Buy Convertible Bonds Before the Fed Cuts Rates

Convertible bonds are an attractive investment when the Federal Reserve starts lowering interest rates because they offer a unique hybrid profile that benefits from two key market dynamics: declining interest rates and a potentially stronger equity market. They combine the defensive characteristics of a bond with the growth potential of a stock in that convertible bonds have terms that afford the owner to convert the bond into the underlying common stock, depending on the conversion features.

The Fed lowering interest rates is often a sign of economic stimulus, which can lead to a further rally in the stock market. Because convertible bonds provide investors with the option to convert the bond into a predetermined number of shares, they can benefit from rising stock prices. This “equity kicker” gives them an advantage over traditional bonds, which only provide fixed income payments and no exposure to stock appreciation.

The true appeal of a convertible bond in a falling-rate environment is its asymmetric return profile. If the underlying company’s stock price soars, the bond’s value will increase, behaving more like an equity, and the owner can convert the bond into stock and book the big profit from selling the common shares.

If the stock price stagnates or falls, the bond’s value is supported by its bond floor and the regular interest payments, protecting it from significant losses. This creates a powerful combination of downside protection with significant upside potential, a very compelling value proposition during a period of economic transition where inflation is holding steady at 2.6% and the Fed poised to start lowering rates at the next Federal Open Market Committee (FOMC) meeting scheduled for Sept. 17.

Within my Cash Machine high-yield advisory service, the model portfolio owns two closed-end funds with convertible bond exposure, my favorite choice being the Advent Claymore Convertible Securities (AVK). It trades near its 52-week high and yields an annual distribution rate of 11.28% that is paid out in monthly payments.

The fund employs about 38% leverage to generate the double-digit-percentage yield, which is another catalyst for total return when short-term interest rates are projected to decline over the next year. Hence, there are three catalysts to drive performance: rising bond prices, rising stock prices and lower borrowing costs. The Cash Machine model portfolio recommends 33 holdings that sport a blended yield of 10.43%, with 95% of the holdings paying monthly distributions.

Investors that want to lock in double-digit-percentage yield before the Fed starts cutting rates should consider Cash Machine and put the power of high-yield investing to work right away.