Sun Shines Bright on Convertible Funds

January's stock market setback and ongoing interest rate jitters have many investors wondering where to put their money. One oft-overlooked place is convertible bond funds.

"Convertibles are a nice place to be anytime there is uncertainty in the market," says Alan Muschott, portfolio manager of the (FISCX Quote - Cramer on FISCX - Stock Picks)Franklin Convertible Securities fund. "The advantage of convertibles is that you get equity participation on the upside with the security of downside protection."

Convertible bonds, or converts, are part bond and part stock. They are typically three-year corporate bonds that pay interest but give you the option to take your principal in cash or a set number of shares of the issuer's stock at maturity (thus "converting" the bond to stock). The terms of the deal -- how much interest you earn, when the bond matures and how many shares of stock you can get at maturity -- are set when the company issues the bond.

For many investors, converts offer a way to invest in stocks with less risk, which isn't a bad proposition in today's choppy market. When the bond is issued, the stock price you'll get at maturity -- the so-called conversion price -- is usually about 20% to 25% above the current price. If the stock is above the conversion price when the bond matures, convert holders end up getting the stock at a discount. On the other hand, if the stock sinks, you still get interest payments -- and the return of your principal at maturity.

From a risk/reward standpoint, Edward Silverstein, portfolio manager of the (MCOAX Quote - Cramer on MCOAX - Stock Picks)MainStay Convertible fund, says the general rule for convertible bonds is that they return about 70% of the upside of the underlying stock, while exposing investors to only 40% or so of the downside.

Morningstar data show that convertible bond funds can outpace the market in both bull and bear seasons.