The Federal Reserve boosted interest rates three times last year and fixed income market observers expect several more rate hikes this year, but that does not mean all corners of the bond market will be adversely affected. Convertible bonds and the related exchange traded funds could thrive if rates move higher.
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 ETF to consider is the iShares Convertible Bond ETF (Cboe: ICVT). The iShares Convertible Bond ETF seeks to track the investment results of an index composed of U.S. dollar-denominated convertible securities, specifically cash pay bonds, with outstanding issue sizes greater than $250 million, according to iShares, the world’s largest ETF issuer.
“Convertibles have characteristics that potentially augur well in the current environment,” according to BlackRock. “They can offer the growth potential of stocks, a possible plus at a time when the economic environment and earnings are generally supportive of equities, as we’ve seen with the steady rise in indexes across most asset classes. But they historically have lower equity beta and bond-like characteristics that may help provide some protection in downturns, where they have tended to exhibit less downside capture.”
Due in part to their equity-like characteristics, convertible bonds often perform well when interest rates rise. Historically, convertibles are among the best-performing fixed income assets in rising rate environments.