A Convertible Income Choice

By Aaron Levitt | February 22, 2012 AAA

Given the slow moving process of getting the economy back on track, the Federal Reserve has signaled that it plans to keep interest rates at historically low levels until 2014. For income seekers that continues to be a problem. Traditional sources of yield such as treasury bills, certificate of deposits and money market funds like the Guggenheim Enhanced Short Duration Bond (ARCA:GSY) pay next to nothing, and will do so for the next year or so. For those relying on their investments for their daily expenses, this means moving into some unfamiliar territory to gain yield. One unfamiliar and often ignored space could be exactly what income seekers need to play the low rate environment and ride any gains in equities.

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Big Yields in Hybrid Bonds
While preferred stock has been widely adopted by the general investing public, their bond/equity twins - convertible bonds have been largely ignored by portfolios. At their core, convertibles are basically a bond with a stock option hidden inside. Much like traditional bread-and-butter bonds, converts have face values, coupon payments and maturity dates, but can be exchanged for a specific number of shares of the issuer's common stock at a later date. This provides investors the potential to play both a company's debt and equity via a single security. Given that many factors affect the price of these investments, including the interest rate climate (which affects the bond side), supply and demand for the underlying stock (which affects the stock side), plus the conversion covenants and we can see why these types of bonds often do not make it to the average retail investor's portfolio. (For related reading, see Convertible Bonds: Pros And Cons For Companies And Investors.)

However, ordinary investors may want to give the bonds a go in their income portfolios. First, these bonds act like an insurance policy for equities. In falling markets, bond holders sit back and collect the securities juicy yields. While in rising markets, the bonds can be "converted" into shares of the underlying firm, benefiting from capital appreciation. According to Bloomberg, since 1995, the S&P 500 had negative performance for 51 out of 185 rolling 12-month periods. During that time, a broad measure of convertible bonds outperformed the S&P during 44 of those periods, by an average of 7.6%. In addition, converts participated on average in 83% of the upside during the rising phases. Secondly, during bankruptcy proceedings, converts rank higher than equities, given them a more favorable position on the ladder. Finally, yields for the average convertible bond tend to be higher than the company's stock dividend yield. This helps with outperformance during sideways or flat markets.

Adding Convert Income
For regular investors, adding convertible bonds has traditionally been quite difficult. After all, the entire size of the global convert market place is only around to $500 billion and $250 billion in the United States. This compares to the roughly $95 trillion in all bonds. Given the tightness of supply, a variety of traditional convertible mutual funds have closed over the recent months. However, for investors there are still ways to add the security type to a portfolio.

With nearly $800 million in assets, the SPDR Barclays Capital Convertible ETF (ARCA:CWB) is the largest exchange-traded fund (ETF) in the sector. The fund tracks 99 different converts from issuers such as Wells Fargo (NYSE:WFC) and EMC (NYSE:EMC) and yields a healthy 3.37%. The ETF has performed well, producing an annualized 14.75% return since its inception in 2009. Offering a lower maturity profile and cheaper expenses, the smaller PowerShares Convertible (ARCA:CVRT) makes an interesting choice as well.

Some the biggest and largest bargains in the space could be had in the various convertible closed-end funds. Asset manager Calamos (Nasdaq:CLMS) made their name specializing in the bond type. However, the firm has recently begun closing their funds to new investments. The Calamos Convertible & High Income Fund (NYSE:CHY) offers exposure to the asset manager at almost a 2.5% discount to its net asset value. Likewise, the Advent Claymore Global Convertible Securities & Income Fund (NYSE:AGC) offers global exposure to the convertibles market, with nearly 40% of its holdings outside of the U.S. The fund can be currently had for about an 8.96% discount and 8.28% yield. (For additional reading, see Open Your Eyes To Closed-End Funds.)

The Bottom Line
Given the low interest rate environment, income investors have continually sought new ways to find yields. One such ignored opportunity, is in the world of convertible bonds. These securities which offer both attributes of bonds and equities could be exactly what a portfolio needs. The previous funds, along with the Bancroft Fund (AMEX:BCV) make interesting choices within the sector. (To learn more, check out Convertible Bonds: An Introduction.)

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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