CWB - CWB: Convert To Something Else

Summary

• Convertible bonds were, at one time, an excellent "hybrid" investment.
• That is no longer the case, thanks to years of loose Fed-induced monetary conditions.
• The corporate and high yield bond markets have felt the sting of 2022's reversal in fortune.
• However, CWB, as the dominant player in this part of the ETF universe, may just be starting its descent.
• We rate CWB a Sell, and urge investors to really understand what they own here.

By Rob Isbitts

Strategy

CWB is the largest ETF that invests in Convertible securities, with more than $4 Billion in assets. These are debt instruments issued by corporations which have a unique feature. Namely, at the holder's discretion or the issuer's decision, exchanged ("converted") into common stock of the same company. The two main types of convertible securities are originally structured as bonds or preferred stock. In either case, the conversion feature swaps out the holder's security for common stock.

Proprietary ETF Grades

• Offense/Defense: Offense

• Segment: Bonds

• Sub-Segment: Convertibles

• Correlation (vs. S&P 500): Very High

• Expected Volatility (vs. S&P 500): Moderate

Holding Analysis

CWB owns about 300 Convertible securities. The vast majority mature within the next 7 years, though all holdings have a convertible feature, which may make the ultimate maturity date less relevant during market climates where many bonds convert to common stock. More than 80% of the portfolio is invested in non-rated bonds, while BB-rated bonds occupy the next largest allocation, at about 10%. 92% of CWB's assets are in securities of US business, with a sprinkling of Asian, European and other regions comprising the other 8%.

Strengths

Allow me to reminisce for just a second. Early in my investing career, I was introduced to the concept of convertibles by the investment group that essentially brought it out of the shadows and made it accessible to investors through mutual funds. At the time, "converts" were an ideal consideration for investor portfolios, since they seemed to offer the best of both worlds. They paid a coupon, though not a giant one. They had bond-like structure, so there was a maturity date.

And most importantly, they had the "kicker" of a potential conversion to that company's common stock. As it was commonly considered back then, if the stock rockets higher in price, conversion is a great scenario. But you had the bond holding as a fallback. It worked quite well for a while.

The basic makeup of convertible securities has not changed, and that means that structurally, they still offer that advantage of being bonds with equity upside potential, if the stock price climbs enough.

There is a bullish case to be made regarding long-term valuation levels of stocks in the Mid Cap and Small Cap space. According to data from Advent Capital Management a convertibles investment manager, companies in that size range were trading at 18x and 12x their earnings, the lowest of all time, as of September 2022.

Weaknesses

Counter to those historically low valuations is the concern that earnings may have peaked. A recession could reduce the E(arnings) of smaller companies, which can lift the P/E ratio for the wrong reasons.

Decades later, convertibles, the bond market and certainly the current market climate are very different than those early days. Sure, the market has matured. But easy credit conditions and the consolidation of so much of the market into ETFs have made converts a very different reward-risk tradeoff. Frankly, they are less distinguishable from straight equity ETFs than ever.

Every year from 2012 through 2019, CWB and the S&P 500 looked like they were related to each other. Their correlation was very high. But over the past 3 years, that consistency and likeness has vanished. In 2020, CWB returned more than 53%, nearly 3 times that of the S&P 500. In 2021, the S&P gained 29%, but CWB produced only a 2% total return. In 2022, they are both down.

Opportunities

Despite our sanguine outlook for CWB, there may be a time in the near future when it can be part of a "recovery basket" of ETFs for some investors. However, that likely occurs after the current downtrend in this market segment, and the stock and bond markets in general, reaches its crescendo.

The other way to think of it is as follows: if the price of those convertible bonds fall hard, that implies that the prices of their underlying stocks have as well. If you owned CWB, you are left holding the bag. However, if CWB is instead monitored and not owned, when all heck breaks loose, you have an opportunity to buy those convertible features at pennies on the dollar. And, if the stock market zips back up in a year or two or three, those potential conversions to stock from convertible bonds are essentially a portfolio of what we call "lottery tickets." Your risk might be very low, and your return potential could be exponential. But that time is not now.

It was the case in March 2020, and as noted above, CWB returned 3X the S&P 500 for the full year. That scenario was like owning a levered ETF, except that instead of actual leverage, you have a portfolio of lower-quality bonds, many of which may eventually mature and at least pay par value. Versus where you bought then, that may be as good or better than a conversion to stock.

Threats

As for that buying opportunity amid a market panic, we are not nearly there. And until we are, CWB is more likely to look more like an equity fund, or a perhaps a levered one to the downside. It all comes back to that credit market situation, and how a liquidity disruption can quickly impact "second tier" bond asset classes like convertibles.

Proprietary Technical Ratings

• Short-Term Rating (next 3 months):Sell

• Long-Term Rating (next 12 months):Sell

Conclusions

ETF Quality Opinion

For reasons noted throughout this ETF profile report, CWB is one we keep on our "willing to consider at a price" list. It has the tenure, size, ETF trading liquidity (during normal times) and relatively focused portfolio that checks many boxes for us.

ETF Investment Opinion

To no one's surprise if you have read this far, CWB gets a sell rating from us. The fundamental picture is weak, the macro outlook is worse, and the technical picture is somewhere between risky and downright ugly. One day, we look forward to potentially issuing at stronger positive rating on CWB. We don't know when, but we aim to identify when those conditions arise.

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