Despite a sharp jump in the market recently, after a veritable crash in June and July, the direction of U.S. stocks remains in question.

But Ted Southworth, manager at the ( NOIEX) Northern Income Equity fund, has one way to play the volatility. By investing in convertible bonds, he stands to profit from an upswing in the market but will also be protected in the event of another downturn.

That's because convertibles pay interest -- sometimes as much as 15% -- while also giving investors the option of converting their bonds into stock at a fixed price. Alternatively, investors can redeem their bonds at a set date in the future for par value.

This strategy -- and Southworth's value-conscious approach to investing -- has borne fruit over the past two years, with his fund beating the S&P 500 by a wide margin. Through July, the fund was down just 3.22%, compared to a drop of 16% in the S&P 500.

1. What are the advantages of owning convertible bonds?

Basically, they have an asymmetric return profile.

Sounds complicated!

Laughs The basic idea is that for a traditional convertible bond, when there is a given change in the underlying common stock a normal convert might participate in, let's say 80% of the upside, but it would participate in only 50% of the downside. We have a shock absorber on the way down. But typically, converts as an asset class over the long term have about the same return as the S&P 500.

2. Last year, some firms that brought convertibles to market agreed to unusually aggressive terms, giving investors the right to sell the bonds back to the company just one year out if the underlying stock didn't perform well. Were you able to take advantage of that?

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There are two different classes of buyers in the convert market: the hedge funds and so-called outright buyers. I'm an outright owner so I would rather have a good underlying common stock representing a company I want to invest in and pay a smaller premium over conversion and a larger coupon.

Hedge funds buy the convert and short the underlying stock; what they're most interested in is stocks with high volatilities and the "put" feature is quite an advantage to them because it shortens the time horizon and gives them the option to get out if it doesn't work. A good part of the growth in the new issue has been structured for the benefit of the hedge funds over the last couple of years.

3. Do you invest in any so-called "busted" converts, or securities that are trading at a premium to their conversion rate?

Because of the decline in the stock market, those conversion premiums have risen and there are a lot more busted converts than there used to be. In fact, it's hard to find normally priced, normal structured converts in sufficient quantity and diversity to make a portfolio.

That's not all bad because busted converts have value, too. I've been buying busted converts for their yield to maturity value. I don't care much about the premium over conversion.

4. Are you finding more opportunities out there these days?

Until recently, no. There has been very little in the new issues market and what there has been, has been thin. I've been trying to stick to a discipline, which has caused my cash level to rise again. Right now we have just under 12% in invested cash.

5. Where have you been putting your money?

There were a flurry of utility issues that came a while back with FPL Group ( FPL), CenturyTel ( CTL) and Alltel ( AT). All of these deals are mandatory convertibles. This means that at maturity it converts mandatorily only into common stock, you don't have a par value that you can receive as an alternative. So it's ultimately a 100% participation of common stock but in the meantime you can get a higher yield and you pay something of a premium over the initial conversion.

6. Any other converts drawing your eye?

We've also bought into Interpublic ( IPG), Best Buy ( BBY) and St. Paul Companies ( SPC).

7. What about high-profile companies that have struggled this year, such as Tyco (TYC), AOL (AOL) and Qwest (Q)? Their bonds have received a good deal of attention. Did you buy into those?

I can't recall owning Tyco. AOL I've never owned because I never quite believed the story and couldn't figure out why putting AOL and Time Warner was such a great thing. Qwest I never owned because, again, the numbers never quite fit our discipline.

Enron was the bullet we really dodged. We owned the stock in a big way when a previous convert matured. I sold the stock off over time because it seemed to be getting a hefty valuation. We were out of it well ahead of the main problems. We've had stocks that have dropped, but nothing that's become insolvent while we've been holding it.

8. You removed the ban on owning lower-quality bonds after missing out on a rally in 1999. Has this changed the way you invest?

We used to have a limit on what we could own. We could own no more than 35% below investment grade. We're at 36% now, but we try and stay with the ones that are just at investment grade or those that could get upgraded but that generate enough cash flow to cover things.

9. What have you been selling recently?

We've been cutting back on some of our more successful positions like Lifepoint Hospitals ( LPNT). One of our disciplines has been to maintain a long list of diversified holdings and not to let any one single position (no matter how much we like it), get too big. For me, too big is if it starts getting much over 3%. We've been underweighted in tech and telecom almost forever and are overweighted in the consumer and utilities.

10. How do you feel about the interest-rate environment right now?

While treasury rates have dropped, the spreads on corporates have widened to historical levels. Right now, that's becoming an opportunity unless you believe we're going to have a very severe second dip -- depression or deflation. Even if stocks don't do anything for the next few years, you can still garner yields to maturity of anywhere from 10% to 15%.

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