BlackRock has announced the launch of the iShares Convertible Bond ETF (ICVT), listed on the BATS Exchange, which seeks to track the performance of the Barclays US Convertibles Cash Pay Bond > 250m Index. This index is composed of US dollar-denominated convertible bonds.

BlackRock’s new iShares Convertible Bond ETF allows investors to participate in the upside potential of equity markets while limiting downside risk.

The ETF captures the benefits of convertible bond investing in a cost-efficient manner and will appeal to investors looking to benefit from potential upside gains in equity markets while wanting to limit the downside risk of investing in equities.

Convertible bonds are hybrid debt instruments that can be converted into a pre-determined number of the issuer’s shares. Thus the price of a convertible bond will mimic the price of the stock as stock prices increase. Specifically, the value will be a function of the amount of shares the bond can be converted into (known as the market conversion rate) and the prevailing price per share. When stock prices fall, however, the bond trades more like a traditional fixed income security and will be valued at the present value of its future expected cash flows. Note that if a stock price falls dramatically this could be a signal that the creditworthiness of the issuer has worsened, which may also be reflected in falling bond prices.

It is worth noting that a significant number of convertible bonds are also callable. This poses a risk to the investor if interest rates begin to fall. Falling rates increase the likelihood of the bonds being called, requiring the investor to re-invest the proceeds in a lower interest rate environment.

However, current sentiment is actually leaning towards a Federal Reserve interest rate increase, possibly in September, due to strong economic performance in the United States. In a rising rate environment stocks tend to outperform bonds, which may make an ETF based on convertibles more appealing than those based on regular bonds. Indeed, during the ‘rising rate taper tantrum’ between May and September 2013, the Barclays Convertible Bond Index returned 3.8%, outperforming Barclays’ broad bond index (-3.3%) and even the S&P 500 (3%).

Furthermore, convertible bonds have historically shown low correlations to traditional bond markets, thud providing investors in the ETF with the added benefit of improving the diversification of their portfolios.

The current maturity mix of the underlying securities in the fund resembles a ‘bullet portfolio’ with a high concentration of intermediary maturities, especially around the three-to-five year bracket (34.2%), but also concentrated around the two-to-three year bracket (15.1%), as well as the five-to-seven year bracket (16%). This results in a weighted-average maturity of 5.63 years. The effective duration is 1.63 years.

For those investors interested in the income provided from these bonds, the weighted-average coupon is 1.98%. The option-adjusted spread (OAS) is 526bp. The OAS is the preferred spread method for bonds with options. It is the yield spread earned over similar duration Treasury securities after removing the yield effect of the embedded options. This gives a better indicator of risks such as liquidity risk and credit risk than other measures.

The fund employs a representative sampling strategy to pursue its tracking goals. It is well diversified on a security level (there are currently around 150 holdings), although has significant exposure to the technology (41.5%), consumer non-cyclical (19.5%), and consumer cyclical (11.1%) sectors.

It is fairly common for issuers of convertible securities to forego having their securities rated by official rating agencies. As such, currently 40% of these securities have no rating. Of the 60% that do, 39% are high yield (although 21% are bordering on investment grade with a rating of BB), while 21% are certified investment grade. The fund has concentrated holdings in Intel (4.1%), Tesla (2.9%), Sunedison (2.8%), Priceline (2.6%) and Microchip (2.3%).

The expense ratio of the fund is 0.35%.