Investors looking to add some spice their fixed-income portfolios, particularly during rising interest rate environments, can consider convertible bonds. Convertibles are hybrid securities because they are bonds with embedded options that allow investors to convert the bonds into equity in the issuing company.
The asset class is accessible via some exchange-traded funds, the dominant name of which is the SPDR Bloomberg Barclays Convertible Securities ETF (NYSE: CWB). CWB tracks the Bloomberg Barclays U.S. Convertible Bond > $500MM Index, meaning the ETF only holds U.S. convertibles with outstanding issue sizes of $500 million or more.
“As the price of underlying stocks gets closer to or above the conversion price, the value of the convertible bond rises, becoming more sensitive to the change of the stock price and taking on more stock-like characteristics,” said State Street Global Advisors in a recent note. “When the stock price falls below the conversion price, the convertible behaves more like a bond, and its value does not fall as much as the stock because the coupon and principal value of the bond creates investment value.”
Advantages Of Convertibles
Due to the convertible mechanism, convertible bonds and CWB act more like stocks than most corners of the fixed-income market. CWB's year-to-date return of 11.5 percent actually puts the bond fund ahead of the S&P 500 by about 60 basis points.
“The option to convert to equities allows investors to participate in some of the upside of a rising equity market,” said SSgA. “Given that convertible financing is particularly attractive for growth companies, which tend to exhibit strong earnings and sales growth but with low cash flows, convertibles often provide growth-oriented exposure.”
Due to the equity-esque nature of convertibles, duration, or a bond's sensitivity to interest rate changes, is not the issue it is with other types of bonds. In exchange for minimal rate risk, investors do incur some credit risk as about half of CWB's 92 holdings are rated Baa or lower.
CWB's 2.4 percent 30-day SEC yield can be exceeded in other, junkier corners of the bond market, but that is better than what investors will find on the S&P 500.
“Because of the value of the option to convert, the yield of convertibles is usually lower than that of nonconvertible corporate bonds from the same issuer,” according to SSgA. “However, the chart below shows that in the past 10 years, convertibles have provided a higher yield than both equities or the traditional core fixed income segment, as represented by the Bloomberg Barclays US Aggregate Index.”
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