Investors seek safer ride with convertible funds

The hybrid securities – bonds that can be converted to stocks – are underrated, some experts say. But they also require expertise.

If a shaky stock market causes you to lose sleep at night, bolstering cash reserves by dumping laggard stocks may give you peace of mind.

But if you want to reduce your portfolio's risk profile and still remain invested, convertible bonds may be part of the answer, some analysts say.

Convertible bonds are a hybrid security, with features of both stocks and bonds. They can be converted into shares of stock in the issuing company, usually at some preset ratio and at the holder's discretion. The trade-off is that the bonds typically have a low coupon rate.

Convertibles have appeal when the "equity waters are choppy," says Morn­ingstar analyst Annie Sorich. "If the market advances in coming months, convertibles will participate in most of the upward move. But you also receive extra downside protection from the bond side, if stocks should falter," she says.

To Alan Muschott, lead manager of Franklin Convertible Securities fund, "They offer you the best of both worlds. The underlying equity performance is the chief driver of convertible prices. Yet the steady stream of interest payments from the bonds is a cushion on the downside."

In 2007, convertible bond funds turned in a respectable performance, rising 7.8 percent, more than twice the rise in the S&P 500 index, according to Morningstar. Their longer-term performance also compares favorably with the large-cap benchmark index. Convertible bond funds had an average annual return of 6.7 percent over the past 10 years, versus 5.9 percent for the S&P 500.

On a risk/reward basis, "convertibles are an underrated asset class," says Steven Rogé, a principal of R.W. Rogé, a financial advisory firm in Bohemia, N.Y. Their lower volatility, about 10 percent below that of the S&P 500, and their better long-term performance gives well-managed convertible bond funds an edge over the far more popular S&P 500 index funds, Mr. Rogé says.

Dividend yields are modest: The average 12-month yield for Morningstar's convertibles category is 2.3 percent, less than half the amount generated by the multisector bond group.

Convertibles trade in a world of their own. For example, when the price of the underlying stock is far from the conversion price, a convertible trades like a bond. These "busted" convertibles are very closely tied to interest rate moves, rising when they go down. When the underlying stock nears the conversion price, however, a convertible bond trades in tandem with the stock. In practice, this means a convertible tends to rise 70 to 75 percent as much, analysts say. When the underlying stock drops, a convertible will typically slide about half as much as its stock.

"If you believe interest rates will be relatively stable and the economy will improve toward the end of 2008, convertible securities will trounce regular bonds and compare favorably with stocks," Rogé says. But if rates rise and stocks fall, you'd be better off with money-market funds.

Convertible funds must be selected carefully. Some, like Fidelity Con­vert­­ible Securities, have a large chunk of straight equities and so are more volatile than "plain vanilla" funds like Vanguard Con­­vert­ible Securities fund and Franklin Con­­vertible Securities fund, says Ms. Sorich.

Because the funds require expertise in credit market analysis, you want to "go with a very seasoned management team," Sorich adds.

Among the funds that merit a look based on their records are Van­­guard Convertible Securities, Putnam Con­vert­ible Income and Growth, and Franklin Convertible Securities, she says.

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