WOLF - CWB: A Bond ETF Driven By Stocks

2023-03-30 17:18:50 ET

Summary

• CWB holds a diversified portfolio of convertible bonds.
• About 80% of the portfolio’s issuers have no credit rating.
• Convertible bonds are driven by the stocks of their issuers, not by the bond market.
• Introduction to a tactical bond rotation.

This article series aims at evaluating ETFs regarding past performance and current portfolios. As holdings change over time, updated reviews are posted when necessary.

Strategy and portfolio

The SPDR Bloomberg Barclays Convertible Securities ETF ( CWB ) has been tracking the Bloomberg Barclays US Convertible Liquid Bond Index since 4/14/2009. It has 295 holdings, an expense ratio of 0.40%, and a 12-month distribution yield of 2.2%. Distributions are paid monthly.

As described in the prospectus , "t he Index is designed to represent the market of U.S. convertible securities, such as convertible bonds and convertible preferred stock. Convertible bonds are bonds that can be exchanged, at the option of the holder or issuer, for a specific number of shares of the issuer's equity securities. Convertible preferred stock is preferred stock that includes an option for the holder to convert to common stock " .

Optionality allows companies to borrow money at a lower rate, and possibly avoid paying the principal, should the bond be converted. In this case, the principal is paid by common shareholders in dilution. Optionality is also attractive for lenders willing to mix fixed income and speculation on the share price. As a hybrid asset, its behavior is part equity, part fixed income. Due to embedded optionality, CWB may be classified by some brokers as a derivative product. In this case, buying it may require some adjustments in trading permissions.

Eligible securities must be U.S. dollar-denominated and have:

• an issue amount of at least $350 million,
• a par amount outstanding of at least $250 million,
• at least 31 days until maturity.

The index is rebalanced once a month. There is no condition on the issuer's credit rating. As of the writing, 81% of the fund's asset value is issued by companies without a credit rating.

CWB has 295 holdings with an average coupon of 1.88% and an average maturity of 3.3 years. The next table lists the top 15 issuers, weighing about 23.6% of asset value. Each issuer may have several bonds in the portfolio. All issuers are below 4%, so risks related to individual companies are moderate (aggregate weights below are calculated by the author).

Historical performance

Due to its characteristics of a hybrid asset, CWB behavior is closer to a stock index than to a bond index. Since inception, it has correlation coefficients of 0.87 with the S&P 500 Index ( SPY ), 0.75 with high yield bonds ( HYG ), and only 0.5 with a broad corporate bond index ( LQD ). Its correlation with Treasury bonds (tested with various ETFs from 1-year to 20+ year maturity) is between 0 and -0.2. It means no correlation at all. Convertible bonds are mostly driven by the common stocks of their issuers, not by coupon rates and treasury yields.

CWB has lagged the stock benchmark by 4 percentage points in annualized total return and shows similar risk metrics (drawdown and volatility).

Data calculated with Portfolio123

The next chart plots 5 years of total returns of CWB and its main competitor, iShares Convertible Bond ETF ( ICVT ). The latter is a bit ahead, but the difference in annualized return is below 1%.

CWB-IEF tactical rotation

Tactical allocation strategies consist of over-weighting assets with the highest probability of future gains. This probability is often arbitrarily measured by past performance. Countless variants are possible depending on the performance metric, weight calculation, look-back period, decision frequency, asset list, and number of positions. The next table tracks a strategy with only two ETFs: CWB and the iShares 7-10 Year Treasury Bond ETF ( IEF ). Every week, it goes long 100% in the ETF with the highest 3-month return, or in cash if both have their prices below the 200-day simple moving average. This CWB-IEF rotational model is compared to both ETFs and to a total bond market ETF ( BND ).

Calculations with Portfolio123

The rotation beats the total bond market in return and shows a lower risk in drawdown and volatility. It has a better risk-adjusted return (Sharpe ratio) than both its components. However, past performance is not a guarantee of future returns.

Takeaway

CWB holds a diversified portfolio of convertible bonds. This asset category has a stronger correlation with stocks than with bonds. Most issuers have no credit rating. Holdings may change significantly over time. In my March 2021 review , Tesla ( TSLA ) was the #1 issuer in the portfolio, it is out now. CWB had an exceptional performance in 2020 due to its concentration in high momentum companies. Performance from 2009 to 2019 and since 2021 has been much less attractive. There is no correlation to Treasury yields. CWB correlation to stocks may boost the performance of a bond ETF portfolio in a bull market. It may also be used in a tactical allocation strategy with other bond ETFs. The CWB-IEF rotation presented here is a simplistic example. QRV Bond Rotation is based on the same idea.

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