It's hardly surprising in a confusing time for interest rates and the markets that some investors would seek solace in convertible securities and the funds that invest in them.
That's because these hybrids have a reputation of providing much of the upside of stocks but with better downside protection.
A convertible security is a bond or preferred stock that pays a set interest rate and can be converted into a fixed number of shares of the company's common stock based on a prestated ratio. The holder of the convertible usually determines whether and when this conversion takes place, though in some cases the company retains the right to determine it.
Conservative investors buy for capital appreciation and some income stream while still protecting their original investment. Convertibles offer lower yields than their conventional counterparts in exchange for the option to convert to common shares at a later date and collect the capital gain. While they tend to outperform in troubled times, they're still subject to general market trends.
It's up to the investor to decide whether the trade-offs are worth it. At most, these complex yet intriguing investments should comprise just a portion of an individual's diversified portfolio.
"Since 1973, convertibles have had almost the same return as the Standard & Poor's 500, but with less risk," said Ravi Malik, a senior portfolio manager with Los Angeles-based Froley, Revy Investment Co., a convertibles specialist with $3.5 billion under management. "This is an attractive period for convertibles because they are cheap right now, and they have typically done well when bonds have negative returns and stocks have moderate returns."
One risk associated with convertibles is that most are "callable," so the company can force investors to convert the bonds to common stock by calling the bonds in a forced conversion.
"In 2003 and 2004, convertibles were knocking the lights out with a wonderful performance, but they got overpriced and 2005 was a little off as a result," said David Citron, a certified financial analyst with WMS Partners in Towson, Md., which has $750 million under management. "Now they're doing better once again."
Convertibles have been popular investments for hedge funds because there are several trading strategies to make money off small movements in the bond, underlying stock or the difference between the two. But those strategies sometimes backfire.
When the price of the underlying stock is far from the conversion price, a convertible trades like a bond. But when the underlying stock approaches the conversion price, the convertible begins to trade like the stock.
So the investor must consider a convertible bond's interest rate and yield, the number of years before maturity and the common stock price that applies upon conversion. Risk and reward must be weighed very carefully.
Because all of this can be too much for an individual investor, mutual funds investing in convertibles offer the best opportunity for many to participate. They're able to devote the time to handling the many transactions required to run an active portfolio of convertibles.
"Convertibles are a 'middle-of-the-road' approach, because you're still getting yield, but if the stock does tremendously well you will participate — to a lesser degree, but you will participate," Citron said. "I recommend that investors use a fund or a separate manager to buy convertibles, rather than try to do it on their own, because they have so many intricacies to be analyzed."
Convertible funds — rather than convertibles themselves — are the logical way to go for most individual investors, and there are plenty to choose from. An added bonus is that the funds also can offer conservative investors exposure to some growth-oriented market areas.
"Convertible funds are a good alternative to balanced funds, yet they remain underused in planning portfolios," said David King, lead manager for convertible funds at Putnam Investments, including the $668 million Putnam Convertible Income-Growth Fund. "While the balanced fund is a professionally managed version of what you already own, underlying securities in a convertible fund can be more interesting."
For example, instead of the food and pharmaceutical stocks typical of balanced funds, convertible funds may include areas such as biotechnology and electronics, King said.
His Putnam Convertible Income-Growth A (PCONX), which is up 4 percent this year and has a three-year annualized return of 11 percent, includes the likes of Northrop Grumman Corp., Xerox Corp., Amgen Inc. and Intel Corp.
"Since convertibles operate like short-duration bonds, we haven't had any real difficulty making money in the convertible market with the Federal Reserve raising rates," said King, who manages Putnam New Value Fund and co-manages Putnam Fund for Growth & Income.
The returns of some other well-known funds that have a significant portion of their portfolio in convertibles have been in a similar range as Putnam Convertible Income-Growth:
The $448 million Davis Appreciation & Income Fund A (RPFCX) is up 5 percent this year and has a three-year annualized return of 12 percent.
The $2 billion Fidelity Convertible Securities Fund (FCVSX) is up 4 percent this year and has a three-year annualized return of 11 percent.
The $632 million Vanguard Convertible Securities Fund (VCVSX) is up 4 percent this year and has a three-year annualized return of 11 percent.
The Vanguard and Fidelity convertible funds are "no-load" (no sales charge) investments. Putnam requires a 5.25 percent load and Davis a 4.75 percent load.
Andrew Leckey answers questions only through the column. Address questions to Andrew Leckey, "Successful Investing," P.M.B. 184, 369-B Third St., San Rafael, CA 94901-3581, or by e-mail at andrewinv@aol.com.