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.

The $3.99 billion, which is almost 10 years old, “seeks to provide exposure to the market of U.S. convertible securities with an issue amount of at least $350 million and a par amount outstanding of at least $250 million,” according to State Street.

Due to the equity component, convertible bonds are often more correlated to stocks than other areas of the fixed income market.

“As the price of underlying stocks gets closer to or above the conversion price, the value of the convertible bond rises, becoming more sensitive to the change of the stock price and taking on more stock-like characteristics,” said State Street in a recent note. “When the stock price falls below the conversion price, the convertible behaves more like a bond, and its value does not fall as much as the stock because the coupon and principal value of the bond creates investment value.”

Inside CWB ETF

CWB allocates over 27% of 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 one of the best-performing groups 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.

“The option to convert to equities allows investors to participate in some of the upside of a rising equity market,” said State Street. “Given that convertible financing is particularly attractive for growth companies, which tend to exhibit strong earnings and sales growth but with low cash flows, convertibles often provide growth-oriented exposure.”

If the Federal Reserve surprisingly reverses course and decides to raise interest rates again this year, CWB could benefit.

“With their unique risk/reward profile, convertibles have historically exhibited low correlations to traditional interest-rate-sensitive bond sectors, making them a potential portfolio diversifier,” according to State Street.

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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.

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