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A Convertible ETF For Rising Rates

Cinthia Murphy

State Street Global Advisors now offers 48 ETFs in Schwab’s OneSource platform—a sort of ETF supermarket that offers access to funds from 13 providers commission free. But none of those ETFs on the platform is gathering assets at a faster pace than the SPDR Barclays Convertible Securities ETF (CWB | C).

CWB is a one-of-a-kind ETF that provides exposure to a market-value-weighted and market-value-selected portfolio of convertible bond securities from the Barclays U.S. Convertible Bond Index. The fund focuses on convertible bonds with outstanding issue sizes greater than $500 million, and is currently serving up a 30-day yield of 2.05 percent on an annualized basis.

Its resonance with investors in recent months has a lot to do with growing concerns about rising rates in the U.S. The Federal Reserve this week reiterated its commitment to ending quantitative easing, fueling expectations for a rate hike by some time mid-2015, if not sooner.

Convertibles Work Both Ways

In that context, it's easy to see why investors would be embracng convertibles, because they are hybrid securities—part bond, part stock. As the price of a convertible bond's underlying stock rises, the convert becomes more equitylike. As the stock price falls, it becomes more bondlike as the embedded call grows more out-of-the money.

“When you have an environment where stock prices are rising and bond yields are falling, or bouncing along the bottom, convertibles become very attractive,” said Elisabeth Kashner, director of research at ETF.com. “The more convertibles act like stocks, the less affected they are by factors that influence the bond market, notably interest rates.”

If we get to an environment where rates rise, but stocks rise too, convertibles will be protected relative to regular bonds, because their pricing will be driven by stock prices,” she added. “On the other hand, if both yields and stock prices hit the skids, convertibles will be no better off than regular bonds.”

To quote Dave Mazza, head of research for SPDR ETFs and State Street funds, “Convertibles are the single best asset class in a rising rate environment.”

CWB Only Game In Town

Mazza may be biased because his firm is the only one that offers a purely convertibles ETF. But there’s no question that what makes convertibles so attractive is that convertible bonds can be exchanged for preferred or common stocks of the issuer.

Since the beginning of the year, CWB has attracted a net of $771 million in assets, growing to a $2.9 billion fund that is the only ETF on the market to offer focused exposure to convertible securities.

“We are seeing adoption of convertibles by retail and institutional investors alike,” Mazza told ETF.com. “They give the portfolio a lower volatility profile, all the while adding some income.”

“A lot of investors are getting out of small-cap equities and moving into convertibles ahead of higher rates,” he noted.

Small-cap stocks were hugely popular last year, but many argue they have grown overvalued, and have struggled to find much upside this year. A fund like the iShares Core S&P Small-Cap ETF (IJR | A-91), for instance, is basically flat year-to-date. Investors have now yanked more than $831 million from the fund since the beginning of the year.

The chart below shows how IJR’s performance compares with CWB in 2014:

CWB_IJR_YTD_Perf

Chart courtesy of StockCharts.com

 

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