Convertible Securities Cut Risk

You can hardly blame investors for being skittish about stocks after the licking they've taken during this devastating bear market. And there's no way to know whether the current advance represents a new bull market or a temporary reprieve before the next round of carnage.

A good convertible-securities fund -- one that's capable of delivering solid returns with low risk -- is just the medicine for this uncertain environment. Even aggressive investors should consider putting 5% to 10% of their assets in converts.

Converts historically have produced most of the returns of stocks in bull markets, yet they've spared investors a lot of the pain of bear markets. What's more, like bonds, they pay you while you wait. If a new bull market turns out to be many months away, you'll still earn income from converts.

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Over the past ten years, converts have handily outpaced the stock market. The Merrill Lynch Convertible Bond Index gained an annualized 2.4% over that period through March 31, while Standard & Poor's 500-stock index lost an annualized 3%. My favorite convertible fund, Vanguard Convertible Securities (symbol VCVSX), gained an annualized 5.1%.

I'm not suggesting that you put all your money into converts. But I think that for many investors, converts make good sense for a chunk of your assets.

Convertible bonds are hybrids -- part bond and part stock. Like a bond, a convert pays an investor a fixed rate of interest. But converts can be exchanged for stock of the issuing company at a preset price. They're very complex securities, which makes investing in a fund ideal. (Some funds also invest in convertible preferred stocks, which are similar to convertible bonds.)

My one concern: Most converts are rated below investment grade. That is, there's a real chance their issuers could default. The average convertible security has a credit rating of BB from Standard & Poor's. That means it's especially important that you invest in a fund with an experienced and knowledgeable manager.

Larry Keele, who has run the Vanguard fund since 1996 and has been investing in converts since 1983, fits the bill. He argues that converts are much less risky than ordinary junk bonds. "We haven't had a default here since the early 1990s," he says. "We may have one this year, but I can almost guarantee it will be very small." He says the best values now are in low-quality converts. "Most of what we're buying in today's market is non-investment grade."

The Vanguard fund currently yields 4.3%. But its average yield to maturity is twice that. That's because the average convert Keele holds trades for only 85 cents on the dollar. If the bonds are held to maturity-less than four years away, on average-they will be redeemed for $1. The yield to maturity, moreover, doesn't count all the gains the fund might realize from the converts rising in price before then. So the funds' annualized return over the next few years could be much higher.

Converts didn't escape 2008's devastation. The Vanguard fund lost 30%. Heavily leveraged hedge funds deserve most of the blame for that awful performance. Faced with massive redemptions, many hedge funds that specialize in convertibles unloaded them, causing their prices to plummet. "Everything was beaten up," says Keele. "Convertibles got as cheap as I've ever seen them."

The market has bounced back nicely, though, and this year the Vanguard fund has gained 7.0% through April 3. That compares with a 7% loss for the S&P 500.

Keele tries not to take big risks with the portfolio. That's not true of some other convertible funds. Fidelity Convertible Securities (FCVSX) plunged 48% last year and has rebounded 5.2% so far this year. If you buy the Fidelity fund, consider it as risky as a stock fund.

Ten analysts assist Keele. He works for Oaktree Capital, one of the largest high-yield-bond managers in the U.S., with more than $50 billion in assets. Vanguard subcontracts with Oaktree to run the fund. Keele manages about $7 billion in converts -- about $1 billion of that in the Vanguard fund. The fund charges annual fees of 0.72%.

The universe of convertibles is small -- they're worth only about $180 billion in the U.S. That, along with converts' complexity, is why you hear so little about them.

In a bankruptcy, converts are in line as creditors behind holders of regular bonds but ahead of those holding preferred stock and common stock.

The strongest companies don't usually issue converts because they can issue regular bonds at low interest rates. Other than that, the convertible universe is widely diversified. "It tracks a variety of industries," Keele says.

Converts don't belong at the center of your investments. But they can be a welcome addition to a well-diversified portfolio that includes stock funds and bond funds. Moving a bit of your stock funds to a convert fund now could, perhaps, cost you a smidgen in return -- but it would help you sleep better at night.

Steven T. Goldberg (bio) is an investment adviser.