Convertible bonds offer investors fixed interest rates, as well as the potential for growth through exposure to equities. Due to the option to exchange these bonds into equity positions, convertible bonds tend to perform better than Treasurys and investment-grade bonds in rising rate environments. For fixed-income investors, incorporating convertible bonds into the mix through the use of exchange-traded funds (ETFs) can add an element of growth, which can provide a hedge against rising rates.

A Primer on Convertible Bonds

Convertible bonds are corporate debt instruments that pay a fixed interest rate and provide investors with the option to convert the bond for a specified number of common or preferred shares of the underlying stock. For example, a convertible bond with a par value of $1,000 and a conversion ratio of 50 would be exchangeable for 50 shares of the underlying stock.

Dividing the purchase price of the bond by the conversion ratio gives the break-even price for converting into the underlying shares. In this example, if the bond is purchased at its par value of $1,000, the conversion ratio of 50 would put the break-even price for the underlying shares at $20.

Any appreciation of the price of the underlying shares over $20 will increase the intrinsic value of the bond. This value can be determined by multiplying the conversion ratio by the share price. With the share price at $25, for example, the conversion ratio of 50 would increase the intrinsic value of the bond to $1,250.

If the Federal Reserve Bank follows through with a series of interest rate hikes over the next several years, the potential for growth as well as income makes convertible bond ETFs a sensible addition to fixed income portfolios. The following is a summary of three convertible bond ETFs, as of March 16, 2016.

The SPDR Barclays Convertible Securities ETF

With assets under management of $2.16 billion, the SPDR Barclays Convertible Securities ETF (NYSEARCA: CWB) was far larger than the younger funds in this category. The fund tracks a market cap-weighted index that includes only the largest convertible bond issuers, limiting its holdings to bonds with minimum issue size of $500 million. The fund paid a distribution yield of 5.32%, generated in part by its extended average maturity of 13.61 years.

The combination of a competitive expense ratio of 0.4% and a narrow trading spread of 0.04% made this fund inexpensive to hold, buy and sell. The daily volume average of $39 million, based on the trailing 45 trading days, provided sufficient liquidity for larger trades. The fund’s three-year annualized return is 6.57%.

The iShares Convertible Bond ETF

With an inception date of June 2, 2015, the iShares Convertible Bond ETF (NYSEARCA: ICVT) has yet to gain traction with investors as evidenced by its $17 million in AUM. The fund’s holdings come from a wider pool of convertible bonds than the SPDR Barclays Convertible Securities ETF, as it draws from issues of greater than $250 million. The fund tracks a market value-weighted index, but limits it positions to bonds that pay interest in cash, while excluding zero coupons, mandatory conversions and preferred convertibles.

The iShares Convertible Bond ETF maintained short-term exposure with an average bond maturity of 1.54 years and duration of 1.3. The fund had the lowest expense ratio of the three convertible bond ETFs at 0.35%, but can challenge investors with a trading spread that averaged 2.64%, which was significantly larger than its distribution yield of 1.68%. The year-to-date return was -5.11%.

The First Trust SSI Strategic Convertible Securities ETF

As the youngest convertible bond ETF, the First Trust SSI Strategic Convertible Securities ETF (NASDAQ: FCVT) differs from the other funds in this group by taking an active, versus an indexed-based, management approach. As result, the ETF’s expense ratio was a multiple of the other two funds in this group at 0.95%.

Like the iShares Convertible Bond ETF, this fund has struggled to attract investors since its inception date of Nov. 4, 2015, with only $4.77 million in AUM and a daily trading average of $14,380. The fund started paying a monthly dividend of 3 cents in January 2016, which on an annualized basis would result in a distribution yield of 1.53%. The fund has a year-to-date return of -1.5%.

The Bottom Line

Convertible bond ETFs offer investors a strategy that can generate growth and income during periods of economic expansion and rising rates. Within this group, however, investors seeking exposure to convertible bonds may want to avoid the smaller ETFs as they try to gain traction, and focus attention on the SPDR Barclays Convertible Securities ETF, the most senior, largest and highest-paying fund in the group.

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