IWM - CWB: Solid Convertible Bond ETF For Total Return Or A Small Cap Alternative

2023-12-31 02:57:11 ET

Summary

• CWB offers investors a way to access innovative companies but with historically lower risk than small cap stock ETFs like IWM.
• Convertible bonds have a favorable reward/risk profile over many years, with equity-like returns alongside payment of principal built into these securities.
• Credit markets' future refinancing needs, the so-called maturity wall, bode well for convertible demand as an alternative to traditional bonds' higher interest expense.
• A yield around 3.5% on CWB looks better and better as interest rates retreat from their highs.

Now that we have endured 11 Fed rate hikes and the small-mid cap stock market is potentially bottoming, an asset class that made sense to avoid in 2023 might just be shaping up as a viable asset class during 2024. We’re talking about the convertible bond market. That negativity that characterized 2022 and most of 2023 may have peaked in late October. That prompts us to consider SPDR Bloomberg Convertible Securities ETF ( CWB ). And as explained below, we rate it a Buy with a 3-year time investment horizon, as it appears to be regaining its appeal as an alternative way to access the growth potential of small cap companies, but with the cushion described just below.

CWB is a $3.6 billion ETF that debuted back in 2009, CWB does a solid job at allowing investors to access what we refer to as a “hybrid” asset class. That is, convertible securities have characteristics of stocks and bonds. They are bonds with a maturity date and coupon rate (or zero coupon), but have the potential upside of converting to the stock of the same company if the price of that stock rises by enough to prompt a conversion from bond to stock.

CWB: attractive again, but for different reasons

For most of the 15 years after the Great Financial Crisis, convertible bonds have offered competitive total returns. CWB began trading in April of 2009, close to the GFC's stock market lows. Since that inception, CWB's 10.4% annualized return through 11/30/23 speaks to the ETF's comparable performance over those years.

However, in 2022, the combined equity and credit features of convertibles were painfully on display as bonds and stocks simultaneous dropped for the first time since 1926. CWB had its worst 12-month period, declining 20.8% in 2022. The pressure of higher rates and historically-weak performance of the types of companies that issue convertibles (small-mid cap) had this asset class in deep trouble until the late-October 2023 bounce.

Current market conditions are setting up to make CWB a better bargain than it has been in years, probably since 2009. But the makeup of the bond market is very different. While rates were falling then as now, from where they came was completely different. The 2008 debacle ushered in a period of below-normal interest rates, while the current market environment is better characterized as a return to that old normal from a near-zero rate era.

If this turns out to be more than a bounce into 2024, CWB is in a prime position to benefit, and with less risk than common equities. However, if this was simply an oversold rebound that doesn’t last too long, convertibles should still be in reasonable shape, given their bond structure. In addition, CWB’s portfolio is primarily focused at the shorter end of the maturity curve, with more than half of assets maturing in 1-3 years and nearly all of the rest coming due within 7 years.

With the drubbing that these types of companies have taken the past few years, that seems to us to be a sweet spot time frame, during which the stock prices will either move higher or the bonds will come due. In the latter case, CWB’s 2% dividend rate will not look very competitive. But while T-bills yield 5%, they don’t carry the immense upside potential of this well-diversified and long-tenured ETF portfolio.

The wild card, as is always the case with convertibles, is their mid-tier credit ratings. CWB’s portfolio includes issuers of convertibles with poor cash-flow but high equity growth potential, making the conversion to the company's underlying equity a worthwhile exchange for a lower fixed rate coupon.

In general, newer and smaller companies tap the convertible market because more traditional bonds aren't as easy to obtain. In part, this is why some 80% of the approximate 300 names held are "not rated" by credit rating agencies (SSGA.com). The securities that do carry ratings average a B, well into junk territory.

Whose default is it, anyway? CWB’s portfolio is of similar risk to investment grade bonds.

Fortunately, the default rate for convertibles is comparable to investment-grade bonds (according to Barclay's Research, it is 1% overtime). This typically low default rate is positive if recessionary forces overwhelm in 2024.

Additionally, a painful maturity wall in corporate credit lies ahead for companies in need of refinancing. Demand for convertibles, as opposed to traditional bonds, may accelerate due to higher refinancing costs and companies consider convertibles as a means of maintaining a lower cost of capital.

If this niche class of hybrid investments reverts to its 5-year rolling period return pattern, an annualized performance above that of many bond asset classes is a strong possibility. As shown above, CWB has come with much less drama than small cap stocks (IWM ETF as a proxy) and its drawdowns have been competitive with a popular Fidelity mutual fund that targets a similar objective.

The Index that CWB is based on dates back to 1988 and has a long-term return of 8.4%. So historically, the asset class CWB represents has delivered equity like returns with below equity risk. In other words, what many income and total return investors seek.

This picture is worth a thousand reasons…to consider CWB versus small cap ETFs like IWM

The chart above is the most significant of all the charts in this article. That’s because it shows just how much less risk investors take via CWB versus a prominent and currently somewhat controversial small cap ETF (IWM) that has stolen headlines recently with its sharp move off of multi-year lows in October.

Not only recently, but over the last decade, CWB offered a way to invest in the future potential of smaller stocks, but with about half the range of outcomes (standard deviation) of IWM. In addition, IWM is currently filled with lower-quality companies, in that 40% of them are unprofitable. While CWB’s portfolio is not one of the highest quality, bonds are higher in the capital structure than stocks, and companies are likely to adhere to the concerns of bondholders before those of stockholders. So, CWB is a timely way to upgrade the approach some investors may consider in place of small cap stock ETFs like IWM.

Current market environment: final considerations

Along with interest rate increases, the 2023 banking crisis made loans that much harder to obtain for newer and less proven companies. These stricter bank lending standards compelled many companies in need of capital to issue convertible bonds. Unlike traditional bonds, convertibles add the equivalent of a call option on the issuer's stock. The issuing company in need of financing benefits by paying a lower coupon. The investor benefits from the fixed coupon payment and promise of repayment of principal at maturity.

However, the big benefit is the option to exchange or convert the bond into that company's equity, assuming the issuer's stock does well. If the recent "risk on" atmosphere continues into 2024, positive stock prices bode well for these securities' conversion potential to be mean price appreciation. (The conversion can be viewed as akin to an out-of-the-money call option on the equity.)

Concluding Thoughts

Interestingly, this asset class was first used to finance our nation's railroads in the mid-1800s. Today, convertible bonds continue to offer a less risky way to benefit from innovative companies, and CWB is the most established ETF to achieve that exposure.

Unlike a year ago, interest rates increases aren't likely to have an outsized negative impact on prices for stocks and bonds in 2024. The last two years have shown convertible bonds have difficulty when rates are rising. Now, a more benevolent interest rates backdrop seems likely and the largest, longest running convertible bond ETF has the potential to reward investors without taking on excessive risk.

The worst may not be over for CWB, but enough damage has been done for us to award a Buy rating at this point, with a 3-year time frame in mind. This might be one of the most overlooked $3 billion ETFs one can find, given how convertibles have been overlooked by so many investors during the recent stock and bond market malaise. We don’t mind being early adopters here, as this is one asset class might just be fit for the post-pandemic, post zero interest rate era we’re in. That is especially the case as growth-oriented mid-and-small capitalization companies come out of the shadow of rising interest rates.

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