With the S&P 500 down nearly nine percent year-to-date, it is not surprising that investors are favoring fixed income exchange traded funds. Nor is it surprising that bond ETFs with perceived correlations to equities, such as convertible and high-yield corporate funds, are out of favor compared to their U.S. government debt counterparts.
For example, the SPDR Barclays Convertible ETF (NYSE: CWB) is lower by more than 9 percent this year. A "convertible security" is a security - usually a bond or a preferred stock - that can be converted into a different security - typically shares of the company's common stock, according to the SEC.
CWB, which debuted nearly seven years ago, has some competitors, but with over $2.1 billion in assets under management, the fund is the undisputed king of convertible bond ETFs.
What investors need to realize about convertibles is that they're a two-way street. These securities allow holders to convert into common shares at prices below the current market price. That's great for the holders, but converted bonds or preferred shares mean new common shares added to the shares outstanding total, which is to say convertibles dilute existing shareholders. The bigger the dilution, the worse the impact on the stock's price.
“Within portfolios, many investors are looking for diversification, and convertible securities can offer that across both the fixed income and equity spectrums. Historically, convertible securities have been shown to have lower risk—but lower returns—than a stock. At the same time, they tend to have higher returns—but higher risk—than a bond. This allows convertibles to be a strong diversifier within an investor’s asset allocation process,” said State Street Vice President David Mazza in a recent note.
Convertibles often sport prices slightly above those of comparable corporate bonds because the option to convert itself has value. While an ETF such as CWB is not considered a junk bond fund, its credit quality is not as high as traditional investment-grade corporate bond ETFs. For example, nearly 35 percent of CWB's 100 holdings are rated below Baa, according to issuer data.
However, investors are compensated for that credit risk.
“While convertible securities typically pay a higher coupon than the related equity dividend, they also move the investor higher up the capital structure than being an equity holder. In the event of default, bondholders are paid out before holders of the same company’s stock,” adds Mazza.
A significant part of CWB's allure is that convertibles are usually the best-performing corner of the fixed income universe in rising rate environments, indicating that CWB would like to see the Federal Reserve boost rates a few times this year.
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