Best Convertible Bond Funds for 2017
Convertible bonds could meet the expected returns from an investment for both income and growth investors. There is an opportunity to generate a steady return or change the investment type to attempt to generate a higher rate of return.
This is no secret product that only exists for the sake of high net worth or institutional investors. Convertible bonds can be owned by anyone looking to start or add to a investment portfolio.
There are many large corporations that issue convertible bonds for investors to purchase, including many Fortune 500 companies.
To put it simply, investors are simply unaware of this investment opportunity because there is a lack of knowledge on convertible bonds. By reading this article, you will obtain more information about convertible bonds and how they work. I will cover things such as why companies use them and how to get exposure.
What Are Convertible Bonds?
Traditionally, bonds are a debt security that companies and government agencies issue. Investors that purchase the bonds are simply lending the company or agency money. There is a set interest rate paid by the issuer to investors for that loan, with the promise of a return of the principal capital after a certain period of time.
A convertible bond, however, is a special type of debt security only issued by public companies which are listed on the stock market exchanges.
A convertible bond initially starts exactly as the “normal” type of bond mentioned above; the big difference is that convertible bonds can be converted into the company’s common stock. However, this can only be done at certain times, with the decision normally being in the hands of the investor.
Before the bond hits the market, the issuing company determines a ratio that would be used to convert the bond into common stock.
Why Consider Convertible Bonds?
The returns on investments within a portfolio are based on its diversification and risk management–both of which are offered by convertible bonds.
Another reason to consider a convertible bond is because it is a mix between a bond investment and a common shares investment. This provides access to both products with one investment.
As mentioned earlier, depending on the issuer, one convertible bond investment can satisfy the needs of both growth and income investors. For example, let’s say a company issues a convertible bond and the common shares of the company do not pay a dividend. Being a bondholder would satisfy the need for income but, should you decide to convert the bond into common shares, you would go from being an income investor to a growth one. And if the common shares did pay out a dividend, then they would still supply income, even after the conversion.
More choices mean more possibilities, and this is exactly what a convertible bond’s flexibility provides. It gives the investor the choice of being a bond investor and holding on to the investment until maturity, or converting the bond into common shares of the company.
Another big benefit is that the shares could skyrocket while owning the bond, with the upside boosting your bottom line. This would occur when the bond is less volatile, with a passive income being earned at the same time.
Having the choice also gives investors the ability to make changes within the portfolio in response to tax liabilities, risk tolerance changes, and investment goals.
How to Get Exposure to Convertible Bond Funds in Your Investment Portfolio
A great way to get access to convertible bonds is by owning an exchange-traded fund (ETF). Rather than focusing on one company, you instead hold to a portfolio of convertible bonds, along with other asset classes. This has the added benefit of adding to your diversification.
An ETF also means access to a professional portfolio management team that will look after the capital and investment decisions regarding the ETF. They will focus on creating value for investors and only convert the bonds when there is a benefit.
ETFs also satisfy the types of investors discussed above, since there will be bond investors generating an income payment. There will also be some stocks within the ETF that pay a dividend (income investors), and others that do not (growth investors).
Why Would a Company Issue a Convertible Bond?
There are a number of reasons why a company would need to raise money, including needing capital for an acquisition, financial restructuring, or funding.
There are two ways for a public company to raise money: issue a bond or issue more common shares. Each method has its own advantages and benefits.
In the case of issuing a bond, there is an obligation to pay an interest payment to investors. This could be an issue if there is a high interest rate, based on the company’s credit rating, potentially resulting in a cash flow problem down the line. This would result in the company being more financially leveraged, which could bring the stock price down if this trend of debt is noticed.
A big benefit of using a bond to raise money is that the payment will be known before the bond is issued due to the fixed interest rate. When interest rates are low and a company has a good credit rating, a convertible bond could be used.
On the other hand, a company that uses equity is seen as not being more financially leveraged. If the company happens to not pay a dividend, there is no harm done to the business’ cash flow.
The negative with issuing more shares is that, since there are more shares available, each share represents a lower percentage of ownership in the company. Investors looking at the company will think twice before buying, especially since it makes another equity rise possible.
Issuing more shares signals that the share price is, according to management, overvalued. Thus, they are taking advantage of the situation and raising as much money as possible.
To get the best of both worlds, a company would look to issue a convertible bond. In this case, the main goal would be to issue a bond with a high probability of being converted.
Compared to normal traditional bonds, the interest rate on convertible bonds is lower. This is because there is a value-added benefit for the investment.
Another reason for issuing a convertible bond is to look out for investors’ interests. Bondholders have the option to invest in a fixed income product and preserve the investment capital. If the bond is converted into common stock, the investors are participating in the company’s upside. This also gives investors control over managing the risk within their portfolios.
How Is a Convertible Bond Calculated Into Common Shares?
A bond would only be converted into common stock if the investor would benefit. Below are two examples of convertible bonds; one is when the bond is beneficial for investors, and the other is when the bond should be held until maturity.
