Bonds (and preferred stocks) that are also convertible into common stock are frequently mispriced. A contributing reason is that there is only one significant convertible bond ETF ($2.25 billion), in part because there isn’t sufficient reliable volume to raise substantial assets to manage (although there are quite a number of convertible-focused mutual and closed-end funds). Typically, convertible debt is offered after a company’s common shares have appreciated substantially. The idea is that by offering bonds that could appreciate above face value, buyers will accept a low coupon. Sometimes all that is required for a mispriced convertible is for the previously popular shares to fall to prior levels. Disappointed, the original bond buyers, who were really desirous of a ‘conservative’ stock substitute, sell the bonds. When they fall to a level reflecting a more normal bond yield, they become interesting.

In early 2016, Royal Gold Corp.’s 2.875% Notes due in June 2019 traded at a price of $86. Perhaps needless to say, the shares fell sharply (58%) in 2015. The notes offered three return elements: the 3.3% current yield (as might be compared with a 1.5% 5-year Treasury yield), an additional 4.4% annual appreciation to face value at maturity, and the possibility of appreciation beyond 100 if the common shares rise sufficiently in those 3 ½ years.

As to credit quality, there were only two essential facts. First, this convertible was the company’s only substantial debt. The balance sheet was actually quite strong. More importantly, Royal Gold, to the surprise of many, is, by profit margin, one of the most profitable companies in the world — far superior to Microsoft. (A confusing point, but helpful from a valuation perspective, is that Royal Gold is not actually a mining company, but a buyer of royalties.) The yield premium and discount were entirely unrelated to credit quality.


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