Shaky Markets Could Raise Profile of Convertible Bond Funds

This year, as many stocks head sideways or south and bonds are still stuck in a rut, investors may turn to convertible bonds as a way to solve both problems.

Convertible what? They're obscure all right. A search of the TSC archives turns up just 31 stories with the term "convertible bond," compared with more than 18,000 with the word "stock." But if current market trends continue, you'll be hearing a lot more about them.

"The stock market is pretty expensive and might not be the success story it's been in the past few years, so convertible bonds could get more play," says Bridget Hughes, a Morningstar analyst who has covered convertible funds.

Convertible bonds or "converts" are part bond, part stock. They're 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. 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 are a way to invest in stocks with less risk -- not a bad proposition with many stocks falling from last year's high valuations. When the bond is issued, the stock price you'll get if you convert is usually about 20% to 25% above its current price. If the stock is above that price when the bond matures, you can get the stock at a discount. If the stock tanks and the bond's price drops too, you still get your principal and the interest payments at maturity. (For more on converts, see TSC's series on the subject.)

"In a down or choppy market (convertible) funds shine. They become attractive because they offer a yield with an equity upside," says Nick Calamos, a convertible specialist who comanages (CCVIX Quote)Calamos Convertible.

So far in 2000, the Lipper convertible securities fund index is up 2.4% through Thursday, while Lipper's general bond index is down 1.4%.

Converts typically offer about 70% of stocks' returns with 40% less volatility than the S&P 500 index. And last year they trounced that benchmark by more than eight percentage points with an average 29.6% return, according to Morningstar. That risk/reward scheme could come in handy in a rocky stock market.

But before you cut that check, keep in mind that there are risks. Convertible bonds are often issued by emerging growth companies, which can be volatile. These companies typically have dicey credit, so adding a stock component sweetens the deal for bond investors. But the stock option also means converts typically pay lower yields than other corporate bonds. Last year the average convertible bond fund had a 12-month yield of 2.6%, compared with 7.7% for the average multisector or strategic income fund, according to Morningstar.

And their downside protection isn't a sure thing. They occasionally have down years, as they did in 1990 and 1994, when they lost 6.8% and 5.4%, respectively.

Still, they can make sense for many investors.

"Convertible funds can be a safer way to play small technology and telecom companies or a way for a conservative investor to get exposure to the equity market," says Morningstar's Hughes.

Ron Roge, a financial planner with R.W. Roge in Bohemia, New York, has included (FCVSX Quote)Fidelity Convertible Securities in the fixed-income portion of aggressive and conservative clients' portfolios since the fund started in 1987. The fund can be 100% of an aggressive investor's bond allocation and anywhere from 10% to 50% of a conservative investor's bond basket.

Buying these hybrid bonds directly may be expensive and too complex for many investors to fathom, so mutual funds are the safest option. But picking funds in the category is no walk in the park either. Some are more aggressive and expensive than others. Here's a look at three options.

Three Ways to Play Converts
	1999 Return	3-Year Avg. Annual Return	Current Yield
(FCVSX Quote)Fidelity Convertible Securities	44.1%	24.7%	2.25%
(CCVIX Quote)Calamos Convertible	35.1	20.7	2.23
(VCVSX Quote)Vanguard Convertible Securities	30.4	16.2	3.53
S&P 500	21	23.1	1
Source: Morningstar, data as of Jan. 27. Yield as of most recent portfolio data and may have changed.

Fidelity Convertible Securities

Although the fund is far and away the category's behemoth with $1.2 billion, its size has driven down expenses, not returns. The fund, which rates four stars out of five from Morningstar, has beaten 80% of its peers over the past three, five, and 10 years, and its 0.77% expense ratio is less than half the category average.

But it's probably best for more aggressive investors since it focuses on small, fast-growing companies with plenty of stock and credit risk. That could dilute its risk protection in a down market. Also, despite the fund's consistently superior record, it has had seven managers in the 1990s. Current manager Beso Sikharulidze took the reins last August.

Calamos Convertible

This four-star fund has taken a more cautious route, but still managed to beat its average peer in nine of 10 years in the 1990s. And convert specialists Nick and John Calamos have run the fund since its 1985 inception. The fund is sold mainly through brokers, so its class A shares levy a maximum 4.75% sales charge. Other share classes give you the opportunity to side-step the charge, but charge higher annual expenses. A shares' 1.4% annual expenses are below average.

(VCVSX Quote)Vanguard Convertible Securities

If you're looking for a cheap, vanilla convertible fund, look no further. The fund has kept up with its average peer, while taking less risk and paying an above-average 3.53% 12-month yield, according to Morningstar. And -- surprise -- the no-load fund is also the category's cheapest, with 0.73% annual expenses. Aggressive investors might not have time for this Dodge Aries K-type of fund, managed by Larry Keele of subadviser Oaktree Capital since 1996. But if you're a conservative investor looking to dip a toe into the stock market, a K-car with a cheap price tag might be just fine.