Historically, convertible bonds are solid performers during rising interest rate environments, but there are other reasons to consider the SPDR Barclays Convertible Securities ETF (NYSEArca: CWB). CWB is the largest convertibles exchange traded fund on the market.
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.
CWB “provides market-cap-weighted exposure to the U.S. convertible-bond market across the credit-rating spectrum. While this market-cap-weighting approach reduces transaction costs, it leads to an unintended, concentrated bet in the technology sector,” said Morningstar in a recent note.
CWB allocates over half its weight to technology convertibles, but that makes sense because the sector is one the largest issuers of such debt. Fortunately for CWB, the technology sector is the best-performing group in the U.S. this year. That is helping drive performance for the ETF because convertible bonds often track equities on a fairly close basis.
Companies, notably those with speculative-grade debt ratings, like convertible bonds because they can raise money at rates lower than those on ordinary bonds.
Other CWB advantages include convertibles’ status as the top-performing bonds when rates rise and an expense ratio of just 0.4%, more than 70 basis points below the average actively managed convertible bond mutual fund.
“The fund’s sector concentration risk is partially offset by its high-credit-quality orientation. About 70% of its holdings are investment-grade companies, whereas the typical fund in the convertibles Morningstar Category has only a fourth of its portfolio invested in securities issued by BBB or higher-rated entities. The fund’s interest-rate-risk profile is on par with the category mean,” according to Morningstar.
Competitors to CWB, the dominant convertibles ETF include the iShares Convertible Bond ETF (BATS: 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.
“Propelled by its low fee and large allocation to technology bonds, the fund’s five-year annualized return of 11.4% through June 2017 surpassed the category group by 3 percentage points. This outperformance was principally driven by the fund’s high correlation to high-tech stocks,” said Morningstar regarding CWB.
For more on bond ETFs, ] visit our fixed income category.
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.