Should You Consider a Convertible-Bond ETF?

One of the fastest-growing exchange-traded funds may come as a surprise:  SPDR Barclays Capital Convertible Securities (CWB), the only convertible-bond ETF. Convertible bonds are a niche asset class with an estimated market cap of less than $500 billion and are traditionally considered the purview of active managers. Only a handful of convertible-bond mutual funds and closed-end funds exist. Nonetheless, CWB almost doubled in size over the past year to more than $2 billion in assets, making it the third-largest convertible-bond fund of any kind. CWB is the sole passively managed option and is worth a look by investors searching for an asset class that can offer compelling risk-adjusted return and some extra yield compared with traditional equity investments.

The Basics
Convertible bonds are fixed-coupon securities that grant the holder the option of exchanging the bond for common or preferred stock at a specified strike price. These hybrid securities are senior to equity in the capital structure but usually subordinate to traditional bonds.

Convertible bonds have different performance characteristics depending on how the associated common stock has performed since the convertible was issued. Convertibles tend to be issued with a strike price that's 20%-30% higher than the current value of the stock. If a convertible bond's corresponding stock price is below the conversion price, it is valued like a straight bond. As the stock price reaches or surpasses the bond's conversion price, it will begin to trade in line with the stock and can benefit from the upside potential of the issuer's stock.

Under the Hood
CWB tracks the Barclays U.S. Convertible Bond >$500MM Index. The index includes bonds with an outstanding issue size of more than $500 million and more than 31 days until maturity. The index rebalances monthly.

The fund has a short history but has performed well within its category since its inception in 2009. Its volatility was average for convertible-bond funds, and its three-year annualized performance landed it in the second quartile of convertible-bond funds. A major contributor to the fund's good relative performance was its low expense ratio: CWB costs 0.40% a year, compared with a median 1.10% for convertible-bond funds. That's a lot of ground to cover.

The convertible-bond market is relatively small and can be illiquid, which may present some challenges for an index-tracking vehicle such as CWB. The fund utilizes representative sampling, and in this case, that means the fund excludes index constituents whose liquidity is insufficient. These thinly traded securities tend to have lower ratings, so the fund's average credit quality tends to be slightly higher than its index's. In most market environments the fund is able to closely track the performance of its benchmark, but when junk bonds outperform, the fund will likely lag the index. A particularly extreme example was 2013, when low-quality convertibles significantly outperformed high-quality. CWB lagged its index by 1.60%--far more than its expense ratio. The fund also lagged its benchmark during its early days in 2009.

Convertibles generally yield less than the company's standard corporate debt because their embedded call option has value. CWB tends to yield between 3% and 4%, compared with the 6%-9% offered by high-yield bond ETFs and 1%-2% from large-blend equity. The fund's distributions are typically taxed at the ordinary income rate. Needless to say, CWB is not a bond substitute, but its slightly above-average yield compared with equity makes it an option for multiasset income investors.

Muted Risk, Muted Return
Many investors think of convertible bonds as a bond with an embedded call option on the corresponding stock. When many different convertibles are held in a fund like CWB, the aggregate portfolio tends to behave like a lower-volatility, higher-yielding version of domestic large-cap equities. The fund is highly correlated with large-cap U.S. stocks (93% correlated with Morningstar's large-cap blend category over the past three years), but its swings are less extreme. CWB's standard deviation over the past three years was 10.1% compared with the S&P 500's 12.1%. Over a longer period, the Morningstar convertible-bond category had an average standard deviation of 12.3% and 12.8% over the past 10- and 15-year periods, compared with the S&P 500's 14.6% and 15.5%. Convertible bonds also tend to experience less drawdown than standard equity: the convertible-bond category captured about 76% of the S&P 500's upside over the past five years but only 60% of its downside.

Both the upside and downside potentials of convertibles are capped. Because convertible owners can still redeem for the face value of the bond no matter how poorly the company's stock performs, they are protected against extreme bear markets. The downside protection of convertible bonds proved valuable in market crashes like 2008, when convertible bond funds lost 39.89% compared with the large-blend equity category's 50.79% decline. As is the case with preferred stock, if a convertible is purchased for a higher price than its conversion value, the fund could take a loss.

The upside potential is also capped because bond issuers can force conversion. If a stock's price rises significantly above the corresponding convertible's conversion price, the company will likely force a conversion. The muted upside capture ratio of convertible bonds was particularly pronounced during 2013's market rally, when CWB generated "only" 63% of the S&P 500's return (the fund posted a 20.51% annual return for 2013) but had little opportunity to provide downside protection.

Because of their equity attributes, convertible bonds are less interest-rate-sensitive than fixed income. Convertibles outperformed high-yield bonds, long-short equity, and large-blend equity when rates were both rising and falling from January 1978 to August 2013. However, the category falls behind when rates are neutral. Convertibles appear to shine during extreme points of the interest-rate cycle.

Investors should consider the default risk of convertibles, which are usually subordinated debt. When companies can raise cash cheaply using straight debt, they are less likely to issue convertible bonds. The credit quality of companies issuing convertibles varies, but currently the average issuing firm has a credit rating of BB. Less than 40% of CWB's portfolio is investment-grade, but its average credit quality is slightly higher than the index's.

Actively Managed Alternatives
CWB is the only convertible-bond ETF available, but there are several convertible-bond mutual funds. Active management is far more common in the convertible-bond space than passive. Actively managed  Vanguard Convertible Securities  is rated Gold by Morningstar's analysts. This fund seeks attractively priced convertibles that provide a balance of equity- and bondlike characteristics. The fund will trim or eliminate a position when prices rise and the convertible begins to act like pure equity. The team has gradually raised the fund's international stake, with an eventual target of 30%. The fund charges 0.52% a year, which is the cheapest among convertible mutual funds.

Another choice is Neutral-rated  Calamos Convertible (CCVIX). The team looks for convertibles that are trading at moderate conversion premiums, meaning the convertible security is somewhat correlated with its underlying equity. This fund is expensive at 1.10% a year.

Neutral-rated  Fidelity Advisor Convertible Securities (FACVX) retains convertibles as they become more equity-sensitive and has built big positions in mandatory convertibles, which are strongly correlated to their respective stocks. Mandatory convertibles are a small component of the broader convertibles market. FACVX is slightly cheaper than the Calamos product at 1.04% a year.

Relative newcomer AllianzGI Convertible (ANZAX) is not yet covered by Morningstar analysts, but its performance record in both risk-adjusted and absolute terms over the past three years has been above-average. The fund charges a 1.06% expense ratio.

 

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