The Synthetic Convertible Security

Consensus wisdom puts forward the position that traders who buy options are speculating. But that is far too general a statement. Long only strategies the synthetic convertible – i.e. the combination of long calls and a fixed income instrument – can actually reduce risk.

Traditional convertible debentures or convertible preferreds are hybrid investments that pay out semi-annual interest or quarterly dividends while offering a conversion privilege where the investor can swap the bond or preferred component for the common shares of the underlying company.

Convertible securities allow investors to participate in the upside should the underlying stock advance while hedging the downside with the cash flow inherent in the income component. Which is to say, there is a point on the risk spectrum where a convertible will cease to trade on the basis of the underlying shares, and will reflect a value based on similar straight bonds or preferred shares.

The problem with many convertible securities is their credit worthiness. Typically when companies have to pay above-market rates to issue straight bonds or preferred shares, they will offer convertible securities hoping the equity kicker will allow the company to raise capital with more favorable terms.

The advantage with exchange-traded options is the ability to create an investment grade synthetic convertible on the underlying market or on a specific stock. The synthetic convertible is simply the combination of a long call option (representing the equity kicker) with an investment grade mid-term corporate bond or a high grade preferred share.

The advantage with a synthetic convertible strategy is that traders can pre-define their risk/reward metrics. That’s useful in the current environment with so many influential hedge funds engaging in “risk on” and “risk off” strategies.

Rather than trying to time a shift from “risk on” (i.e. buying equity, selling fixed income) to “risk off” (buying fixed income, selling equity), the synthetic convertible allows you to trade both sides combining the limited risk aspects of a long call position with the cash flow metrics of a bond or preferred share.

To mimic the “risk-on-risk-off” trade, you can use the iShares S&P/TSX 60 Index Fund (XIU, Friday’s close: $17.20) as a proxy for the Canadian equity and perhaps the iShares DEX Real Return Bond Index Fund (XRB, recent price $25.83) as the surrogate for Canadian inflation protected bonds.

If you want to enhance your after tax yield, you could assume a little more risk by combining a good quality straight preferred with a long call. The convertible preferred will generate a higher pre-tax and post-tax yield with the tax advantaged aspect of dividends being particular useful if you are trading within a taxable account.