Structured Invest, a wholly-owned subsidiary of UniCredit Bank, has rolled out a second exchange-traded fund tracking the performance of convertible bonds from European issuers. The UC Thomson Reuters Balanced European Convertible Bond UCITS ETF (dis) (Xetra: ECBC) provides diversified investment opportunities in large, liquid convertible bonds across a variety of sectors and credit ratings.

Convertible bonds allow investors to participate in the upside potential of the company’s stock but is valued more like a bond when stock prices decline.

Convertible bonds are hybrid debt instruments that can be converted into a pre-determined number of the issuer’s shares. This allows the bond to participate in the upside potential of a company’s stock price. 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 also 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 as the likelihood of the bonds being called would increase, potentially requiring the investor to re-invest the proceeds in a lower interest rate environment.

In a rising rate environment however 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, thus providing investors in the ETF with the added benefit of improving the diversification of their portfolios.

The Thomson Reuters Monthly Europe Focus Convertible Index underlies the ETF and is designed to follow bonds with a high degree of convexity. High convexity may present an additional desirable feature to investors as the price of highly convex bonds tend to fall less severely when interest rates rise, and rise more strongly when rates fall compared to a bond with lower convexity. The index furthermore applies an issuer cap of 8% at each monthly rebalance to limit overconcentration.