Loading...
 

Shorter maturity bonds, those due to mature in less than five years, have advantages. In fact, they can be very attractive additions to a convertible portfolio.  The clearest benefit is a relative insensitivity to moves in interest rates, while still offering relatively high yields.  Granted, the current interest rate environment can best be described as benign, and Value Line sees no reason to assume rates will trend meaningfully higher any time soon.  Nonetheless, if interest rates are a reflection of inflation prospects, then it follows that if inflation fears emerge, interest rates will rise. As bond yields rise to compensate for higher inflation, bond prices will drop. Bonds with longer maturities are going to be especially vulnerable to rising rates because of the risk investors would be taking by holding such long-dated debt. And while near-term bonds are not immune, it is clear that a bond with 20 years to maturity is a much greater risk than a shorter-term security. 

Interestingly, some convertibles with short maturities will likely also be relatively insensitive to equity moves, as well.  This is particularly true of short-term convertibles that are trading with very high premiums over conversion value (“busted” convertibles).  Consider a convertible with three to five years left to maturity that is trading with a premium over conversion value in excess of 100%, which would imply that the stock that underlies the security is trading well below the conversion price.  No matter what happens to the stock, bondholders will be entitled to par, typically $1,000, at maturity.  As the time to maturity nears, the bond is going to trend toward par, regardless of where the stock is trading.  Of course, if the stock does manage to rise above the conversion price by maturity, bondholders will participate.

Another variable to consider is the typically high investment values short-term convertibles have.  Recall that investment value is the price where the convertible would have to trade in order to provide a yield to maturity that approximates that of a non-convertible bond with a similar coupon and maturity.  The closer the convertible is to its maturity, the higher its investment value is going to be.  The higher the investment value, the less sensitive the security is to drops in the common stock.  This is true regardless of the premium over conversion value.  If the issuing company maintains its creditworthiness, and interest rates are stable, the investment value should provide a solid floor beneath which the convertible should not trade.

About 45% (about 250) of the convertible bonds under our review will mature in five years or less. Issues trading well above par are essentially equity substitutes and therefore do not really provide the benefits of short maturity bonds.  And those that have some degree of call risk would further mitigate the benefits of a short maturity.
 
As with any convertible investment, the maturity should be one of many variables to consider.  Fairly priced short-term convertibles will often provide superior downside risk, and a chance to participate in a common stock advance should it trend meaningfully higher.  Of course, credit risk should be as closely evaluated for short-term bonds as it is for securities of longer maturity.  Regardless of the term of the bond, the company still has to pay off the bond for the strategy to work.