Convert to Convertibles to Guard Against Rising Rates

July 17th at 9:00am by Tom Lydon

Yields on 10-year U.S. Treasurys have declined over the past few days, but the prior spike in those yields and the ensuing carnage on the bond market is still fresh on many investors’ minds. Long duration bonds and emerging markets sovereigns were predictably stung by the jump in 10-year yields.

Even shorter duration such as high-yield bonds and supposedly safer ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD) did not offer much in the way of shelter to bond investors as yields jumped. Those rising yields translated to increased spreads over Treasurys for corporate bonds, implying higher credit risk. [Conflicting Opinions on Corporate Bonds]

In the past 90 days, LQD is down 4.8% while the SPDR Barclays Short Term High Yield Bond ETF (NYSEArca: SJNK) is barely higher. Investors that think rates are bound to rise again and remain elevated can prepare for that scenario with the SPDR Barclays Convertible Securities ETF (NYSEArca: CWB). Over the past three months, CWB has gained 4.2%. [Benefits of Hybrid ETFs]

CWB, which has over $1.3 billion in assets under management, tracks”the Barclays U.S. Convertible Bond > $500MM Index, an index that tracks United States convertible bonds with outstanding issue sizes greater than $500 million,” according to State Street.

More importantly, the utility of convertible bonds in rising rate environments is well documented. Said another way, CWB’s recent bullishness is not a new phenomenon. The average return for convertible bonds in quarters when interest rates rose dating back to 1993 is 3.97%, according to Morgan Stanley Wealth Management.

Although convertible bonds do pay interest (CWB’s dividend yield is nearly 3.7%), the bonds can be converted into shares of the issuer’s common stock, making convertibles less sensitive to interest rate risk and “a little more tuned to equities,” wrote Matthew Rizzo, head of investment strategy at Morgan Stanley Wealth Management, in research published last week.

Nearly 32% of CWB’s 93 holdings are rated below Baa and 27.5% are not rated, but a combined 38.5% are rated Baa or A. Top sector weights include 28.4% to technology, 17.6% to consumer non-cyclicals and 15.7% to financial services.

The benefits of convertible bonds are especially apparent in bad market years. In 2002, the stock market was down 22%, while the convertible bond market was down 8.5%. Investors should note CWB’s index does not convert its holdings into stock. Instead, the fund will hold convertible bonds to give investors exposure to the market similar to the way any other bond index would and will track the risk/return yield of its index. Either way, CWB offers an opportunity to stay in the bond game while generating decent returns in the face of rising rates.

SPDR Barclays Convertible Securities ETF

ETF Trends editorial team contributed to this post. Tom Lydon’s clients own shares of LQD.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

Tickers