Is it a bond or is it a stock? When it comes to a convertible bond, it's a little of both.
And thanks to its chameleon-like characteristics, mutual funds investing in convertible bonds are the best-performing bond funds around these days. In fact, the asset class is beating both stock and bond funds. Money managers are looking increasingly to convertibles as an alternative to junk bonds because they stabilize the volatility of stocks while providing portfolios with a little extra zest.
Even though yields on some high-yield bonds are topping 10%, convertible bond mutual funds are still beating them.
The average convertible bond fund has grown 7.3% this year through July 25. Meanwhile, the average bond fund is up 2.7%, the S&P 500 climbed 0.9% and the average stock fund returned 5.4%.
Many of the funds driving these returns have done it by focusing on (what else?) technology. In fact, more than half of the new issuance in convertibles recently has been in the technology sector. And biotech companies like
Human Genome Sciences
are also playing the convertibles market. Investors say it's a safer way to handle an on-again off-again tech market.
Convertible bonds, also called converts, are corporate bonds that investors can switch into the company's stock instead of redeeming them for cash when the bonds mature. If a stock rises, the convert rises, too. If a stock falls, typically the convertible bond doesn't decline as much as the stock. Their coupon, or yield, is lower than that of a comparable nonconvertible, but converts give you more options.
Companies like issuing convertible bonds because if they'll have a hard time raising money in a volatile stock market, they don't have to go the expensive junk bond route where they'll have to pay more to borrow. And investors like convertibles because they get a security that acts like a stock, but with less volatility.
"Money managers like converts because it means that a company has cash flow," says Ron Roge, a Bohemia, N.Y., financial adviser who uses convertible bond funds in 15% of the fixed-income portfolios he builds for clients. For the past two years, he's switched exclusively to convertible bond funds instead of high-yield.
During a steamy market run, converts do well because their price is tied to the performance of the stock while they "offer more downside protection," says William Hardy, an analyst with
. That's because the coupon buffers some of the volatility. The first half of this year has seen a record number of convertible offerings, with 92 new deals totaling about $35 billion.
Even some junk-bond fund managers are getting into the convertible game. Margaret Patel, portfolio manager with the
Pioneer High-Yield fund, says she's been a fan of converts because she wants to be in sizzling technology and telecommunications sectors. "It's rare for those companies to issue high-yield debt," she says.
Demand for high-yield bonds has been dismal in the past year and companies know they aren't likely to get favorable borrowing rates there, so a year or 18 months after an initial public offering, it's not surprising to see a company come to the bond market with a convertibles issue.
Patel has a 26% technology stake in the $61 million fund. Lately she has picked up convertible bonds of semiconductor companies. She likes
, a memory chip maker, which she's bought over the past nine months, and
, a circuit maker that was recently acquired by
In addition to chips, wireless players have also been frequent issuers in the convertibles market. "Owning a convertible allows you to get a piece of the action," says Edward Everett, portfolio manager of the $1 billion
Oppenheimer Convertibles Securities, which sports a 35% holding of technology issues.
Recently, a few biotech names have also made an appearance in the convertibles market. In addition to Human Genome,
Insight Health Services
have also had successful convertible deals.
Other recent winners in the convertible market have been utilities like
, also boosting the fortunes of these funds. Still, neither Everett nor Patel say they're interested in utilities for the long term, believing they will face increased pressures from deregulation.
Instead, Everett says he likes wireless communication services and broadband plays because he expects the underlying stocks will continue to do well.
If you need any more evidence that technology is a key focus of convertible fund managers, consider that Ariston recently launched an Internet convertible bond fund to focus on different aspects of Net investing, such as infrastructure and business-to-business.
Everett, for one, says he's staying away from Internet issues. "If a company doesn't have any assets, then it doesn't have anything of value to an acquirer," Everett explains. "Then there's nothing to support the bonds. What's the downside protection?"
What's more, it may be hard for a mutual fund to play just one sector of the convertible market. As Everett says, "If you're a convertible bond fund manager, you have to eat what's served at the convertible cafe."