Convertible Opportunities

During the first four months of this year, convertible investors witnessed a peculiar event.

While the Standard & Poor's 500 dropped 4.0 percent, convertible funds declined 6.6 percent, according to Morningstar. The losses were highly unusual because convertibles almost always outdo the S&P during downturns. For instance, when the S&P lost 9.1 percent in the crash of 2000, convertible funds stayed in the black. As the S&P continued falling during the next two years, convertibles outperformed by wide margins.

Convertible owners can blame part of their recent ill fortune on hedge funds. After a recent run of mediocre results, many hedge investors panicked and dumped their holdings in convertible arbitrage funds. That brought pain to convertible investors of all stripes, but the downturn could have produced some intriguing opportunities.

“Many convertibles are the cheapest that they have been in years,” says Nick Calamos, a portfolio manager of Calamos Convertible.

The Skinny

Convertibles are hybrids — bonds that can be converted to stock. Because they pay bond-like yields, the securities tend to be resilient in stock downturns. And when stocks rise, convertibles tend to climb — though not as much as conventional equities. Hedge funds often buy a convertible and short shares of the company that issued the bond. The aim is to take advantage of situations where a company's convertible is relatively cheap compared to the common stock. The arbitrage techniques produced impressive results during the downturn that began in 2000. With technology stocks collapsing, the short positions of hedge funds showed huge gains, more than compensating for any losses in the long positions. The technique proved particularly effective in 2001 when the S&P lost 12 percent, while the average convertible arbitrage fund gained 15.1 percent, according to Hennessee Group, a hedge fund tracker.

Seeing the results, investors poured into the hedge funds. With more funds scouring the landscape for undervalued convertibles, prices climbed. Eventually the convertible bubble popped.

Still, there are signs that the market for convertibles has cooled. A confirmation that prices may have finally reached bargain levels came in June when Vanguard Convertible Securities reopened to new investors. The fund had closed in May 2004, a time when prices were climbing and the portfolio manager couldn't find enough opportunities to deploy cash.

Iron's Hot

With prices down now, this could be an opportune moment to build a long-term position in convertibles. Despite the recent woes, convertibles have produced an impressive long-term record. During the past 15 years, the average convertible fund has returned 10.1 percent annually, about half a percentage point less than the S&P 500. But the convertibles have been substantially less volatile — as measured by standard deviation — than the benchmark.

If convertibles provide a mix of equity and fixed-income characteristics, why not buy the pure thing — balanced funds, which typically hold collections of stocks and bonds? Balanced funds can be appealing, but convertibles offer a unique kind of exposure. The typical balanced fund holds blue-chip stocks and high-quality bonds. That is different from the convertible world, where about half the choices are rated below investment grade. Many convertible issuers are technology and other growth names that are found in the volatile Nasdaq. Because of their high yields, convertibles offer a relatively tame way to play aggressive stocks and bonds.

“Convertible funds provide some unusual diversification that can be particularly appealing for conservative investors,” says Dominick Tavella, a registered rep with Diversified Financial Consultants in Bellmore, N.Y., which processes trades through broker/dealer Investacorp.

A champion selection is Calamos Growth & Income A, which has returned 14.4 percent annually for the past 15 years, 3.7 percentage points ahead of the S&P. The fund has clobbered the benchmark during downturns, but portfolio managers John and Nick Calamos are no pussycats. Besides convertibles, they sometimes hold big stakes in volatile stocks. When convertibles seemed expensive last year, the fund had 45 percent of assets in stocks. Lately, the fund managers are selling stocks to scoop up cheap convertibles. Now the fund only has 30 percent of assets in stocks. A big holding is a Ford convertible with a yield of 7.8 percent. “The yield is safe, and you could get some capital gains if the business improves,” says Nick Calamos.

Another fund that holds a mix of stocks and convertibles is Davis Appreciation & Income A. A year ago the fund had 80 percent of assets in convertibles. Then as prices rose, portfolio managers Andrew Davis and Jason Voss shifted down to 50 percent in convertibles. The managers aim to maintain a portfolio that will deliver 80 percent of the S&P's returns during rallies — and only 50 percent of the losses in declines. Most often they have succeeded, besting the S&P by 6 percentage points in the past five years. To avoid trouble, the fund focuses on companies with steady businesses. A top holding is International Rectifier, a maker of chips that are used to regulate the flow of power in electronic products ranging from computers to refrigerators. The company boasts healthy margins and a track record of success going back decades. The convertible yields 4.8 percent.

Middle of the Road

In the world of convertibles, some pay rich yields and act much like bonds, while others behave more like stocks. Franklin Convertible Securities A aims to stay in the middle of the spectrum, holding issues that have some of the yield of bonds and the upside potential of stocks. “If our companies do well, we get most of the upside of the stocks with less risk,” says portfolio manager Alan Muschott. A big holding is an issue from Community Health Systems, a growing owner of rural hospitals. The profits seem secure, because in most of its market, the company operates the only hospital.

For a relatively pure dose of convertibles, consider Putnam Convertible Income Growth A. Portfolio manager Dave King has 95 percent of his assets in convertibles. King stays broadly diversified, holding solid companies from a wide range of industries. A favorite holding is an issue from Northrop Grumman.

“We think the stock will go up,” says King. “And if it doesn't move for a while, we can be patient because we are collecting a yield of 5 percent.”

Such rich yields can make convertibles attractive holdings at a time of erratic markets. By adding a convertible fund or two, investors can get downside protection and the chance to benefit from any market rises.

Steady Hands