In an improving stock market and rising interest rate environment, convertible bonds and the related exchange traded fund could be an attractive option for a fixed-income portfolio.
Convertible bonds are a type of fixed-coupon security that allow the holder the option to swap the bond security for common or preferred stock at a specified strike price. Within the capital hierarchy, convertibles are senior to equities but subordinate to traditional bond securities.
“Because of their equity attributes, convertible bonds are less interest-rate-sensitive than fixed income,” according to Morningstar analyst Abby Woodham. “Convertibles outperformed high-yield bonds, long-short equity, and large-blend equity when rates were both rising and falling from January 1978 to August 2013. However, the category falls behind when rates are neutral. Convertibles appear to shine during extreme points of the interest-rate cycle.”
Year-to-date, the SPDR Barclays Convertible Securities ETF (NYSEArca: CWB) has increased 7.4%, compared to the 3.4% gain in the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG). [It Could be Time to Call on the Convertibles ETF Again]
CWB tracks a collection of investment-grade and speculative-grade securities, including bonds rated A 8.8%, Baa 25.6%, below Baa 34.2% and not rated 31.4%. The ETF has a 2.16% 30-day SEC yield.
Convertibles typically perform well when the equities markets strengthen, which occur during a healthy economic environment, reports mike Cherney for the Wall Street Journal.
Additionally, while convertibles may move with the broader equities market, the securities are less volatile than stocks since they would pay their full principal at maturity like a regular bond.
“Convertible-bond funds like CWB tend to behave like a lower-volatility, higher-yielding version of domestic large-cap equities,” Woodham said. “CWB is highly correlated to large-cap U.S. stocks, but its swings are less extreme.”
Nevertheless, there are still some lingering concerns over valuations as investors have pushed up convertible bond prices in their quest for yields. Consequently, the average yield on new convertible notes this year is down to 2.7% from 3.8% in 2011.
SPDR Barclays Convertible Securities ETF
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Max Chen contributed to this article.