Fed Pain For These Bond ETFs

Plenty of fixed income exchange-traded funds are benefiting from the Federal Reserve's reluctance to raise interest rates this year. That group includes, but is not limited to U.S. government bond funds, emerging markets debt ETFs and high-yield corporate bond offerings.

Predictably, the corners of the bond market and the ETFs offering exposure to those areas that would be alright with higher interest rates are being pinched. That includes convertible bonds and ETFs such as the SPDR Barclays Capital Convertible SecETF CWB, the largest ETF dedicated to convertible bonds.

“Convertible bonds are a type of hybrid fixed-coupon security that allow the holder the option to swap the bond security for common or preferred stock at a specified strike price. Due to the bond’s equity option, convertible bonds typically pay less interest than traditional corporate bonds,” according to ETF Trends.

Related Link: Poll: Economists Expect Next Fed Rate Hike In June

CWB shareholders do not see their positions in the ETF converted to equity in the issuers found in the fund. Historical data indicate that in previous periods of tightening by the Fed, convertibles were the best-performing part of the fixed income universe, so it stands to reason that with the Fed not raising rates, this asset class is struggling.

“While investors have shown willingness to return to corporate bond and equity funds as both asset classes rebounded from their lows, the added complexity around convertible bonds looks to have put off investors. The eight convertible bond ETFs globally have continued to see strong outflows in the eight weeks since the market started to rally in mid-February. Convertible bond ETFs saw $173 million of outflows in the opening quarter, which is the third straight quarterly outflow for the asset class,” said Markit in a new research note.

The research firm points out that although CWB is higher year-to-date, the ETF is trailing the S&P 500 and traditional investment-grade corporate bond ETFs, such as the iShares iBoxx $ Invest Grade Corp Bd Fd LQD.

What investors need to realize about convertibles is that they're a two-way street. These securities allow holders to convert into common shares at prices below the current market price. That's great for the holders, but converted bonds or preferred shares mean new common shares added to the shares outstanding total, which is to say convertibles dilute existing shareholders. The bigger the dilution, the worse the impact on the stock's price.

For now, it is Fed policy that is likely to dictate CWB and rival convertible ETFs.

CWB “outflows represent 5 percent of the assets managed by these ETFs at the start of the year and contrast with the ytd inflows seen into equity funds and those into the wider corporate bond asset class which underpins how unpopular convertible bonds have become in the current market,” added Markit.