Convertible bonds pay interest but can also grow like stocks. By Elizabeth Leary, Contributing Editor May 31, 2007 When stocks are unsteady, convertible bonds can be a refuge. Converts are securities with traits of both bonds and stocks. The idea is to earn some of the appreciation when the company's stock price rises but also to defend your principal when the stock falls. Converts have proven their worth in lean years. On average, the Merrill Lynch All U.S. Convertible Bonds index beat Standard & Poor's 500-stock index by a total of 14 percentage points during the 2000Ð02 bear market.Technically, converts are a type of bond; there's a fixed-interest coupon and maturity date. So if you don't sell and the firm doesn't default, you're guaranteed to recoup the face value eventually. The main difference between a convertible and a regular bond is that you can exchange a convert for a set number of shares of the common stock. For that reason, if a company's stock rises, its converts become more valuable. If the stock lags, well, you're still a bondholder and will get some interest income, although it'll be less than what you would have collected with a standard bond. Convertible bonds today yield an average of 2.5%. It sounds complicated, and it is. Most convertibles come with a slew of terms and conditions that make them tough to analyze and price. So most individuals should invest in converts through mutual funds. An excellent low-risk choice is Vanguard Convertible Securities (symbol VCVSX; 800-635-1511). It holds 90% of assets in convertible bonds and 8% in convertible preferred stocks, which are similar. Manager Larry Keele, who has been with the fund since 1996, estimates potential losses and gains of each convertible primarily on the basis of its terms and the bond's price. A stock's appreciation potential is secondary. "We're not stock pickers or economic forecasters," Keele says. The fund returned 9% annualized over the past ten years to April 2, beating the S&P 500 by an average of one percentage point per year with substantially less volatility. It currently yields 3.1%. Advertisement In contrast, the leader of the convertible-fund pack is considerably more aggressive. Fidelity Convertible Securities (FCVSX; 800-343-3548) has been the top-performing no-load fund in the category since Tom Soviero became its manager in June 2005, with an annualized gain of 17% over his tenure. Soviero's background is in high-yield bonds and stock picking (he's run Fidelity Leveraged Company fund since 2003), and it shows. He goes for misunderstood, beaten-down converts with turnaround potential, as well as winners that trade more like high-powered growth stocks. The trade-off is a lower yield, recently 1.8%. Moreover, Soviero keeps 15% to 20% of assets in ordinary stocks, so Fidelity Convertible is more exposed to general stock-market downturns than the Vanguard fund is. Fidelity's long-term record is outstanding -- an annualized 13% over the past decade -- but the fund's manager has changed frequently. If Soviero moves on, check his successor's background. How they work: Convertible bonds 101 Auto-parts maker ArvinMeritor issues convertible bonds that mature in 2027 and pay 4% interest. Each bond, priced at $1,000, converts to about 37 ArvinMeritor shares, trading at $19 at the time of issue. With the shares worth a total of $703, the bond has no conversion value. Scenario 1: The stock soars to $35 over the next year. The bond's price could rise to about $1,400. Advertisement Scenario 2: The stock plunges to $5. The bond will likely fall to roughly $800, trading in line with regular bonds of similar quality and maturity. (Standard & Poor's gives ArvinMeritor's debt a junk rating of BB-.) Scenario 3: The stock stays at $19. The bond's price will probably remain about $1,000. Even if the stock stays in a rut for a long time, the bond will maintain its value as long as the firm is on a sound footing.