Convertible Bond Funds May Be Safe Haven

The stock-market selloff and interest rate uncertainty have many investors wondering where to stash their money. One oft-overlooked place is convertible bond funds.

"At this point nobody knows where the bottom is," says Edward Silverstein, portfolio manager of the MainStay Convertible (MCOAX Quote) fund. "During times like these, convertibles protect you on the downside and, when stocks eventually rally again, they allow you to join in the upside."

The S&P 500 is down 12.5% this year, while the average convertibles fund is off only 4.75%, according to fund tracker Morningstar. 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.

Silverstein's fund, down 4.8% this year, has returned an average of 8.5% annually over the past three years, over two full percentage points better than the average convertibles fund, and more than double the S&P's annualized return of 4.1%.

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.