Convertibles: High Risk, High Yield

05/30/2016 9:00 am EST

Focus: ETFs

At $200 billion, the market for convertible bonds is a tiny fraction of the $39 trillion US bond market. But these assets can pay high yields, and though they come with special risks, those risks are minimized in convertible bond funds, explains Tim Begany, editor of Personal Finance.

The one we like best, SPDR Barclays Convertible Securities ETF (CWB), is an exchange-traded fund currently yielding 5.1% and a good instrument to diversify the income-generating portion of your portfolio.

Convertibles combine features of stocks and bonds. Like bonds, convertibles pay interest regularly until they mature or are called (redeemed early by the issuer). They also offer the option of exchanging the bonds for stock.

Convertibles are also good hedges against rising interest rates, which cause existing bonds to drop in value. This is because convertibles can benefit from gains in the issuer’s stock making them less sensitive to rising rates.

Their main risk is lower credit quality. While convertible bonds are available from all types of companies, those with credit ratings below investment-grade (less than BBB) are the most frequent issuers.

True, these firms are more apt to default, but historically their default rate is only about 4%.

Besides their complexity, individual convertibles sometimes lack liquidity, meaning investors can’t always buy or sell them quickly like stocks and traditional bonds. So it’s best to own them through a fund.

The seven-year-old SPDR Barclays Convertible Securities ETF has lower expenses than most of the other convertible bond offerings and keeps a lid on volatility.

Overall, CWB rose an average annual 7.1% the past five years; CWB’s ten-year record shows a 5.8% rate of return.

CWB has a low turnover, replacing only 28% of the portfolio a year on average since its 2009 launch.

Turnover results mainly from buying and selling as needed each month to match the Barclays convertible bond index, though the fund also occasionally sells to eliminate convertibles that are becoming hard to trade.

Holdings otherwise remain in the portfolio until they mature or are called. As a bond fund, CWB doesn’t exercise conversion options. Low turnover helps keep fund expenses to just 0.4% of assets.

With its equity component and lower credit rating, CWB can show substantial price volatility. It fluctuates almost three times as much as the broader bond market.

But the fund looks tame next to a pure stock portfolio. The past three years, CWB was 23% less volatile than the S&P 500 while providing solid total returns and more than twice the yield.

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By Tim Begany, Editor of Personal Finance

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