Take a Ride with Convertibles

11/04/2015 9:00 am EST

Focus: ETFs

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

Convertible bond ETFs offer investors a unique risk-reward profile owing to their equity-like appreciation potential and bond-like income production, explains Mark Salzinger, editor of The Investor’s ETF Report.

Most convertible bonds are hybrid securities that are redeemable, i.e., convertible, for stock at a predetermined price and quantity.

Convertibles are best considered a way to gain equity-like exposure to smaller companies, whose risk is mitigated over longer periods by the steady income production and floor value of its bond-like characteristics.

Given this kind of structure, convertibles tend to generate performance in between that of stocks and bonds over longer periods.

Through September 30, 2015, SPDR Barclays Convertible Securities (CWB) generated a three-year-annualized return of 9.3%.

Over that time, Vanguard Total Stock Market (VTI) and Vanguard Total Bond Market (BND) had annualized returns of 12.5% and 1.6%, respectively.

CWB also experienced 25% less volatility than VTI, giving it comparable risk-adjusted returns to the broader stock market.

This does not mean that convertibles are always a less risky way to gain equity-like exposure. Many issuers of convertible bonds are smaller companies with low credit ratings...or they have no credit rating at all.

So, while CWB’s average credit rating was recently BBB—the lowest tier of investment-grade credit ratings—more than one-third of its portfolio was unrated.

Technology companies are the largest issuers of convertible bonds. They make up more than 43% of CWB. Consumer noncyclical (17%) and finance companies (13%) are the only other sectors to account for more than 10%.

iShares Convertible Bond (ICVT) invests in a portfolio that is similar to that of CWB. Technology companies dominate (43% of assets), followed by consumer stocks (cyclical and non-cyclical, 29%).

ICVT has a bigger proportion of its portfolio in bonds rated below investment-grade (about 38%), as well as more in unrated securities (41%).

Part of that divergence stems from ICVT’s broader portfolio: it holds more than 155 bonds, vs. about 100 for CWB.

This breadth results from holding a greater number of smaller issues. ICVT invests in convertibles with at least $250 million in total face value; CWB only invests in those with at least $500 million.

This could make ICVT slightly more risky than CWB despite their similarities. To compensate for its additional risk, ICVT recently yielded more (3.8%) than its peer (3.0%).

For now, investors who are interested in such securities should stick with CWB because of its larger size and less risky portfolio.

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