Many fixed-income investors are reassessing their holdings as interest rates begin to rise. Consequently, more are beginning to include convertible securities, along with a related exchange traded fund, to ride out the storm in bonds.
Convertible bonds can be seen as a type of best of both worlds security, providing limited exposure to stocks with some of the safety features of bonds, according to Covestor.
“Convertibles are an in-between investment that can potentially substitute for both stocks and bonds,” Daniel Beckerman, who manages the Asset Allocation portfolio on Covestor, said in the article.
Convertible bonds are a type of corporate bond that allow investors the option to convert to equity at a set strike price above the current trading price of the company’s stock.
Since the bonds can be converted into stock of the issuer, convertibles are often more intimately correlated to equities than other segments of the bond market. But like bonds, convertibles promise coupon payments and return of principal at a set date. [Convertibles Cruise Into 2014]
While convertibles may have lower yields than other corporate bonds, the securities allow investors to participate in the potential upside in equities.
“If the market does well, convertible bonds will benefit, although investors will miss out on the first move higher until the strike price is reached,” Beckerman added. “If stocks perform poorly, then investors have some downside protection because convertible bonds have maturity dates, so investors will get the principal and yield. Historically, the performance of convertible bonds has been competitive with stocks but with lower volatility.”
The SPDR Barclays Convertible Securities ETF (NYSEArca: CWB) is the only convertible bond ETF available. CWB has gained 20.0% over the past year. The CWB comes with a 1.77% 30=day SEC yield.
“Convertible bond funds like CWB tend to behave like a lower-volatility, higher-yielding version of domestic large-cap equities,” according to Morningstar analyst Abby Woodham. “CWB is highly correlated to large-cap U.S. stocks (93% correlated with Morningstar’s large-cap blend category over the past three years), but its swings are less extreme.”
Nevertheless, potential investors should be aware that the securities are still considered debt subject to the issuer’s credit risk. Additionally, the securities can underperform if rates rise while stocks fall.
SPDR Barclays Convertible Securities ETF
For more information on bonds, visit our bond ETFs category.