During the stock market rout in October, shares of Corporate Express, an office products supplier, dropped more than 18%, to $14.69. But its convertible bond fell only 2.5%. Therein lies the beauty of convertibles--bonds or preferred shares you can turn into common stock. When the equity market gets jumpy, convertibles can be a haven. Their yields help shield you against moderate declines, but they still give you a chance to make money if share prices take off. "They are great for investors who are afraid to be in the market and afraid to be out of the market," says Michael Rosen, manager of Oppenheimer Bond fund.
To get this protection, you'll have to pay a premium over the value of the common shares. That's because convertibles carry higher yields than their companies' common stock (they average 3.3%, against 1.2% for Standard & Poor's 500-stock index). Take a Home Depot convertible that yields 3.25%, matures in 2001, and can be converted to 21.7 shares of stock. It was selling recently for $1,310, which represents a 7% premium over $1,223--the value of those 21.7 shares. Convertibles like Home Depot's with low yields and premiums move closely with changes in the stock prices, while those with higher premiums and yields act more like bonds. Convertibles typically come with three years of call protection, but you can exchange them at any time for a predetermined number of stock shares.
Not surprisingly, convertibles lag during market booms--but not by much. The Merrill Lynch All Convertibles Index was up 18.63% for the year through Oct. 31, vs. 22% for the 500 underlying stocks in the index. But from Oct. 1 through Nov. 13, when stocks fell 6.73%, the index dropped only 2.96%. Indeed, today's market of "low inflation, steady interest rates, stable bond prices, and a modest outlook for equities is best for these securities," says Anne Cox, director of global convertible research for Merrill Lynch.
The risk in convertibles comes when a company's credit quality deteriorates or the Federal Reserve raises interest rates. Either can cause convertible prices to tank. If the underlying stock soars, you won't share in 100% of the gains. Cox notes that when a company's stock price increases, its convertible generally rises two-thirds as much.
Mutual funds are the most practical way to dive into convertibles (table). That's because the $120 billion market is dominated by institutions, making it hard for consumers to find issues at good prices. You also benefit from the diversification a fund offers. Over the past 10 years, convertible funds have delivered nearly 80% of the returns of the average diversified stock fund with only two-thirds of the price volatility.
When you are shopping for convertible funds, decide whether you want more equity exposure or bond protection. Davis Convertible Securities A Fund, the top-performing fund for the five years ended Oct. 31, took advantage of the bull market and invested 25% of its $65 million in assets in common stocks and real estate. As a result, it gained an average of 18.85% in the period, beating the average convertible fund return of 13.38% and the average stock index return of 18.76%. Andrew Davis, the 34-year-old manager, placed a big bet in the financial sector with a hefty 40% of his fund invested in the convertibles and stocks of banks such as Citicorp and insurers such as American International Group. Many convertible issues in his portfolio are trading with low premiums, which make the fund perform more like an equity than a bond fund. Consistent with that character, Davis has a low average conversion premium of around 20%.
TAMER PLAY. If you're looking for a tamer play, Franklin Convertible Securities Fund and Oppenheimer Bond Fund have little to no stock holdings. They also invest in small-capitalization companies, the most common in the convertible universe. Because "small- to mid-caps are typically underweighted in an investor's portfolio, this is a great way to play the sector without the volatility," says Ian Weinberg, a certified financial planner with LPL Financial Services. Indeed, Wall Street's troubles have sent some managers on buying sprees. Mitchell Cone, co-manager of $249 million Franklin Convertible, added to his biggest position, electronics company DII Group, and bought Mark IV Industries, an industrial conglomerate. Both funds have low 25% conversion premiums and their yields top 4.5%.
If small caps aren't to your liking, Putnam Convertible Income Growth Trust has 30% in stocks, mostly large-cap value plays with high-dividend yields. The fund has an overall yield of 4.14%. When the stock market turns shaky, it's nice to know your fund is throwing off that kind of cash.