Convertible Bonds Offer a Smooth Ride

Looking for an investment that has returned more than stocks over the long haul but has done so with much less risk, and that also boasts juicy yields? Consider convertible bonds, aptly dubbed “equities with training wheels” by Howard Marks, who heads the firm that runs my favorite convertible bond fund.

A lot of people overlook converts because they’re complex and they represent a tiny corner of the investment universe. Because of that complexity, you’re almost certainly better off avoiding individual convertibles. This is a sector in which a good fund is the best option.

In this category, one fund stands above all other no-loads. That fund is Vanguard Convertible Securities (symbol VCVSX). Its results have been superb. Over the past 15 years, the fund returned an annualized 7.4%, an average of 2.0 percentage points per year better than Standard & Poor’s 500-stock index (all returns are through January 17). The fund yields 3.8%, and its annual expense ratio is 0.68%, compared with 1.22% for the average convertible mutual fund.

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Although the Vanguard fund has beaten the S&P 500, it has been 30% less volatile than the market. Convertible shareholders have experienced fewer gut-wrenching ups and downs than stock investors in recent years. During the 2007-09 bear market, the Vanguard fund lost 34.3%, while the S&P 500 plunged 55.3%.

Converts are hybrids -- part bond and part stock (there also are convertible preferred stocks). Convertible bonds yield less than most traditional bonds, but they come with an equity kicker: the right to convert your bond into stock of the issuing company at a preset price. For example, you might be able to convert one of these bonds, with a face value of $1,000, into 50 shares of stock. If the stock currently trades below $20, converting doesn’t make sense. If the shares trade much above $20, converting is a good deal.

Larry Keele, 54, has been lead manager of the Vanguard fund since 1996. His employer, Oaktree Capital, of Los Angeles, has run the fund since 1986. In late 2010, the fund added two co-managers, who pick only foreign converts. So far, foreign converts are just 15% of assets, but that percentage is expected to roughly double over time.

Most convertibles are issued by troubled or highly leveraged companies. Many converts are rated as “junk,” meaning there’s a real risk that the issuer could default. But Keele, his co-managers and eight analysts do thorough credit research. In fact, since Oaktree started managing the fund, it has experienced only one default. That was late last year when AMR, the parent company of American Airlines, filed for bankruptcy reorganization. And the fund’s holding in AMR was tiny.

The fund hit a bad patch recently, losing 7.0% over the past year. Keele says the main blame lies with the lousy performance of many of the lower-quality stocks underlying the convertibles that the fund owns. Foreign converts didn’t help, either.

But Keele sees opportunity in the loss. “Valuations of small and midcap stocks are a lot more attractive today than they were a year ago,” he says. “Converts are trading at lower prices today. That means higher yields and more downside protection.”

Meanwhile, the size of the convertible market has shrunk markedly in recent years. The reason: Yields on regular bonds are so low that fewer companies see a reason to offer an equity kicker. Keele estimates that the U.S. convertible market is about $220 billion. The world market, including the U.S., is about $500 billion.

Keele sees no signs that the shrinkage will reverse soon. But “a lot of corporate debt comes due in the next several years, and I think converts will get their fair share of the new issuance.”

By Vanguard standards, the fund is unusually active, with annual turnover of 80% to 120% annually. Keele generally doesn’t like to own converts that are selling far below their conversion prices and, therefore, trade almost entirely like regular bonds. And he sells converts that rise so far that they closely track their underlying stock price. His strategy seems to work.

One note of caution: The long-term returns of the fund relative to stocks are almost too good to be true. The last decade or so has been an unusually bad period for stocks, and an unusually good stretch for bonds. To some degree, converts have benefited from the high returns on bonds.

In future years, I’d expect converts to provide somewhat lower returns than stocks. But those returns will continue to come with that soothingly low volatility. As 5% to 10% of your portfolio, converts make all kinds of sense. Records show that Keele has between $500,000 and $1 million of his own money in the fund.

One other negative: You can’t buy the fund without purchasing it directly from Vanguard. But I think it’s worth going to Vanguard for this gem. No other no-load convertible fund is nearly as good.

Steve Goldberg is an investment adviser in the Washington, D.C., area.