The latest addition to PowerShares’ ETF lineup is a fund focusing on convertible bonds, a unique asset class that maintains characteristics of both fixed income and equity securities. The new PowerShares Convertible Securities Portfolio (CVRT) will seek to replicate the performance of the BofA Merrill Lynch All U.S. Convertibles Index, which serves as the benchmark for a number of convertible bond mutual funds [see the free Mutual Fund To ETF Conversion Tool]. That index is a broad measure of the U.S. convertible market, including both investment grade and non-investment grade convertible securities.
Under The Hood
|Modified Duration||5.77 years|
|Average Conversion Premium||25.86%|
|Average Equity Market Cap||$2.24 billion|
|% Investment Grade||43.3%|
|% Speculative Grade||24.3%|
|% Not Rated||32.4%|
|Source: PowerShares, as of 5-26-2011|
The new convertible bond ETF has about 60 individual holdings, with the largest individual components being debt of Amgen, Inc., General Motors, and United Continental Holdings. The fund has an average coupon of nearly 4% and a modified duration of about 5.8 years.
Convertible bonds combine various features of traditional stock and bond investments into a single security, potentially creating an attractive risk/return profile. From the beginning of 1995 through the first quarter of 2011, the index to which CVRT is linked returned just under 9% annually. That percentage beat investment grade corporates by about 180 basis points and junk bonds by 75 basis points, and even topped the annualized return from the S&P 500 [see Bond ETFs: 12 Stops Along The Risk/Return Spectrum].
Convertible bonds are described as such because holders of these securities have the option to convert the debt instrument into a predetermined number of common shares. So if the common stocks of the issuer appreciates past a certain threshold, holders will be incentivized to convert their holdings to equity. For example, a convertible bond with a par value of $100 may be convertible to one share of common stock. If the stock is worth $80 per share, investors will maintain the bond position and collect coupon payments. But if the stock appreciates to $120, investors can convert the note to common stock, which is then more valuable. As such, convertible bonds allow investors to participate in the upside potential of an issuer through the option to convert to equity while maintaining downside protection through coupon payments that are senior to any distributions to shareholders. Currently, the average conversion premium for CVRT is approximately 26% [Five Bond ETFs Worth A Closer Look].
In return for the option to participate in the equity upside, convertible bonds may offer generally lower coupon payments. At just 3.9%, the average coupon for CVRT compares to about 5.7% for the iShares iBoxx Investment Grade Corporate Bond Fund (LQD), which generally consists of debt from higher quality issuers (about a quarter of the CVRT portfolio is rated below investment grade). So convertible bonds may be a useful asset class for those willing to give up a bit of current return in exchange for greater upside potential if stocks rally.
The competition in the convertible bond ETF space isn’t exactly intense; State Street has offered the SPDR Barclays Convertible Bond ETF (CWB) for a little more than two years; that fund has about $900 million in AUM, and currently offers a dividend yield of about 3.9%. CWB seeks to replicate the Barclays Capital U.S. Convertible Bond >$500MM Index, and holds approximately 110 individual securities. CWB maintains a dividend yield of about 3.9%, similar to the new PowerShares fund. CVRT will be slightly cheaper, charging 0.35% compared to 0.40% for CWB [also see Convertible Bond ETF Under The Microscope].
[For more on the new convertible bond ETF, see the CVRT fact sheet. For updates on all new ETFs, sign up for our free ETF newsletter.]
Disclosure: No positions at time of writing.