Time for Convertibles?

07/25/2017 2:50 am EST

Focus: DIVIDEND

Richard Moroney

Editor, Dow Theory Forecasts

In today’s environment of strong but increasingly risky equity markets coupled with rising interest rates, convertible securities seem especially attractive, explains Richard Moroney, editor of Dow Theory Forecasts.

However, be aware — convertible securities are really stocks dressed up like bonds, and not the other way around. That distinction has important implications for how investors should use this asset class.

Convertible securities combine characteristics of stocks and traditional fixed-income securities. Convertibles come in two flavors — convertible bonds and convertible preferred stocks.

Convertible bonds feature a coupon rate and a fixed maturity date, just like traditional bonds. As part of the company’s debt structure, they have preferential treatment versus equity in cases of bankruptcy.

Like nonconvertible preferreds, convertible preferred stock pays a fixed dividend rate, which  carries precedence over the dividend paid on common shares.

Most of these convertibles can, under certain conditions, be exchanged or converted into a specific number of shares of the issuer’s common stock.

Historically, convertible securities have participated in a greater portion of the stock market’s upside than its downside. 

For the full 25-year period through year-end 2016, convertibles captured 96% of the S&P 500 Index’s annual return of 9.2% at a lower risk level, as measured by standard deviation.

Convertibles typically do better than conventional bonds in periods of rising interest rates. Because convertibles usually feature shorter maturities (oftentimes three to five years), duration is lower, which makes them less sensitive to interest rate movements.

Also, in rising-rate environments, which tend to pinch traditional bonds, convertibles may favor the returns of the equity market.

You can invest in convertibles using an exchange-traded fund. SPDR Bloomberg Barclays Convertible Securities (CWB)  has gained 10% so far this year. With assets of nearly $4 billion, this ETF is the biggest in the convertible space.

The fund charges an annual expense ratio of 0.40%. A smaller option is the iShares Convertible Bond (ICVT) , with assets of $185 million. The fund, up 9% year-to-date, has an expense ratio of 0.20%.

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