This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Gary Stringer, president and chief investment officer of Memphis, Tennessee-based Stringer Asset Management.
The U.S. stock market is at all-time highs, but one of the best ways to capture equity upside right now may instead be through convertible bonds.
As global equity markets appreciate and the business cycle advances, convertible bonds offer a diversified source of return and a compelling risk/reward trade-off.
The structure of convertible bonds allows them to participate in equity market upside, while presenting an attractive yield and less volatility risk than the global equity market.
Another benefit is that convertible bonds also have a relatively low correlation to traditional equities and bonds, which should prove beneficial if market volatility increases.
How It Works
Convertible bonds are hybrid securities, combining characteristics of equities and traditional bonds, as each convertible bond is exchangeable for equity shares. As equity prices move upward, the value of the convertible bond moves up to a degree based on its conversion feature. This can lead to a healthy amount of equity sensitivity as equities move higher.
However, as equities sell off, convertible bonds will fall. But they generally will find support on the downside as they begin to be valued for their fixed-income characteristics, such as the return of principal and interest payment.
As the chart above demonstrates, a convertible bond may go through different phases during its life depending on the underlying equity price and the conversion feature.
When the underlying equity price is below the conversion price, the bond will tend to act more like a debt security rather than an equity. As equity prices increase, the bond’s value will also increase due to the conversion feature.
The Sweet Spot
When the underlying equity price meets the conversion price, the investor enters a sweet spot where they are participating more in the equity upside while also collecting interest payments. As the equity price continues to rise, more equity sensitivity is experienced.
Combined, we like these characteristics in this elevated equity market environment.
Consider, for example, that though convertible bonds can participate in equity market gains, they have shown about 25% less volatility than the global equity market. This reduced volatility can translate into a more consistent return stream for investors—a smoother ride.
The ETF market has a few strategies to offer investors looking to tap into equity upside through convertible bonds, funds like the First Trust SSI Strategic Convertible Securities ETF (FCVT), the iShares Convertible Bond ETF (ICVT) and the SPDR Bloomberg Barclays Convertible Securities ETF (CWB). Two of these funds are outperforming the SPDR S&P 500 Trust (SPY) this year:
Chart courtesy of StockCharts.com
At the time of writing, Stringer Asset Management held ICVT and CWB among its universe of ETFs included in its suite of ETF Portfolios. Stringer Asset Management is a Memphis, Tennessee third-party investment manager and ETF strategist. Contact Stringer Asset Management at 901-800-2956 or at [email protected]. For a complete list of relevant disclosures, please click here.
Bloomberg Barclays U.S. Convertible Cash Pay Bond – This index represents the market of U.S. convertible bonds with outstanding issue sizes greater than $250 million. Convertible bonds are bonds that can be exchanged, at the option of the holder, for a specific number of shares of the issuer’s preferred stock or common stock.
MSCI ACWI (Net) Index – This index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI Index consists of 23 developed and 23 emerging market country indexes. Net total return includes the reinvestment of dividends after the deduction of withholding taxes, using a tax rate applicable to nonresident institutional investors who do not benefit from double taxation treaties.