State Street ( STT) last week introduced the first exchange traded fund in the U.S. that invests in convertible bonds. While many mutual funds own the securities, the SPDR Barclays Capital Convertible Bond Fund ( CWB) is the first ETF to target them. Convertible bonds are debt instruments that can be turned into stock when they rise to a certain price. As a company's shares rise, its convertible bonds will trade more like the stock. If the shares drop, the convertible acts more like a bond. The fund holds 36 of the 135 holdings in the Barclays Capital U.S. Convertible Bond >$500MM Index, which was built with $6 million of seed money from State Street. A Transocean ( RIG) bond is the largest holding at 7% of the fund, followed by an EMC ( EMC) issue with a 6.7% weighting. Even though the chances of Transocean defaulting in the next few months are remote, investors should note the fund's high concentration. But those large positions will shrink as new money flows into the fund, causing it to look more like the underlying index. Overconcentration is a potential pitfall of fixed income products. The bear market crushed funds that owned too many financial services bonds, for example. The SPDR Barclays fund doesn't make huge sector bets. Bonds from technology companies make up 23% of the fund, followed by 19% in healthcare and 17% in energy. Financials only comprise 10%. Convertible bonds aren't typically the highest-quality debt. A third of the fund's holdings have junk-level credit ratings and another 12% aren't rated. The average rating of the fund's holdings is Baa1, "investment grade" by Moody's ( MDY) standards.
Convertible bonds can be extremely volatile. The fund's underlying index lost 30% of its value in the year that ended March 31. That's a lot for a bond index. The asset class suffered as the weakening fixed income market hurt the flow of capital into convertible arbitrage. Convertible securities also took a hit from the solvency and liquidity concerns, credit rating downgrades and overall deleveraging in the broader bond market. The odds of another event like this are slim. While convertible securities are suitable for investors with normal risk tolerance, people with lower thresholds should stay away. If you invest in the SPDR Barclays Capital Convertible Bond ETF, it might be wise to devise an exit strategy to avoid big declines. For example, you could plan to sell shares if they fall below their 200-day moving average or if the yield curve inverts. The fund has a 0.4% gross expense ratio and plans to pay dividends monthly. The index's yield is 6.05%. I wouldn't invest more than 10% of your bond portfolio in this fund given its potential for volatility. For most investors, 5% is enough.