Entering 2016, the financial markets are preparing for the Federal Reserve to begin raising interest rates after keeping them at the bottom for several years. Many investors, apprehensive about the potential effects of an interest rate increase, are seeking investments that offer both greater income opportunity and additional safety. For such investors, convertible bonds, mixing the benefits of the debt and equity markets, may be an appealing investment.

Explaining Convertible Bonds

Convertible bonds are corporate bonds that offer bondholders the option to exchange the bonds for a certain number of common or preferred stock shares if the company's stock price rises above a specified level, referred to as the conversion price. Otherwise, convertible bonds are just like other corporate bonds, issued at a par value and having fixed coupon rates and maturities.

The advantage of convertible bonds is that they allow the bondholder the potential to profit from a company in both the debt and equity markets with minimal risk. The tradeoff is that in exchange for the extra opportunity for profit, bond buyers have to accept a significantly lower coupon payment than would be offered with similar traditional bonds.

The price of convertible bonds usually moves in concert with the price of the company's stock shares. The bonds carry less risk than an outright equity investment since they can be redeemed at par on maturity, and in the event of bankruptcy, bondholders stand ahead of stockholders.

There are very few exchange-traded funds (ETFs) that offer investors specific exposure to convertible bonds. Two of the three available ETFs as of 2015 have only recently been introduced, and the oldest existing fund only dates back to 2009. However, it is likely that more will be introduced as the interest rate environment begins to shift.

SPDR Barclays Convertible Secs ETF

The SPDR Barclays Convertible Secs ETF (NYSEARCA: CWB) was launched by State Street Global Advisors in 2009 and has garnered more than $2.5 billion in assets under management (AUM). The fund aims to provide investment results that track the price and yield performance of the Barclays U.S. Convertible Bond >$500MM Index. The underlying index is a market-cap-weighted index designed to reflect the overall performance of the U.S. market of convertible bonds, both investment grade and non-investment grade, that have issue sizes in excess of $500 million. The fund is usually at least 80% invested in securities contained in the index or securities that the fund manager identifies as having characteristics essentially identical to the characteristics of securities contained in the index.

More than half of CWB's holdings are in securities rated BBB or lower, or in unrated debt securities. The allocation of the fund's assets is heavily weighted in the technology, utilities, consumer non-cyclical and financial services sectors that, combined, account for nearly 60% of the fund's holdings. The average maturity of the fund's portfolio holdings is 11.52 years, and the average coupon is 4.08%. Top portfolio holdings include Watson Pharmaceuticals at 5.5%, Wells Fargo at 7.5%, Fiat Chrysler at 7.875% and Intel at 3.25%. The fund's portfolio turnover ratio is 38%.

The expense ratio for the SPDR Barclays Convertible Secs ETF is 0.4%. The 12-month dividend yield, as of November 2015, is 4.54%. The fund's five-year annualized return as of 2015 is 7.58%. Morningstar rates the fund as offering above-average returns with only average risk, making this fund a good fit for investors seeking an established convertible bond ETF offering a favorable risk/reward profile.

iShares Convertible Bond ETF

The iShares Convertible Bond ETF (NYSEARCA: ICVT) was introduced by Blackrock in June 2015 and has accumulated nearly $20 million in total assets as of November 2015. This fund aims to track the price and yield performance of the Barclays U.S. Convertible Cash Pay Bond >$250MM Index, a subset of the Barclays U.S. Convertibles Cash Pay Bonds Index. The underlying index is a market value-weighted index designed to reflect the performance of U.S. dollar-denominated convertible bonds with outstanding issues greater than $250 million. The fund is typically 90% or more invested in the securities of the underlying index. It may invest a maximum of 10% of assets in futures, options or swap contracts, or securities with similar characteristics to those contained in the index.

Like the other funds in this category, more than 50% of the iShares Convertible Bond ETF portfolio holdings are in securities rated BBB or lower. The portfolio allocates the bulk of its assets to the technology, health care, consumer defensive and financial services sectors. The weighted average maturity of the fund's holdings is 8.48 years, and the average weighted coupon is 1.95%. While no single security accounts for more than 5% of portfolio assets, major holdings include Verisign, Inc. at 4.30%, Intel Corporation at 3.25% and Gilead Sciences at 1.63%.

The iShares Convertible Bond ETF has an expense ratio of 0.35%. The fund has not been traded for long enough to establish annual dividend yield or return figures, nor has it been around long enough to acquire risk/return ratings from Morningstar. This fund is best-suited for investors seeking convertible bond exposure who are willing to take a chance on a relatively new fund and who prefer the fund's broader range of potential bond investments as compared to the SPDR Barclays Convertible Securities ETF.

First Trust SSI Strat Convert Secs ETF

The First Trust SSI Strat Convert Secs ETF (NASDAQ: FCVT) was launched in November 2015 by First Trust Advisors. So far, the fund has only secured about $5 million in total assets. It is an actively managed ETF with the stated investment goal of providing the maximum total investment return possible through a diversified portfolio of U.S. domestic and foreign convertible securities. The fund is typically 80% or more invested in such securities. The fund manager uses quantitative and fundamental analysis to attempt to identify convertible securities that offer above-average value and risk/reward characteristics. Unlike the two other ETFs in this category, this fund is not restricted in terms of geography, credit quality or issue size. The fund may hold debt securities denominated in currencies other than the U.S. dollar.

The bulk of the debt securities in the FCVT portfolio are rated BBB or lower. The fund's assets are concentrated in the technology, health care, consumer defensive and financial services sectors. More than half of the fund's current holdings have maturities between one and five years. The average weighted coupon is 2.02%. Major holdings include Allergan Plc, Series A at 5.5%, Hologic with a variable rate, Nvidia at 1% and Tesla Motors at 0.25%.

The expense ratio for the First Trust SSI Strat Convert Secs ETF is 0.95%, more than twice that of the other two ETFs in this category. As the fund is brand new, there are no figures available for dividend yield or annualized return. For the same reason, Morningstar has not yet established any risk or return ratings for the fund. This fund is best suited for investors who are willing to pay the fund's substantially higher expense ratio because of their belief that the fund's active management and wide open investment style will result in superior returns. Since the fund is new and has no established track record, it is not suitable for generally risk-averse investors.

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