ICVT: Convertible Bond Fund for those unsure of what comes next

I find convertible bonds interesting. It is a unique financial instrument that combines the characteristics of bonds and stocks, respectively. Convertible bonds include a conversion feature that gives their owner the right to convert them Bonds in a specified number of common shares in the issuing company at a specified conversion price, if those shares trade above the conversion price. If the shares fall below the conversion price, the convertible bond behaves like a bond, with some degree of principal protection and coupon payments.

It’s not an area you tend to focus on a lot, but there are some good funds playing in this area. the iShares Convertible Bonds Corporation (Bat:ICVT) is one of them. The hybrid nature of convertible bonds makes ICVT unique from a risk/return perspective, such as it is Investors benefit from the benefits of a stock’s upside without experiencing the same downside. The ETF’s focus on cash-paying convertible bonds creates a predictable level of income, which increases the appeal for those who want yield.

A closer look at the wallet

ICVT includes over 338 positions, resulting in a portfolio with an effective duration of 1.40 years and a current 30-day stock yield of 3.17%. No position makes up more than 2.41% of the total fund, making it generally well diversified. Note that the stock’s beta is only 0.57, which also proves that convertible securities have stock-like properties, but not to the full extent of fully owning stocks.

One thing to note is that since these bonds are convertible, they are usually not rated for credit quality. Just something to consider. You can always dig deeper and look at the credit quality of issuers through pure bond issues.

Sector allocations

One of the most surprising things to me when looking at this fund is how much exposure it has to technology. I don’t often cover the convertible bond space, but the fact that it’s so dominant I find interesting and perhaps attractive if you’re bullish on technology, but maybe want a little less volatility in stocks outright.

The other major sector here, of course, is the consumer cyclical space, at about 21%. Between the technology and consumer cyclicals, I would describe this as more of a risk-on type of fund that benefits from lower volatility in overall stocks, but without the same degree of risk to other market averages that are purely stocks.

Peer comparison

Now let’s do a comparison between ICVT and one of its biggest competitors in the convertible bond ETF space – the SPDR® Bloomberg Convertible Securities ETF (CWB). This fund tracks a broader index of convertible securities including non-cash-paying convertible bonds such as zero coupon, subordinated, preferred and mandatory convertible bonds and convertible preferred stock. Although ICVT focuses more narrowly on cash-paying convertible bonds—which may provide a more stable income stream and reduced volatility compared to the broad mandate of Action Bank and Bonds—Work Bank and Bonds can offer the broader diversification benefits and breadth of convertible bonds.

When we look at the ICVT to CWB price ratio, overall ICVT has outperformed, but has had some tough time on a relative basis since 2021.

Weigh the pros and cons

On the plus side, the hybrid nature of the fund leads investors to gain exposure to the upside of equities while participating in the relative safety of the fixed income component. Second, although convertible bond prices are positively correlated with the underlying stocks, the fact that they are not as perfectly correlated as the companies they represent provides interesting diversification benefits in a broader portfolio.

the negative side? For me, the biggest issue is the potential illiquidity (not in the ETFs but in the underlying holdings). The convertible bond market typically goes through periods of illiquidity, which means there may be price disturbances in periods of high volatility.

Conclusion

For investors seeking diversification by creatively mixing their exposure to equities and fixed income, the iShares Convertible Bond ETF is worth considering. This fund exploits the dual nature of convertible bonds – it provides the opportunity to participate in equity capital appreciation, mitigates downside risk, and pays income in the form of dividends and interest. If you’re not sure whether bonds will outperform stocks in the future, this could be a good transitional way to approach where we are in the cycle.

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