A layman’s guide to understanding bonds: Part VIII

The difficulty when considering fixed income allocation is that very few, if any, corporate bonds being issued these days are actually simple, standard debt instruments.

Most, if not all, are “hybrid” bonds, which are a combination of debt and equity.

Convertible bonds: Begin life as a vanilla bond, paying a fixed coupon and a return of investment at face value.

However, they also contain an inbuilt call option, such that if the share price of the underlying equity exceeds a predetermined level, holders have the option to convert their bonds into equity at that price.

You may regard this as “the best of both worlds”, because if the share price is not performing well, you will continue to receive coupon payments and will (assuming the company does not go bankrupt) be paid back on maturity.

If the share price rallies, you may wish the shares had been bought instead, but with convertibles you can decide to jump over to equity.

Sadly, life is not quite so simple.

These days even vanilla convertibles are few and far between. There is so large a range of hybrid forms that it is almost a case of one being unique from any other.

Hybrids could be convertible (you have the choice to convert), converting (conversion at a price is automatic), redeemable (you can redeem based on some predetermined factor), redeeming (company can redeem on its discretion), and the list goes on.

For some that pre-set share price that triggers conversion may be a moving target rather than a fixed price.

And for others, the complexities are such that only someone really in the know can properly kick the tyres on them to decide what the right price should be.

It’s also worth noting that the greater the complexity, and/or the greater control the company has over the instrument rather than you the investor, the higher the price (coupon) will have to be.

Preference shares: Have been around for a very long time and as such are the earliest form of hybrid instrument.

An ordinary share pays a dividend only at the discretion of the company in each dividend period. A preference share, or “pref”, pays a fixed dividend from the time of issue, more akin to the coupon on a bond.

Pref prices will move in step with ordinary share prices, hence the hybrid nature of debt/equity mix.

Dividends on prefs must be paid in full before a company can consider paying dividends to ordinary shareholders and rank higher than ordinary shares in the case of wind-up.

That seems simple enough, until you consider that like bonds, prefs can also be convertible, and converting, and all the other variations on a theme.

The bottom line is simple: if you are considering an investment in fixed income or hybrid debt/equity instruments, it is essential you act through an industry professional who can advise you whether that particular instrument offers value or not, and whether it suits your own preferred risk/reward profile.

This concludes the Market Index educational series on bonds.