A Bond ETF With An Equity Feel

Investors looking for bonds that often feel like stocks can consider convertible bonds, which are easily accessible via the SPDR Bloomberg Barclays Convertible Securities ETF CWB.

Convertible bonds are hybrid securities that give investors the option to convert those bonds into shares of common stock of the issuing company.

What Happened

Historically, convertible bonds have been among the best areas of the bond market to be involved with when interest rates rise, but CWB betrayed that reputation last year. Amid fears about the state of high-yield corporate debt and the fourth-quarter equity market plunge, CWB showed its correlation to equity market gyrations.

After slumping in the last three months of 2018, CWB finished the year lower by 2 percent compared to 0.1-percent gain for the Bloomberg Barclays U.S. Aggregate Index.

Why It's Important

The correlations between convertible debt and stocks can't be understated.

“As the price of underlying stocks gets closer to or above the conversion price, the value of the convertible bond rises, becoming more sensitive to the change of the stock price and taking on more stock-like characteristics,” said State Street in a recent note. “When the stock price falls below the conversion price, the convertible behaves more like a bond, and its value does not fall as much as the stock because the coupon and principal value of the bond creates investment value.”

Another element of the convertible game investors need to acknowledge is that convertibles are usually closer to junk bonds on the quality spectrum than they are to investment-grade corporate debt. CWB holds 174 bonds, 23.51 percent of which are rated below Baa and 56.67 percent of which are not rated, according to issuer data. Investors, however, are compensated for that risk.

“Because of the value of the option to convert, the yield of convertibles is usually lower than that of non-convertible corporate bonds from the same issuer,” said State Street. “However, the chart below shows that in the past 10 years, convertibles have provided a higher yield than either equities or the traditional core fixed income segment.”

What's Next

While there is some risk associated with convertibles relative to Treasuries or investment-grade corporates, there are advantages compared to direct equity ownership.

“Convertibles’ periodic fixed coupon payment and the return of the principal value at maturity (if not converted before maturity) can potentially provide downside risk mitigation that is absent in equities,” according to State Street. “Convertibles have experienced lower volatility and less drawdown than the broader equity market over the past 10 years.”

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