No move from the Fed. We take a look at convertible bonds, one of only two fixed income groups that currently have a positive score direction in the Asset Class Group Scores.
In a move that was widely expected, the Fed announced Wednesday afternoon that it would leave the federal funds rate unchanged. The five-year FVX and 10-year TNX US Treasury Yield Indexes remained unchanged on their default charts, while the US Treasury 30-year Yield Index TYX reversed into Os at 2.225%.
As we mentioned last week, there are currently only two fixed income groups that have positive score directions – the inverse fixed income group and the convertible bonds group. With that in mind, today we wanted to take a look at convertible bonds, which, because they make up a very small portion of the fixed income market are often overlooked. However, the unique features of convertibles can make them an attractive inclusion in your fixed income allocation.
Convertible bonds are hybrid securities with features of both debt and equity. Convertible bonds have an embedded option which the bondholder the right, but not the obligation, to exchange the bond for a pre-determined number of shares of the issuer’s common stock. A convertible bond investor can profit from exercising the conversion option if the market price of the issuer’s stock is higher than the conversion price. The conversion price is the price at which the bond can be converted to common stock (e.g. a $1,000 par value bond redeemable for 50 shares of stock would have a conversion price of $20). In a situation where the underlying equity value of a convertible bond is higher than its conversion price the bond will generally trade much like equity, i.e., the price of the convertible bond rises and falls with the stock price.
Due to the hybrid nature of convertible bonds, they have both advantages and disadvantages for fixed income investors. First, because of their equity-like characteristics, convertible bonds are typically less affected by interest rate fluctuations than other segments of the fixed income market like Treasuries and investment grade corporate bonds. Which means they can provide diversification within a fixed income allocation. However, this is a double-edged sword, because convertible bonds also show a higher correlation to equity markets than other types of bonds, which means they may provide less diversification from an overall portfolio perspective, and just as equities are generally more volatile than bonds, convertible bonds are typically more volatile than other areas of the fixed income market.
While convertible bonds have higher volatility and generally higher possible returns than non-convertibles, the value of the straight (option-free) bond acts as a floor to the value of the convertible bond, thereby making it less risky than a straight equity investment. However, because the option to convert is an option to the bondholder, a convertible will have a lower yield than an otherwise equivalent straight bond. Several methods for valuing convertibles exist. The most common and straightforward is the value of a straight bond plus the value of a call option on the issuer’s equity.
If you are interested in adding convertible bonds to your fixed income portfolio, you may wish to consider the following ETFs: SPDR Bloomberg Barclays Convertible Bond ETF CWB, iShares Convertible Bond ETF ICVT, and the First Trust SSI Strategic Convertible Securities ETF FCVT.
