Securities from the Midfield (Part 2 of 2)

By: Raymond Kerzérho

Last month, we reviewed three asset classes that belong in the middle ground between safe assets (government bonds) and risky assets (equity). I will close this short series by reviewing three more classes.

Because their dividends benefit from a tax credit, Canadian preferred shares are popular with investors looking for tax-efficient income. But like corporate bonds, they do carry credit risk. With top-grade issuers like the major Canadian banks, the probability of default is minimal. But any issuer’s preferred shares are always subordinated to its bonds and therefore are riskier. In addition, preferred shares are typically callable at the issuer’s option, which limits the potential capital gains when market conditions are favorable. Therefore, investors should require a significant yield premium as compensation for the extra risk.

Emerging-market bonds are issued by the governments of fast-growing developing countries such as Brazil, Russia and Turkey. These bonds are generally denominated in U.S. dollars. They typically offer a relatively high yield due to their credit risk, which is similar to that of high-yield corporate bonds. Interestingly, this credit risk is partly driven by politics rather than by business conditions, and so, emerging-market bonds can provide diversification benefits for portfolios.

Convertible bonds are corporate bonds that can be exchanged at the holder’s option for a specific number of shares of the company's common stock. If the issuer’s stock appreciates beyond the conversion price, the convertible bond gains value. Convertible bonds are often issued by companies with a subpar credit standing. In addition, they are usually the most junior debt on the issuer’s balance sheet. And lastly, they are fairly complex and illiquid securities. In general, I consider convertible bonds to have a risk level similar to that of equities.

In summary, Canadian preferred shares, emerging-market bonds and convertible bonds all share a level of risk that is similar to that of equity, in addition to a high level of income. Some investors are attracted by the advantageous tax treatment of preferred shares and the upward price potential of convertible bonds, and still others are interested in the high income and diversification benefits offered by emerging-market bonds. However, they must be particularly wary of the complexity of preferred shares and convertible bonds. PWL Capital’s portfolio managers have the expertise to use all of these asset classes effectively and where appropriate to improve portfolio diversification and enhance its return potential.

The Economic Pulse will take a hiatus next month, but will return with new commentaries in September.