How Convertibles Can Smooth a Rough Ride

These bonds have the characteristics of both equity and debt, offering the safety of income and the growth potential of equity

In these turbulent times, investors may be ready for a convertible. Not the car, but convertible securities, which are a hybrid form of corporate bonds that are exchangeable for equity shares at a pre-set exchange rate.

The convertible-bond market is hopping right now. So far in 2001, companies have issued 140 convertibles, valued at $74 billion, according the Morgan Stanley's In 2000, 146 convertibles worth $62 billion were issued. With three months yet to go, 19% more have been released this year than last.

Why convertibles? They can be a creative and somewhat less risky way for savvy investors -- and even retirees who have a shorter time horizon in the market -- to diversify their portfolio. Convertibles have the characteristics of both equity and debt, offering the safety of income and the growth potential of equity. They pay a fixed rate of interest until maturity -- usually 10 to 15 years -- though the interest payments are generally less than a straight bond.


  At any time, a convertible can be traded for stock at the predetermined exchange rate. When a company's stock soars, the corresponding convertible trades near the price of the underlying equity. When the stock falls, however, convertibles lose their equity value and take on the characteristics of a bond. Companies can redeem their convertibles, but that rarely happens.

All in all, convertibles are a nice way to hedge the uncertainty in the market, especially if you're making other bets that the market will fall. In fact, convertibles are popular with hedge funds that have been short-selling stocks (betting their value will fall) and buying convertibles to hedge those bearish bets. "Over time, convertibles tend to lag the stock market slightly in total returns but protect better in down markets," says analyst Bill Harding of Morningstar, which tracks 28 convertible bond funds.

Indeed, with the Dow down 17% this year, equities haven't been good to a lot of investors. The same is true of fixed-income markets. Despite the Federal Reserve's interest rate cuts, only companies with the highest debt ratings are issuing bonds right now.


  The convertible market "has become a very, very big market, and going forward I think it will have a big impact on the equity markets," says T. Rowe Price's Robert Rubino, who manages the company's Corporate Income Fund. He says many savvy investors are bored with regular bonds but don't want to bet the farm on stocks, so they get the best of both worlds in convertibles.

Who's issuing convertibles? Companies in almost any industry sell them, but they're most often issued by technology, Internet, or biotech companies, in which volatility and risk are often the highest. The wireless communications company Nextel, the biotech concern Alza, and the broadband and telco Omnicom are among the companies with convertibles currently recommended by Morgan Stanley. The value in these convertibles emerges for different reasons, depending not only on the conversion ratio to stock and the interest payment on the bond but also on the company's current risk profile and its stock-price fluctuation. So, investors have lots of factors to consider.

Indeed, buying convertibles is no Sunday drive with the top down. They're complex financial instruments that many brokers recommend investors buy through a mutual fund. Money managers such as Fidelity, Vanguard, and Pimco have funds that invest specifically in convertibles. In all, more than 25 companies peddle convertible funds. Within them, money managers buy and sell convertibles, keeping them as bonds or exchanging them for stock as equity prices rise and fall. Deciding if and when to convert is similar to buying stocks directly, but if the stock suddenly tanks, convertible investors have insurance in the form of a bond.


  The risk in these securities is that they'll never provide the returns of straight stocks or bonds. Either way you play them, convertibles offer slightly less value than if you just bought stock or the company's higher-income bonds. But convertibles are a nice option for investors unsure of where the market is headed. That's why brokers recommend that people buy them through a fund. Buying a convertible fund leaves the tough calculations to a pro, which is probably wise for the less-skilled investor.

How have these funds performed? Many have returns this year that resemble the performance of stock funds, but in most cases, losses are less substantial than funds invested in the broader market. Over the past three years, convertible bond funds have returned an average of 8.45% to investors, vs. 3.5% for the S&P 500, Morningstar says. Year-to-date, convertibles have lost money, but their losses have been lower than index funds. The average convertible-bond fund lost 14% year-to-date, compared to 18% for the S&P 500.

The performance of Morgan Stanley's Convertible Index, compiled by the company's convertible guru, Anand Iyer, better illustrates the benefits of convertibles. The index of 225 convertibles is down 9.6% through Oct. 3, compared to a 29% drop for the underlying 225 stocks. "So if you shorted some of those stocks over the past year and bought the convertible, you're a happy person right now," says T. Rowe Price's Rubino, who manages the company's Corporate Income Fund.


  This year's two best performing convertible funds are managed by Calamos Asset Management. The Calamos Convertible and Convertible Growth & Income funds have outperformed all others in 2001, according to Morningstar. These funds are managed by Chicago investor John Calamos, who has traded in convertibles for more than 20 years, along with his nephew Nick. Their aim is to invest in convertibles with moderate conversion premiums, meaning they offer some upside potential of stocks but limited downside risk.

"That line of attack has kept the fund clear of many of the more equity-sensitive convertibles -- those that have high correlation to stock-price," says Morningstar's Bill Harding. The Calamos Convertible Growth & Income fund has lost 7.7% year-to-date but, over three years, has returned 21%. Among other funds, Morningstar's Harding also ranks Fidelity's Convertible Securities Fund among the high performers. It has lost of 12.6% for the year but gained 17.5% over three years.

Certainly, because of the double-sided nature of convertibles, they're still largely an instrument of the highly skilled investor. But convertibles can be a hedge for any investor against downside in the stock market. If the market rebounds, convertibles won't prove as useful as stocks. But a long rally in this market could come months from now. Until then, for investors looking for a way to cut their losses, convertibles might be a nice option.

By David Shook in New York

Edited by Patricia O'Connell

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