The Federal Reserve raised interest rates in March and many bond market observers expect at least one more rate hike before the end of this year. More rate hikes could be good news for convertible bonds and exchange traded funds, such as the SPDR Barclays Convertible Securities ETF (NYSEArca: CWB).
CWB, which is passively managed, is the largest convertible ETF and is higher by almost 8% year-to-date.
Convertible bonds are a type of hybrid fixed-coupon security that allow the holder the option to swap the bond security for common or preferred stock at a specified strike price. Due to the bond’s equity option, convertible bonds typically pay less interest than traditional corporate bonds. The fund, though, does not convert its holdings into shares, but investors are exposed to the equity premium due to the way the bonds are priced.
“A convertible bond may go through different phases during its life depending on the underlying equity price and the conversion feature. When the underlying equity price is below the conversion price, the convertible will tend to act more like a debt security rather than equity,” according to Stringer Asset Management. “As the equity price increases, the bond’s value will also increase due to the conversion feature. As the underlying equity price converges with the conversion price, the investor enters a sweet spot where they are participating more in the equity upside, while also collecting interest payments.”