While the debate among market participants rages about the frequency of rate increases in 2016, investors worried about capital protection may consider an industry first fixed-income product product since not all bonds would get hammered with the gradual normalization of interest rates.
Case in point: convertible bonds that could potentially offer higher total returns as they allow meaningful participation in both equity returns and current income along with a certain degree of principal protection.
For the uninitiated, convertible bonds are debt instruments that can be converted into certain amount of ordinary shares of the issuer’s equity at some point in time. Convertibles, a hybrid debt instrument with equity-like traits, tend to outperform stocks in rising rate environments and have historically outpaced bonds during periods of rising rates. The embedded option that allows the holder to convert debt into equity pares the interest rate sensitivity of the convertible securities.
First Trust, the Illinois-based sixth-largest issuer of exchange-traded funds in the US, launched the first actively-managed convertible fund recently, the First Trust SSI Strategic Convertible Securities ETF (FCVT), in collaboration with California-based fund manager SSI Investment Management Inc. SSI combines quantitative and fundamental analysis to select securities that represent favorable risk-reward characteristics in an effort to offer superior total return while mitigating downside risks.
FCVT is essentially an unconstrained fund without any geographic restrictions and can even hold convertible instruments denominated in other currencies. Its broad spectrum allows it to invest in any credit quality, including junk bonds, and with effective or final maturities of any length. However, at least 75 percent of the fund’s assets would be invested in convertible securities that had, at the time of original issuance, $200 million or more outstanding in par amount.
The fund contained 107 securities as of 1/6/2016, indicating it’s a fairly well-diversified portfolio with the top five holdings including such names as Allergan Plc, Hologic Inc, Wells Fargo, Tesla Motors and Priceline Group. Investors that believe convertibles afford an opportunity to generate alpha since they are less efficient than other segments of the financial market may find FCVT appealing.
The fund comes with an annual expense ratio of 0.95 percent, which is more than double than the two existing passively-managed funds – the SPDR Barclays Convertible Securities ETF (CWB) and the iShares Convertible Bond ETF (ICVT).
Given FCVT’s ability to continuously adjust and re-balance without the restrictions of a specific index, the higher management fees could be well justified.
Disclosure: No holdings
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