Convertibles: Hybrids for Income

11/14/2013 9:00 am EST

Focus: STRATEGIES

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

Convertible securities are bonds or preferred stocks that pay less interest than regular bonds or preferred stocks, but that can be converted into common stock at a certain price, explains Mark Salzinger, editor of The Investor's ETF Report.

As such, they may offer a potentially compelling package: less risk and higher potential income than pure equity exposure, but increasing benefit as a stock gains.

Because of the conversion feature, the value of individual convertible securities is often highly correlated to the value of the underlying stock.

This gives convertibles far more capital appreciation potential than conventional bonds, especially when the conversion price is close to or above the current stock price.

At the same time, convertibles are bonds: they pay periodic interest and return principal on a given maturity date, so the value of the bond portion of the convertible creates a floor under the security's price—as long as the issuer remains solvent.

However, current issuers of convertible bonds tend to be smaller companies and/or companies with credit ratings below investment grade. So their prices may suffer during economic downturns, or just poor performance for small-caps.

Thanks largely to their hybrid nature, convertibles tend to outperform high yield bonds during periods of rising interest rates.

According to Morningstar, the average convertible bond mutual fund gained 7.3% in periods of rising interest rates over the past 35 years. High yield bond funds gained only 1.1% when rates were rising.

This month we add SPDR Barclays Convertible Securities (CWB) to our coverage. The fund invests in convertibles from US companies, and each convertible must have been part of an offering worth at least $500 million. This eliminates the smallest issuers.

Recently, CWB held 91 securities; its largest position accounted for nearly 5% of the portfolio. Technology accounts for nearly one third, followed by the consumer non-cyclical (18%), finance (13%), and consumer cyclical (12%) sectors. About 40% of the portfolio is rated investment grade.

The portfolio has a sort of barbell maturity structure, with a big portion in convertibles with shorter maturities and another big slug in longer maturities.

We think CWB is appropriate for moderate, income oriented investors, especially as interest rates are low and likely to rise over the coming years.

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