon of 1.65%, maturing in 2019 (ID No. EJ0220339; ISIN DE000A1G0WC7) and with a 45% equity sensitivity. The bond floor is 19% below the current bond price.

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