Stocks or bonds? For income-focused investors, why not blend the best of both worlds to collect interest and enjoy share price upside?
This is the goal of convertible bonds, a “country club” favorite. (Before the holidays you may be tempted to add some convertibles to your portfolio simply so that you can brag about them to friends and family!)
Convertible bonds, like the preferred shares we discussed last week, pay regular interest. In this way, they act like bonds. You buy them and “lock in” regular coupon payments.
But convertibles are also like stock options in that they can be “converted” from a bond to a share of stock by the holder. So you can think of them as bonds with some stock-like upside.
Switching from creditor to shareholder can be a lucrative move. But buying convertibles does require individual research – and heartburn. Take Tesla’s debt that holders can “convert” next March into Tesla stock for a $359.87 conversion price. Today that’d be an underwater trade for bondholders, with the stock price about $15 lower.
This sounds fine until we consider that convertibles already pay less interest than regular bonds because of their additional lottery ticket potential. When we buy convertibles, we need upside – and we’re not amused when Elon Musk’s “antics” send his company’s share price lower.
I’d rather save us the research, headaches and heartburn by “outsourcing” our convertible bond portfolios to industry experts. As usual, we’ll look to closed-end funds here for three reasons.
First, we can find CEFs that pay more than individual convertibles we’d be able to buy. Fund managers get the first phone call on these types of deals. Plus, they have access to cheap money that lets them leverage their returns relatively safely. We’re going to discuss an excellent convertible-focused CEF fund yielding 5.9% in a moment.
Second, CEFs can (and often do) trade for discounts to their net asset values (or NAVs – the street value of the convertible bonds they hold). Thanks to current pessimism in CEF-land, the fund I’m going to highlight trades for just 87 cents on the dollar.
Third, we can hire a manager like Thomas Dinsmore to work for us for free. He usually charges a 1.1% management fee, but thanks to his Ellsworth Growth and Income Fund’s current 13% discount, Dinsmore’s remuneration is “comped.”
For you Contrarian Income Report subscribers, this discussion on convertibles may ring a bell. Our asset manager Nuveen recently expanded its Preferred & Income Securities Fund’s mandate. Along with preferred securities, the fund began buying hybrids such as convertible securities. (Again, this is a fancy way of saying the fund started purchasing debt that has options to convert to equity.) I advised subscribers not to worry about JPS’ mandate change because we trust the management team.
While few know JPS, more aspiring country clubbers know CWB. The SPDR Barclays Capital Convertible Bond ETF is the most popular mainstream (read: widely marketed) vehicle to purchase convertibles. It lets investors brag that they own a basket of convertible bonds. But if their friends are impressed, their accountants are not.
CWB has, on the surface, been fine. It’s generated 168% returns over the last ten years.
The problem is that its stock market competition, the S&P 500, returned 293%, and its bond market competition, JPS, returned 286%. Which means this “dumb ETF” blended the two strategies and did worse than them both!
We have one “pure play” option in CEF-land that meets our criteria as a potential investment. Dinsmore’s fund, ECF, pays 5.9% today (versus CWB’s 3.8% yield) and trades at a generous discount to its NAV (versus a slight premium for CWB).
ECF has returned a tidy 6% on its portfolio since inception and it’s outperformed its too-popular ETF cousin over the past ten years as well. Including dividends, ECF has generated 204% profits versus our only 168% for CWB.
Disclosure: none
