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Convertible Funds Make Most of Limp Market

Mutual funds that own convertible bonds can deliver rich interest income when stocks are flat.

NEW YORK (TheStreet) -- After last year's stock rally and this year's sluggish start, investors are agonizing about what to do next. Investors don't want to sit on the sidelines during a year when earnings seem likely to rise.

One solution could be convertible bonds, hybrid securities that can be converted to stock. Because they pay bond-like yields, convertibles usually outdo the

S&P 500 Index

when stocks drop. When the S&P 500 lost 9% in 2000, convertible funds returned 3%, according to

Morningstar

(MORN) - Get Report

. During the turmoil of 2008, convertibles sank, but they still outperformed the S&P by 4 percentage points.

When stocks rise, convertibles tend to climb, though not as much as typical equities. Many convertible funds aim to deliver 60% of stock market gains. They reached the goal in 2006, when the S&P 500 returned 15% and convertible funds gained 10%.

Though convertibles do best in bull markets, the securities can be rewarding when stocks are flat. During those periods, convertibles can deliver rich interest income. Convertibles currently yield about 4%, a nice payout at a time when the S&P 500 yields 2%.

By limiting losses in downturns, convertibles have achieved intriguing long-term records. For the past 15 years, convertible funds have returned 7.5% annually, almost matching the S&P. And convertibles are less risky than the S&P, as indicated by standard deviation.

If convertibles provide a mix of equity and fixed-income characteristics, why not buy balanced funds that hold stocks and bonds? Balanced funds can be sound choices, but convertibles offer a unique vehicle for diversifying portfolios. While balanced funds typically own high-quality bonds and blue-chip stocks, most convertibles are rated below-investment grade. Issuers include technology companies and other growth businesses. Cushioned by their high yields, convertibles offer a relatively tame way to play aggressive stocks and bonds.

Convertibles often climb during periods when junk bonds rally. That happened in 2009. During the past year, convertible funds returned 42%, 12 percentage points more than moderate allocation funds, which hold balanced portfolios of stocks and bonds.

For a relatively steady fund, consider the

MainStay Convertible Fund

(MCOAX) - Get Report

, which has returned 4.9% annually during the past five years, outdoing 96% of its competitors. While the average convertible fund has a credit quality of BB, the Mainstay portfolio often has a credit quality of BBB-, the lowest investment-grade rating given by Standard & Poor's. "We like better-quality companies that are generating free cash flow and don't have a lot of debt," says fund manager Edward Silverstein.

A favorite issuer is

Teva Pharmaceutical Industries

(TEVA) - Get Report

, an investment-grade producer of generic drugs. Silverstein says the company is likely to report sales growth for years as demand increases for low-cost generics. The company has little debt and strong cash flow.

Another holding is an issue from

TheStreet Recommends

Cameron International

(CAM)

, a maker of valves and equipment used on oil and gas wells. Growing demand in emerging markets should help the company to maintain its strong balance sheet.

Silverstein sometimes buys weaker issues that have sunk to bargain levels. Among the many bonds that collapsed in 2008 were issues from

Great Atlantic & Pacific Tea Company

(GAP)

, operator of the A&P grocery chain. With hedge funds forced to dump convertibles at any price, yields on the A&P bonds topped 30%. Silverstein bought during the panic and held as the prices recovered and yields fell down to 9%.

"We have gotten back to a sane world where bonds are trading more in line with their real values," says Silverstein.

For a portfolio that includes some lower-quality bonds, consider the

Lord Abbett Convertible Fund

(LACFX) - Get Report

, which has returned 2.5% annually during the past five years. The portfolio has an average credit quality of BB-. Last year portfolio manager Chris Towle grabbed some busted convertibles, depressed securities that investors buy primarily for their rich yields. His favorite issues were selling at 50 cents on the dollar, even though the companies had plenty of cash on their balance sheets.

He has been moving away from deeply depressed issues and focusing on healthy companies with growing earnings. Favorite issuers include

Sybase

(SY) - Get Report

, a producer of enterprise software, and

EMC

(EMC)

, a maker of information storage devices. "They are benefitting from increased spending on Internet infrastructure," says Towle.

-- Reported by Stan Luxenberg in New York

.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.