Convert to Defense in a Down Market

This column was originally published on RealMoney on June 8 at 11:16 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

I had thought 2006 might be a slight down year for U.S. stocks, but the recent downdraft has made me start to think about what to buy if the selling persists.

Convertible bonds have appeal in this environment. These are corporate bonds that can be converted into shares of common stock.

Convertible bonds tend to trade more like stocks in an up market as the underlying stock moves closer to the set conversion price for the bonds; conversely, they trade more like plain-vanilla bonds in a down market as they move away from the conversion price.

Closed-end funds specializing in convertible bonds have a number of merits over buying individual issues: They have better liquidity, there is no single-issuer risk, and there is less trading slippage.

One closed-end fund I have written about is the Calamos Convertible Opportunities & Income Fund(CHI). Although this is a fine fund, it trades with a whopping 20% premium to its NAV.

Another fund that I have started to buy for clients is the Advent Claymore Convertible Securities & Income Fund(AVK).

It matches up well to the Calamos fund. It trades at a 4.7% discount to NAV and the yields are quite similar: 8.34% vs. 8.97% for Calamos.

Comparing NAVs can help to assess how the managers of closed-end fund are doing better than the market price, which for closed-end funds has much more to do with sentiment. Over the last two years and the last 12 months, the Advent fund's NAV has been better. (See Head to Head on NAV chart below.)

Market prices are a different story. With its huge premium, Calamos has done better over the last two years and 12 months. I believe this is because of Calamos' stellar reputation. (See Head to Head on Market Price chart below.)

Although it is tough to say whether Calamos' premium over Advent will narrow, I feel much safer committing new money to a product with a small discount.

Looking under the hood, Advent is diversified, with no positions accounting for more than 5% of assets and only two accounting for more than 4%.

Although it is rare that a bond goes to zero, any individual convertible issue can be much more volatile than other bonds.

Head to Head on NAV

Source: Yahoo!

Head to Head on Market Price

Source: BigCharts.com

The fund is heavily weighted toward the financial sector, but these companies issue a lot of corporate debt. What impresses me about the sector selection is that the fund is not too heavily weighted in more faddish sectors like energy and basic materials.

The reason to own a fund like this is to add yield and reduce volatility. If the fund chases too much heat, it could become more volatile.

I would offer one caveat: I have no real expectation for price appreciation with Advent.

If the market is going to sell off, reducing volatility and adding yield to a diversified portfolio is what I'm looking to get from buying this fund.

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