Gregg Greenberg

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Sun Shines Bright on Convertible Funds

Gregg Greenberg

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.

In the bull market of 2003, the average convertible bond fund returned 26.6%, compared with 28.7% for the S&P 500. In other words, converts delivered 93% of the upside of the stock market. Meanwhile, when the stock market sank in 2002, convert funds fell just 8% for the year vs. 22% for the index, which is only 36% of the decline.

The three- and five-year average annual returns for convertible funds look just as impressive. Over the past three years, convert funds gained 8.2% annually vs. 3.6% for the S&P, and over the past five years converts were up 3.5% vs. a loss of 2.3% for the index.

Comparing convertible bond funds to equity indexes may sound like mixing apples and oranges, but fund managers like Muschott say it's appropriate to lump converts in with stocks. Says Muschott, "At the end of the day, the performance of a convertible bond depends on the movement of the underlying stock. That's why fixed-income guys don't think of convertibles in their world."

And in the current environment, when investors are fleeing bonds over worries about higher interest rates, convert fund managers find it preferable to be viewed as equity players.

According to Morningstar analyst Kerry O'Boyle, convert fund investors have little to fear from rising interest rates. That's because most fund managers shy away from holding too many busted converts -- those trading so far below their conversion price that they're effectively trading like bonds. These busted converts are susceptible to a rise in long-term rates.

If a convert manager holds too many busted converts, then his fund will skew toward mirroring a traditional bond fund. At the other end of the spectrum, some convert funds are de facto stock funds because their portfolios are dominated by converts that are deep in the money. When a convert is deep in the money, the underlying stock is so far above the bond's conversion price that instead of the bond capturing only 70% of a stock's upside, it moves closer to 100%.

One method for detecting where a convert fund manager falls on this spectrum is to look at a fund's current yield.

For example, the current yield on the relatively new (GRVAX Quote - Cramer on GRVAX - Stock Picks)Gartmore Convertible fund is 3.3%, which is 30 basis points higher than the Morningstar average for convert funds. Jerry O'Grady, the fund's co-manager, says he prefers to be slightly conservative in his management, thereby foregoing some of the upside from the equity to maintain a higher yield. (Remember that a higher yield on a bond means a lower price, which ultimately pushes it further away from the conversion price.)

Silverstein's MainStay fund, on the other hand, offers a little lower-than-average yield of 2.6%, sacrificing a wee bit of downside protection in exchange for additional upside.

Current yield is a good starting point for comparing funds, but it by no means offers a complete picture due to the many moving parts involved with converts. For instance, some fund managers hold more straight equity than others, thereby lowering a fund's total yield. Others choose to hold higher-quality bonds, which also would lead to a lower current yield. (Companies in better financial health don't need to pay as high a coupon to compensate investors for the risk they'll default.)

O'Boyle says the important thing for investors to keep in mind when evaluating convert funds is to make sure the manager remains "true to the asset class" by not moving too far in either direction along the stock/bond spectrum. He also advises investors to seek out fund managers with the most experience in this tricky asset class.

Gartmore's O'Grady says convert funds should play an important role in an investor's asset allocation, but they often are neglected by financial advisers who are unaware of their benefits.

"Financial planners often struggle when they allocate their clients' assets between stocks and bonds," says O'Grady. "The smart ones realize that a good convert fund can fill the gap between the two very nicely."