Convertible Bond ETFs: Best of Both Worlds?

by on June 8, 2009 | ETFs Mentioned:

Most ETFs available to investors today fit neatly into one of several primary asset class categories: equity ETFs, bond ETFs, commodity ETFs, etc. But as the ETF industry continues to rapidly expand, sponsors have introduced increasingly complex funds that track unconventional benchmarks and defy a quick categorization. SPDR Barclays Capital Convertible Bond ETF (CWB) is one such security that offers exposure to a unique “hybrid” asset class.

A Quick Primer

Convertible bonds, while issued as debt securities, can be exchanged for common equity at a predetermined conversion ratio. For example, a company whose stock is trading at $100 may issue convertible bonds in $1,000 increments that can be converted to five shares of common stock. If the company’s stock price rose above $200, the bondholders would (presumably) exchange their debt for common stock. Because holders of convertible bonds maintain an “upside” related to the convertibility of the securities, the interest rate is typically lower than rates on otherwise comparable corporate bonds. These reduced borrowing costs make convertible bonds an attractive financing option for companies, although the potential equity dilution in the event of a rising stock price is a serious drawback.

CWB’s Performance

With equity prices plummeting over the last 18 months, many older convertible bonds fell further “out-of-the-money,” diminishing the likelihood of an equity conversion. As the value of the equity option has declined, prices of many convertible bonds have decreased, as these securities essentially became fixed income instruments paying an interest rate well below a market level. As equity markets have staged an extended rally in recent months, the equity options of many convertible bonds (particularly recent issues) have increased in value, resulting in rallying convertible bond prices.

Since convertible bonds maintain characteristics of both debt and equity securities, it isn’t surprising that CWB’s performance has fallen between returns of diversified equity and bond ETFs. Since its inception in April of this year, CWB has returned 5.9%, compared to 9.3% for IVV and -0.5% for AGG. Although convertible bonds may sound like exotic securities, in reality they are a combination of bonds and stocks, and as such, their risk and return characteristics fall somewhere in between. The equity upside, coupled with downside protection in the event of sinking equity prices, makes convertible bonds an interesting option for investors seeking to generate higher returns than traditional corporate bonds with a lower risk profile than common equities.

Convertible Bond ETF Performance