The current investment climate defies historically held common knowledge and perceptions concerning markets. In the past, bonds and stocks were inversely related; bond markets strengthened and yields declined as stocks declined, and vice versa. Due to recent central bank trends and policies, however, debt and equity markets are achieving new highs in tandem. The German-led European Central Bank and the Bank of Japan are both operating with negative interest rates in an effort to create market liquidity. Furthermore, economic stimulus to combat stagnant inflation has led to historically low bond yields at all-time high prices. The U.S. Federal Reserve has simultaneously kept markets on edge for rate hikes, with ambivalent language and indefinite postponements. Thus, investors are faced with the challenge of capitalizing on the bullish stock market without sacrificing potential yield amid rising bond prices. One solution may lie in convertible bonds.
Convertible Bonds
Constructed as a hybrid security, convertible bonds have a niche appeal for a number of yield-conscious institutional investors seeking the potential upside of specific stocks without the downside risks. Mechanically, convertible bonds are interest-bearing bonds that convert to common stock at a specific exercise price. Once the “strike price” is achieved in the equity market, the bonds appreciate in tandem with the common stock price. Convertible bonds offer investors the conservative, defensive nature of a bond, with the potential to turn into common stock in a market rally.
Savvy investors use convertible bonds to target a particular stock while hedging in order to achieve an interim return on investment while waiting for the stock to appreciate to a predetermined level. The bond coupon, while comparatively smaller than a traditional corporate bond issue, still maintains a yield factor that provides an annual income stream. The conversion option affords the investor the potential for larger gains if the stock price rallies.
Many institutional traders use convertible bonds for arbitrage by buying the convertible bond and shorting the stock. This allows for a “risk-free” profit, as they are technically long the stock through the bond. If the shares rally, they break even on the stock trade (the losses from the short are offset by the gains from the convertible bond), and if the shares fall, they make money on the short. In either scenario, interest payments are collected. Institutional traders provide a large market demand for these bonds, which benefits individual investors with a broader securities market that is ideal for indexing.
From the individual investor’s perspective, convertible bonds offer income and the additional opportunity for capital gains. Caution should be exercised, however, as debt from issuing companies is often on the lower tier of investment-grade or even lower junk status (companies normally pay higher coupon rates for senior debt issues when compared with companies rated BBB+ or better). Additionally, calculating valuations and following any prospective rating changes within a portfolio can be complicated. Premiums and cash-flow payback differentials are challenging to calculate on a per-bond basis, especially when the exercise price is close to the market price. Many issues also provide call provisions that often will be exercised in low interest rate environments, such as the current market. The prospective retail investor lacks the resources of a Bloomberg terminal and other industry tools that are in the hands of most industry professionals. The SPDR Barclays Convertible Securities ETF (CWB) offers a relatively simple way for individuals to participate in the convertible bond arena with diversification and relatively low transactional fees.
Composition
Founded by State Street Global Advisors in 2009, CWB tracks the Barclays US Convertible Bond > $500 MM Index, and is the largest and most established convertible-bond ETF on the market. The fund attempts to mirror the Barclays index, and this is reflected in most of the portfolio allocations, which are within 2 to 3 percent of the benchmark weightings. CWB has assets of $2.4 billion, and there are 53 million shares outstanding.
Within the fund, the average coupon is 3.77 percent, average maturity is 10.5 years, average price per bond is $125.6 and average yield-to-worst is 4.11 percent. Current yield is 3.61 percent, and average yield to maturity is 1.41 percent. Turnover average is 38 percent.
Due to the nature of the convertibles market and its associated companies, the bulk of CWB’s portfolio is lower-rated (BBB and under, or junk status), with a large percentage of unrated securities. As of August 15, 2016, the portfolio quality consisted of ratings as follows: Aaa (0.68 percent), A (6.43 percent), Baa (16.56 percent), below Baa (32.73 percent) and unrated (43.60 percent).
The maturity breakdown within the portfolio is as follows: 0-1 year: 9.34 percent;1-2 years: 16.82 percent; 2-3 years: 24.48 percent; 3-5 years: 14.81 percent; 5-7 years: 3.47 percent; 7-10 years: 3.84 percent; 10-15 years: 2.61 percent; 15-20 years: 3.46 percent; 20-30 years: 11.21 percent; and over 30 years: 0.89 percent.
From a sector perspective, CWB divides its portfolio with a predictably heavy weighting in technology, one of the biggest gain sectors in the equity markets. Of its holdings, 47.93 percent are technology companies, followed by consumer non-cyclicals (17.81 percent), finance (11.65 percent), energy (7.14 percent), communications (4.67 percent), consumer cyclicals (4.48 percent), utilities (3.92 percent), basic industry (1.41 percent), capital goods (0.66 percent) and other industrials (0.34 percent).
CWB’s current top 10 holdings are Mandatory Exchangeable Trust (5.75 percent), Wells Fargo (7.50 percent), Watson Pharmaceuticals (5.50 percent), Nvidia Corp. (1 percent), Bank of America (7.25 percent), Teva Pharmaceutical Industries (7 percent), Intel (3.75 percent), Verisign (4.34 percent), Tyson Foods (4.75 percent) and Intel (2.95 percent).
Fees and Expenses
CWB’s expense ratio is 0.40 percent. This is among the lowest available in the market. For comparison, the First Trust SSI Strategic Convertible Securities ETF (FCVT) is 0.95 percent, Franklin Templeton’s Convertible Securities Fund is 0.88 percent and the Fidelity Convertible Securities Fund is 0.85 percent.
CWB can be traded commission-free at Charles Schwab.
Performance
As of the end of the second quarter of 2016, CWB trailing total NAV returns for one year were 4.60 percent, three-year returns were 7.0 percent and five-year returns were 10.46 percent. A $10,000 investment made in 2009 at inception would be worth over $21,000 at present (including distributions).
The 30-day SEC Yield is 2.57 percent, and the 12-month yield is 5.23 percent. The difference generates from capital gains, which are paid almost every year. Investors should therefore consider holding the fund in a tax-deferred account.
Conclusion
CWB offers investors stock market exposure with a substantial yield, making it a solid choice for income investors who want equity risk. Since convertible bonds behave like equities once they hit a strike price, over the long run, funds such as CWB tend to behave more like stocks than like bonds. Investors should not expect defensive protection from CWB in the event of a market correction or a bear market. CWB is, however, approximately 30 percent less volatile than the broader S&P 500 Index. Finally, CWB is technology-heavy, and investors should evaluate current technology exposure before adding CWB to a portfolio.
