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Home>Research & Insights>Investment Insights>This Fund's Recent Surge Comes From Its Sector Bets

This Fund's Recent Surge Comes From Its Sector Bets

Be aware of this fund's heavy tech-sector exposure.

Phillip Yoo, 09/06/2017

SPDR Bloomberg Barclays Convertible Securities ETF CWB provides market-cap-weighted exposure to the U.S. convertible-bond market across the credit-rating spectrum. While this market-cap-weighting approach reduces transaction costs, it leads to an unintended, concentrated bet in the technology sector. Tracking error has also been an issue, and there is a cheaper index alternative. These considerations limit the fund's Morningstar Analyst Rating to Neutral.

Roughly half the fund's portfolio is invested in the technology sector, which is a source of risk. Its exposure to this sector was less than a fourth of the portfolio at the end of December 2012. Any negative developments in the sector could significantly hurt the fund’s return. This concentration is driven by growth-oriented companies such as Intel INTCLam Research LRCX, and Microchip Technology MCHP that have issued large amounts of convertible debt in the past few years. The surge in high-tech-sector stock prices enabled these companies to tap the convertibles market at attractive terms. Convertible debts may also be more accessible than traditional debt financing for many high-tech firms because they often have volatile cash flows.

The fund's sector concentration risk is partially offset by its high-credit-quality orientation. About 70% of its holdings are investment-grade companies, whereas the typical fund in the convertibles Morningstar Category has only a fourth of its portfolio invested in securities issued by BBB or higher-rated entities. The fund's interest-rate-risk profile is on par with the category mean.

Buoyed by the rise of high-tech stocks, the fund had a spectacular run. Its five-year annual return through June 2017 was 11.4%, handsomely beating the category average of 8.4%. However, the fund trailed its benchmark by 1.1% because of the underlying market's illiquidity during the same period. While its 0.40% fee is one of the lowest in the category, the 1.1% rift between the fund and the benchmark is alarming.

Fundamental View
Like a regular bond, a convertible bond pays coupons, but this security gives investors an option to convert the debt into equity if the issuing company's share price rises above a prescribed price. Traditionally, tech and healthcare firms have been the largest issuers of convertible debt, as these companies often have limited assets to pledge as collateral and volatile cash flows, which may deter lenders from providing capital. But they have been able to attract investors looking to participate in stock price appreciation.

Market-cap weighting skews the portfolio toward the largest debt issuers, which may not offer the best risk-adjusted returns. During the past five years, tech companies have issued a disproportionate share of convertible debt. A few factors have driven the recent surge of issuances. The surge of the broad high-tech sector was the most influential contributor. For example, Technology Select Sector SPDR ETF XLK gained 15.8% annually in the past five years through June 2017. The uptick fueled investors' appetite for the sector and made it easy for the businesses to issue convertible bonds at favorable terms. Also, as rates rise, companies gravitate toward convertible financing because interest payments are lower than more-traditional forms of financing.

This fund is biased toward the high-tech sector, which accounted for roughly 50% of the portfolio, as of June 2017. Tech, media, and telecommunications issuers make up seven out of the fund's 10 largest positions. This single sector concentration makes the fund highly vulnerable to sector-specific risk.

Compared with its category peers, the fund has a more-conservative credit-risk profile. Nearly 70% of its assets were rated investment-grade (BBB or higher), with the rest in the below-investment-grade bucket as of June 2017. The split for the category is 25/75 on average. This allocation explains the fund's better downside protection, as measured by five-year maximum drawdown through June 2017, which ranked the fund in the category's top third. Most convertible-bond funds, including this one, have a relatively short duration with moderate interest-rate risk.

Phillip Yoo is an analyst, passive strategies research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

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