The market has seen a sudden surge in convertible bond investing owing to the growing concerns of rising rates that hit the conventional debt markets. Meanwhile, stock markets set new highs last month and with decent economic fundamentals, this type of bond is back in the limelight.
This is especially true thanks to solid economic data such as a revised U.S. GDP figure of 3.6% for Q3 against 2.8% predicted earlier, a reduction in jobless claims and a continued surge in manufacturing numbers renewed the taper concern. This has pushed up interest rates leading to the widest spread between the 2-year and 10-year bond yield since July 2011 (read: 3 Sector ETFs to Profit from Rising Rates).
What Should the Bet Be Now?
Amid such a backdrop, it is necessary to look for some ETFs which are less-vulnerable to rate rises but offer decent level yields. At the same time, investors can take advantage of soaring equity markets. But finding a better option other than convertible bond ETFs that can serve all these factors in one product is a tall order.
The convertible bond is a ‘hybrid ‘product of both debt and equity. These are those products that can be exchanged if the holder chooses to, for a specific number of preferred or common shares if the company’s share price climbs past a said conversion price during the bond’s tenure. If it falls, some yield will still pass on to the investors’ though probably not as much as with a traditional bond.
As such, these are attractive for investors seeking to tap the potential upside in equities while enjoying a steady flow of income and reduced downside risk (read: Convertible Bond ETFs for Income With Growth Potential).
The price of these bonds generally moves in-line with the underlying shares. However, unlike shares, the convertible bonds have some coverage against downside risks as investors can redeem these at par on maturity if the issuer is in business. And in case of bankruptcy, convertible bond holders get paid out ahead of equity holders.
Flurry of Convertibles in 2013
To make the most of the situation, a deluge of issues from the likes of Yahoo (YHOO), Tesla Motors (TSLA), NetSuite (N) and Salesforce.com (CRM) has hit the market in 2013. The sales of converts more than doubled to $38.3 billion this year from $18.7 billion last year.
The largest was Yahoo’s issuance of $1.25 billion of convertible senior notes due 2018 in November. The deal had a conversion premium of about 45–50%. Low-yielding products are especially in demand due to rising rate concerns amid a prospective taper (read: Time for the Convertible Bond ETF?).
Choices are very few in this corner of the ETF world. There is only one pure-play in the convertible bonds section – SPDR Barclays Capital Convertible Securities ETF (CWB - Free Report) . Quite expectedly, the current macro backdrop has led to some great trading in CWB in the recent past.
Over the last six-month period, CWB has outpaced one of its big traditional bond counterparts PIMCO Total Return ETF (BOND - Free Report) by a wide margin and though it did not exactly catch up, was close to the return offered by the broad equity ETF SPDR S&P 500 (SPY - Free Report) . This suggests that the ETF could be an interesting pick for investors seeking exposure to the fixed income market, while still experiencing a bit of the equity rally.
This Barclays fund has so far generated $1.9 billion in assets and is exposed to 97 securities with average maturity of 12.88 years. The fund charges 40 basis points in expense per year and has a dividend yield of 3.47% currently. Around 35% of the holdings are rated Baa or higher thus implying lower default risks.
However, the fund hasn’t exactly done great in this QE Taper environment. It is flat over the past six months, which compares very unfavorably to its convertible bond counterpart, and the broad stock market as a whole as well.
‘QE Taper’ and ‘rising interest rates’ have become synonymous in the market. We would like to notify investors that even if the Fed starts tapering, income seeking investors may weather the fall in bond prices with rising stock prices through this instrument.
And with the broader economy finally finding its footing, stock markets are expected to hold steady next year, potentially making CWB a solid pick for investors seeking a good combo of fixed income and equity in their portfolios.
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report >>