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Why 2018 Could Be Great for Convertible Bond ETFs

Sanghamitra Saha
Wall Street finished in the green reversing its five-day negative trend on Thursday following news that United States and China have ramped up their efforts to resolve lingering trade disputes

Stock markets continued to set new highs in the latest trading session and with decent economic fundamentals, convertible bonds are back in the limelight. Yields on the benchmark 10-year Treasury notes were at 2.63% on Jan 23, 2018, up from 2.41% recorded on Jan 23, 2017 and 2.46% on Jan 2, 2018, when Trump’s tax reform bill turned into a law.

The U.S. economy grew an annualized 3.2% sequentially in the third quarter of 2017, slightly lower than market expectations of 3.3%. The Fed had guided three rate hikes in 2018. Also, there is a whiff of policy tightening in developed economies like the Euro zone and Japan.

No wonder, investors have started to position their portfolio according to the likely rise in yields. They must be in demand due to their high-yield and innocuous nature. Moreover, convertible bonds appear lucrative as these provide some benefits of bonds as well as stocks.

What Are Convertible Bonds?

Convertible bonds are those that can be exchanged if the holder chooses to, for a specific number of preferred or common shares if the company’s share price climbs past a said conversion price during the bond’s tenure.

Like traditional bonds, convertible bonds are issued on par, pay fixed coupons and have fixed maturities. The main difference is that convertible bonds offer investors the right to convert their bond holdings into a company’s shares at the holder’s discretion.

This allows investors the potential to play both sides of a company — debt and equity — in a single security offering a lower risk choice. The lack in this arrangement is that investors are compelled to accept a far lower coupon payment than traditional bonds of the same company.

On the other hand, these bonds are less risky than equities. In case of bankruptcy, convertible bond holders get paid out ahead of equity holders. The price of these bonds generally moves in-line with the underlying shares. However, unlike shares, the convertible bonds have some coverage against downside risks as investors can redeem these on par upon maturity, if the issuer is in business.

All in all, these bonds are great instruments to tap a towering stock market, minimize risks and enjoy strong current income

ETF Impact

Choices are very few in this corner of the ETF world. The options are SPDR Barclays Capital Convertible Bond ETF CWB, iShares Convertible Bond ETF ICVT and First Trust SSI Strategic Convertible Securities ETF FCVT (read: Convertibles/CEFs/Preferred Stock ETFs).

So far this year (as of Jan 23, 2018), CWB has gained about 3.7% while PIMCO Active Bond ETF BOND has lost about 0.6% and iShares 20+ Year Treasury Bond ETF TLT has shed about 1.4%.

Bottom Line

These are apt in a rising rate environment. These offer higher yields but “convertibles have had lower default rates than high yield bonds”, according to Barclays. Notably, CWB yields about 4.04% annually (read: Forget Hedge Funds: Buy These ETFs Generating Sizable Alpha).

We would like to notify investors that even if the Fed starts hiking rates, income seeking investors may weather the fall in bond prices with rising stock prices through this instrument.

And with the broader economy finally finding its footing, stock markets are expected to hold steady this year, potentially making convertible bond ETFs solid picks for investors seeking a solid combination of fixed income and equity in their portfolios.

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