Rising rate fears and stock rally drive interest in convertible bonds


Convertible securities have garnered interest from investors looking for limited exposure to stocks along with some of the safety features of bonds.

“Convertibles are an in-between investment that can potentially substitute for both stocks and bonds,” said Daniel Beckerman, who manages the Asset Allocation portfolio on Covestor.

In the portfolio he owns SPDR Barclays Convertible Securities ETF (CWB), which posted a total return of more than 20% last year.

Convertible securities combine features of stocks and bonds, and have performed well lately for investors looking for a mix of the two asset classes.

CWB Chart

CWB data by YCharts

Convertible bonds are corporate bonds that give investors the option to convert to equity at a specific strike price higher than the stock’s current price.

Convertible bonds typically have lower yields than corporate bonds but give investors the chance to participate in the potential upside movement of a stock. That’s why they’re considered hybrid securities, and commonly referred to as bonds with a call option on the stock.

There are several reasons why convertible bonds have been popular lately. First, fixed-income investors are worried that potentially higher interest rates could hit bond prices, so they’re looking for alternatives. Also, a more than 30% rally in the S&P 500 index last year has helped boost convertible bond returns. Convertible securities didn’t perform as well as U.S. large-cap stocks, but the bonds do provide some cushion if stocks fall.

“If the market does well, convertible bonds will benefit, although investors will miss out on the first move higher until the strike price is reached,” Beckerman said. “If stocks perform poorly, then investors have some downside protection because convertible bonds have maturity dates, so investors will get the principal and yield. Historically, the performance of convertible bonds has been competitive with stocks but with lower volatility.”

Of course, like any investment, convertible bonds have risks. One major risk is that the issuing company defaults, so convertible bonds are sensitive to overall economic conditions. Convertible bonds may also perform poorly if interest rates rise and stocks fall. Finally, many companies that issue convertible bonds have credit ratings below investment grade.

Photo Credit: Jon Matthies

DISCLAIMER: The investments discussed are held in client accounts as of December 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.