Income is becoming harder to source in this low-yield environment and too much fixed income exposure can mean missing out on equity market upside. Convertible bonds split that difference for investors and for those that don’t want the commitment of a dedicated convertibles ETF, the Principal Spectrum Tax-Advantaged Dividend Active ETF (PQDI) is an ETF to consider.
PQDI, which debuted in June, features exposure to income-generating assets, such as preferred stocks and government bonds, but the rookie ETF also allocates nearly a third of its weight to convertible bonds.
PQDI “seeks to provide current income. Under normal circumstances, the fund invests at least 80% of its net assets, plus any borrowings for investment purposes, in dividend-paying securities at the time of purchase,” according to Principal. “Such securities include, without limitation, preferred securities and capital securities of U.S. and non-U.S. issuers. The fund invests significantly in securities that, at the time of issuance, are eligible to pay dividends that qualify for favorable U.S. federal income tax treatment.”
Companies, notably those with speculative-grade debt ratings, like convertible bonds because they can raise money at rates lower than those on ordinary bonds. Convertible investors later convert those bonds into equity.
Convertible Call
On the fixed-income side, as a result of the increase in a fiscal and monetary stimulus, long rates have increased, and the yield curve has slightly steepened over the past month. Consequently, a traditional 60/40 portfolio now yields the lowest amount on record as a result of the low rates and reduction in dividends, which may lead to challenges for income generation.
Convertible bonds are a type of hybrid fixed-coupon security that allows 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.
Convertible bonds are seen as a middle ground between stocks and bonds. The securities pay lower coupons than regular unsecured debt securities, but they can also make up the difference if the company’s shares continue to appreciate it.
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