Sun Shines Bright on Convertible Funds

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%.