Conservative investors face a conundrum: Since markets have
soared in recent years, it may be time to trim some stock exposure.
But shifting to traditional bonds carries risks as rising rates
threaten fixed-income holdings.
Part of the solution may lie in an often-overlooked investment:
convertible bonds. These hybrid securities combine bond-like traits
with some potential for stock market gains. Like traditional bonds,
they typically offer fixed coupon payments and promise repayment of
principal at a set maturity date. But they also give investors the
option of converting the bond into a predetermined amount of the
For conservative investors, convertible bonds can add valuable
diversification and help smooth the ups and downs of a traditional
stock-and-bond portfolio. "You want them to be a sea anchor to help
the portfolio maintain less volatility," says Rich Howard,
co-manager of Prospector Capital Appreciation Fund, which devotes
roughly 20% of assets to convertibles. In rocky markets, the bond
value acts as a floor, limiting the downside risk. What's more,
because convertible bonds are tied to shares of common stock, they
have historically proven less vulnerable than traditional bonds
when interest rates rise.
These securities aren't risk-free. Issuers often have lower
credit quality, and investors run the risk that they'll default on
the debt. They're complex to analyze and trade--making investment
through a mutual fund or exchange-traded fund a better bet. And
investors in recent years have complained of slim pickings in the
convertible market, as rock-bottom interest rates made it more
attractive for companies to issue traditional debt. But that's
beginning to change as interest rates tick up: U.S. convertible
bond issuance totaled $25.8 billion in the first nine months of
this year, up more than 70% from the same period in 2012, according
to market-research firm Dealogic.
Acting Like a Stock--and a Bond
A big selling point for convertible bonds: They can behave more
like stocks when stocks go up and more like bonds when stocks go
down. If the underlying stock is trading well above the conversion
price, the convertible will perform much like shares of that stock.
If the stock is trading well below the conversion price, the
conversion feature has little value and the convertible will trade
more like a bond. "You're looking to collect the coupon while you
wait for something good to happen in the equity that would provide
your upside," says Wayne Anglace, co-manager of the Delaware
Dividend Income fund, which devoted about 14% of assets to
convertibles at the end of September.
Although issuers generally offer lower coupons on convertible
bonds than they would pay on plain-vanilla debt, money managers say
they're finding convertibles with yields that look attractive
compared to stock dividend yields and many traditional fixed-income
investments. In the Delaware fund, for example, the convertible
holdings yielded 3.5% at the end of September, Anglace says,
compared with just over 2% for Standard & Poor's 500-stock
index and 2.6% for the ten-year Treasury.
While convertibles aren't immune to rising rates, their ties to
equity prices have helped them weather interest-rate hikes
relatively well. Calamos Investments recently looked at nine
periods over the past 20 years when the ten-year Treasury yield
rose one percentage point or more. Convertibles delivered negative
returns in only one of those periods and posted double-digit gains
in six, while a broad bond-market index suffered losses in all nine
One way to incorporate convertibles into your portfolio: Add a
small dose (perhaps 10% or so) of a stand-alone convertible fund,
an allocation that can reduce the risk of a standard stock-and-bond
portfolio without reducing expected returns, studies show.
Morningstar counts just 16 mutual funds in the under-the-radar
convertible market. But one of the category's oldest funds, Calamos
Convertible, just reopened to new investors in September.
Other good fund options include Fidelity Convertible Securities
), SPDR Barclays Capital Convertible Securities ETF (
) and Vanguard Convertible Securities (