Example 1:
| Face Value | Interest Rate, Paid Annually | Years Until Maturity | Convertible Ratio | Stock Price at Bond Issue Date | Stock Price After 5 Years of Issue Date |
| $1,000 | 5% | 10 Years | 100 | $10.00 | $12.00 |
In this example, the bond would be issued at a face value of $1,000 and would mature in 10 years. Also, on the issue date, the same $1,000 could be used to purchase 100 shares of the company ($1,000 ÷ $10.00), which is the same as the conversion ratio. Therefore, there is no benefit of converting the shares on the issue date.
Now let’s say that, five years later, the conversation ratio is reevaluated to determine whether there is a benefit.
The bond value would be $1,000 plus the $50.00 interest payment ($1,000 × 0.05). Therefore, the share value would have to be greater than $1,050 for the investor to benefit. If the shares were converted, the total value would be $1,200 (100 shares × $12.00). In this case, there would be a benefit of $150.00 in added investment value ($1,200 – $1,050) from converting the bond.
In this example, over the five-year period, the shares moved higher by 20%. Even though the shares were not held by the theoretical investor, there was still participation in the upside of the share price.
This gives the investor flexibility and the freedom to make a move only when it is beneficial. Otherwise, the bond could be held until maturity while simply receiving the face value of the bond.
Example 2:
| Face Value | Interest Rate, Paid Annually | Years Until Maturity | Convertible Ratio | Stock Price at Bond Issue Date | Stock Price After 4 Years of Issue Date |
| $1,000 | 4% | 5 Years | 100 | $10.00 | $9.00 |
In this example, the bond was issued at $1,000, which pays out $40.00 a year. The bond will mature in five years time.
Today, the bond would be purchased for $1,000 and would be equal to 100 shares of the company. Therefore, purchasing the bond and converting it immediately would result in the same outcome.
Let’s say four years have passed and the convertible bond is recalculated to determine if it should be converted into shares. Four years later, the bond would be worth $1,040 ($1,000 + $40.00 interest payment).
If the bond was converted into common shares, the total value would be $900.00 (100 shares × $9.00). This would result in a loss of $140.00 ($900.00 – $1,040) if the bond was converted. In this scenario, the bond would not be converted and held until maturity, unless the stock price increased over the next year.
Convertible Bond Funds List
| ETF Name | ETF Symbol | Price | Dividend Yield |
| SPDR Barclays Capital Convertible Bond ETF | CWB | $48.21 | 4.08% |
| iShares Convertible Bond ETF | ICVT | $51.38 | 1.89% |
| First Trust SSI Strategic Convertible Securities ETF | FCVT | $26.97 | 1.33% |
1. SPDR Barclays Capital Convertible Bond ETF
SPDR Barclays Capital Convertible Bond ETF (NYSEARCA:CWB) seeks to track the results of the Bloomberg Barclays U.S. Convertible Bond Index. The convertible bonds would need an issue size of $500.0 million or greater to be considered. At all times, at least 80% of the assets are invested in securities that make up the index or are similar in nature.
There are more than 90 holdings within CWB, the top three being Wells Fargo & Co (NYSE:WFC), Allergan plc (NYSE:AGN) and Bank of America Corp (NYSE:BAC). These three holdings represent approximately 11% of the fund’s total capital investment.
As mentioned earlier, ETFs provide diversification for an investor and serve as a portfolio of assets. This is evident in CWB’s holdings, with 55% of the ETF being in convertible bonds, 32% being in preferred shares, seven percent being in U.S. stocks, and the remainder being in cash or other bonds.
This mix of investment assets has resulted in a high-yield convertible bond fund which is paid out monthly. The current dividend yield on CWB is 4.08%.
2. iShares Convertible Bond ETF
iShares Convertible Bond ETF (BATS:ICVT) attempts to track the returns of the Bloomberg Barclays U.S. Convertible Cash Pay Bond >$250MM Index. At least 90% of the fund’s capital is invested in the securities of the underlying index. The rest is invested in future contracts, options, swap contracts, and cash.
There are more than 190 total holdings, with the top three investments made in DISH Network Corp (NASDAQ:DISH), Intel Corporation (NASDAQ:INTC) and Verisign, Inc. (NASDAQ:VRSN). There is no holding that is worth greater than four percent of the ETF.
The assets classes that are currently held within ICVT are convertible bonds, U.S. bonds, stocks, and cash. The convertible bonds represent 93% of the fund’s total investments.
The dividend is paid out on a monthly basis. The dividend yield is 1.89%, based on the current trading price of $51.38.
3. First Trust SSI Strategic Convertible Securities ETF
First Trust SSI Strategic Convertible Securities ETF (NASDAQ:FCVT) invests at least 80% of the fund’s assets in U.S. and non-U.S. convertible bonds. The remaining of the funds are invested in preferred shares, common shares, and cash.
FCVT does not follow an index; it only looks at generating a total return at the end of the day. Said return would be the actual rate of return when factoring in interest income, capital gains, and dividends. The total return is calculated over a certain period of time.
In total, there are currently 122 total holdings within FCVT. Top holdings include investments in Priceline Group Inc (NASDAQ:PCLN), Tesla Inc (NASDAQ:TSLA), and T-Mobile US Inc (NASDAQ:TMUS).
All the funds are invested in the United States. The top three sectors are utilities, healthcare, and consumer defensive.