Convertible Securities Straddle Two Worlds

Ever-rising stock prices are making some investors uneasy. Yet few experts are calling an end to the bull market. Bond prices, which hit bumps earlier this year, have been posting gains. So which type of investment is better now?

Neither, say some financial analysts. They point to an option that combines elements of bonds and stocks: convertible securities. "With a stable-to-rising bond market, and stocks still growing in value, the conditions are really quite good for the convertible securities market," says Richard Janus, managing director of convertible securities at Society Asset Management Inc. in Cleveland.

Many investors are clearly coming to the same conclusion. Inflows are up at a number of convertible-bond mutual funds.

One top-rated fund, the Lincoln National Convertible Securities Fund, has returned 18.5 percent through Oct. 31, not far off the pace of the Standard & Poor's 500 stock index. The current annualized yield is about 6 percent. Unlike regular mutual funds, which can sell an unlimited number of shares, this is a closed-end fund, with a set number of shares issued. It is available only over the New York Stock Exchange (symbol: LNV).

Convertibles are "ideal products" for cautious investors who seek price gains from the stock market yet "still like the conservatism of bond products," argues Kevin Putt, a vice president of Lynch & Mayer Inc., the New York investment firm that manages the Lincoln National fund.

Here's how the investments work:

A convertible bond pays interest like regular bonds, but can typically be converted into shares of the company's stock if the stock reaches a certain price. Its share price generally moves in the same direction as the issuer's underlying stock.

But there is no free lunch here. A convertible bond's yield will be less than the interest on regular corporate bonds. And, if you do ever convert the investment into shares of stock, your capital-gain will be less than if you had initially invested directly in the stock, experts say.

Still, convertible securities are less volatile than bonds or equities alone. While they slightly underperform market indexes in a rising stock market, they tend to do better than the indexes in a down market, Mr. Putt says.

Another type of convertible security is convertible preferred stock. This is a class of equities that can be converted into common stock. Preferred stock usually pays a fixed dividend, like a bond. It too tends to rise with the value of the firm's stock.

An estimated $200 billion worth of convertible securities exist around the world, half in the United States.

There are two primary ways of buying convertible securities:

1. You can purchase individual convertibles through a broker. Many are issued by small or mid-size companies. But some large blue-chip firms have issued them, including Ford, Motorola, and GM.

2. You can buy into a closed-end or open-end mutual fund investing in convertibles. For novice investors, this is the best strategy, since the fund provides greater diversification, says Mr. Putt. Individual investors have to be particularly careful, since many convertible bonds and preferred stock have "call" provisions. These enable the issuer to redeem the securities. For example, when interest rates fall sharply, the issuer could retire older, more costly, bonds and replace them with newer bonds paying lower rates. The investor then has to figure out where to put his money all over again - with lower interest rates.

Fund managers are probably better able to deal with call features than smaller investors, Putt notes. Moreover, whether to make the conversion is not always an easy decision for unsophisticated investors. "We usually never convert" he says. Rather, the security will be sold prior to conversion and the proceeds invested in another convertible issue.

The mutual-fund side of the convertible market is relatively small, at about $6 billion in market value, says Jon Hale, an analyst at Morningstar Inc., in Chicago. But the funds have done relatively well in recent months.

Morningstar tracks both closed-end and regular mutual funds. The closed-end funds tend to trade at a discount of about 10 percent or better. For example, if the net asset value of the securities owned by the fund is $100 a share and the discount rate is 10 percent, then a person could actually buy the share for $90.

The best-performing open-end convertible fund, among major fund families, is the Value Line Convertible Fund (800-223-0818), up 19.9 percent through Nov. 22. Lincoln National's convertible fund, mentioned above, is Morningstar's top-ranked closed-end convertible fund. Lynch & Mayer plans to introduce an open-end convertible fund in 1997.

Most major mutual-fund groups have convertible funds. Morningstar tracks 43 open-end convertible funds, some with fairly high performance ratings.

"This year their performance has been about as expected, with the funds doing slightly better than pure bond funds, but slightly underperforming equity funds," Hale says. Many of the funds posted substantial rallies along with bonds in October.

Bob Schwartz, portfolio manager of the Lincoln National fund, says, "Assuming there is at least a neutral bond market next year [without losses], plus strong gains for smaller and mid-sized companies, convertible securities should do well in 1997."