Investors can’t decide which scares them more, a bond market poised for massive changes as interest rates rise, or a stock market that reached record highs despite a weak economy.
For investors who aren’t completely happy with either side of the stocks/bonds picture, convertible securities offer an interesting straddle, a way to ride the fence of indecision with the potential for getting the best of both worlds.
While convertibles are esoteric enough for many investors to reject them as a potential holding out of hand, they’re attractive enough that they’re showing up in more funds, and are increasingly popular.
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There have been more convertible securities issued year-to-date than a year ago, and the increasing supply has brought a few managers off the shelves and into the market.
Most recently, Calamos Convertible Securities (CCVIX) was reopened to new investors, with company chief executive John Calamos Sr. noting that widening spreads have increased interest among issuers. Perhaps more important is that convertibles, historically, do better than more traditional fixed-income securities at times when rates are rising.
To understand why — and to get how convertibles can be a good fit — let’s start at the beginning to examine how these securities work.
Convertible securities are hybrids, typically interest-paying bonds (but sometimes preferred stock) that can be swapped for shares of the issuing company’s stock at a predetermined price.
The bondlike yield facet of a convertible protects against stock declines, while the ability to convert into stock offers shelter against falling bond prices.
When interest rates are going up, bond prices fall; but in a market like we have now — where stocks have been on the rise — an investor can get the best of both worlds.
Said Calamos at the time his fund reopened: “The equity portion of the convertible market pulls it along with the equity market, so that’s been positive for convertibles in a rising interest-rate environment, so you have many investors looking at convertibles as part of their fixed-income asset allocation, and having more positive results.”
If you think of a convertible like the car, investors get to put the top down when the sun is shining, but they can cover up for protection when things get stormy.
Money managers who use convertibles frequently say that they expect the investment to deliver about two-thirds of stock-market returns with half of the downside risk, meaning a convertible fund would gain around 6.5 percent for every 10 percent market rise, but fall just 5 percent during a 10 percent market correction. That’s attractively conservative.
In practice, convertibles have been a good diversifier to balance the stock and bond chunks of a portfolio.
For the last five years, the average convertible fund had an annualized return of 8.75 percent, just a bit less than the average large-cap-growth fund, but better than might be expected.
That five-year history still includes a lot of the financial crisis of 2008, a point when convertibles lost ground but showed their protective side (the average convertible fund lost 33 percent in ’08 compared to 37 percent decline in the Standard & Poor’s 500).
On the fixed-income side, the average high-yield bond fund gained a hair under 10 percent over the last five years, a bit better than convertibles, but over the past year — when the rate environment was changing and stocks reached new heights — the average junk-bond fund gained 1.1 percent compared to 6.1 percent in convertibles.
At the same time, convertibles are an area where even do-it-yourself investors may want to hire a money manager, if only because many of the issues carry investment ratings that are below investment grade.
While defaults are not particularly common, “busted convertibles” — where the convertible price is 50 percent or more above the current price, making the chance of converting into stock slim — are not uncommon; many convertible managers — particularly those running closed-end funds looking for a good income — will buy busted convertibles on the cheap. (Technically, a busted convertible could be considered a “nonconvertible,” since it’s never going to morph.)
Thus, this is one of those areas where interested investors can get some comfort from a professional manager and a diversified portfolio that can minimize the pain if any single issue goes bad.
David Snowball of MutualFundObserver.com noted that investors don’t necessarily need a convertibles fund or closed-end offering to get exposure, as many “strategic income funds” include them as a holding.
Calamos, in announcing his fund’s reopening, noted that, “One of the things we have learned over the years is that convertibles are not specifically an asset class. It’s how you use them to manage risk that’s very important. … It’s a way we feel we can manage risk.”
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at firstname.lastname@example.org or at P.O. Box 70, Cohasset, MA 02025-0070.
Copyright, 2013, MarketWatch