Convert To Convertibles As Rates Rise

Now that the Federal Reserve has raised interest rates and is on course to do so several times in 2016, fixed income investors are evaluating avenues for coping with higher rates. Rising rates need not chase investors from all bond ETFs. Some have been holding up nicely while others may have been beaten up more than warranted given the ability of those funds to remain sturdy if rates continue to rise.

One of their primary destinations should be convertible bonds.

Convertible bonds earn that moniker because they can be converted into shares of the issuer's common equity. Convertibles, which are seen as having equity-like traits, have actually outperformed stocks during periods of rising rates as well being the top-performing fixed income asset class in rising rate environments. The embedded conversion option in convertible bonds mutes their sensitivity to higher interest rates.

Today, there are several convertible bond exchange traded funds on the market, including a newly minted, actively managed option. One of those options is the iShares Convertible Bond ETF ICVT, which debuted in June. 

The obvious reason for considering an ETF such as ICVT in a rising rates environment is the tendency of convertibles, likely because of their correlation to equities, to perform well in the face of higher borrowing costs.

“For example, when the Fed raised rates from 1 percent to 5.25 percent from June 2004 to June 2006, traditional bonds returned only 2.9 percent. Convertible bonds outperformed traditional bonds by returning 6.1 percent. Converts outpaced bonds, but still trailed equities which returned 7.5 percent annualized,” said iShares Head of Fixed Income Strategy Matt Tucker in a recent note. 

ICVT's sector tilt is highly cyclical, which positions the ETF to thrive as rates rise. Over 56 percent of the ETF's 155 issues hail from the technology or consumer discretionary sectors. Top 10 issues in the ETF include convertibles from Dow component Intel Corp. INTC, Priceline Group Inc. PCLN and Elon Musk's Tesla Motors Inc. TSLA.

“In 2013, the Fed indicated it would begin to reduce its bond purchases and 10-year US Treasury rates increased by 1.3 percent to 3.02 percent. Bonds fell in value and stocks rallied. Traditional bonds had losses of about 2 percent during 2013. The conversion feature helped keep convertible bond returns closer to equities, as they returned 26.4 percent and stocks returned 32.4 percent,” adds Tucker.