Convertibles are hybrid securities that offer both bond and stock characteristics. They come in two forms: convertible bonds and convertible preferred stocks. As their names suggest, these securities can be converted into a company's common stock at a specified price.
The appeal of convertibles is that they offer much of the upside potential of stocks while limiting downside risk. The income that convertibles pay out provides a cushion from losses, and if a stock's price rises enough the convertible will get a nice boost in appreciation.
Because convertibles are generally more correlated to stocks than regular corporate bonds (and sport lower yields), they haven't totally shielded investors from stock market losses of late. But they have weathered the market's storm better than equity offerings. The average convertible fund has declined 9.8% over the trailing 12 months ended August 22, 2002, while the S&P 500 index has lost 16.2% over that time, and the typical domestic-equity fund has shed 15.7%.
The allure of convertibles is more evident in their attractive long-term risk/reward profile. The typical convertible fund's returns over the past 10 years doesn't trail the venerable S&P 500 by much, and it has been much less volatile to boot. Moreover, a few of the group's better offerings, such as Calamos Convertible CCVIX, offer the Holy Grail in investing--a long-term return superior to the index with less volatility.
Even though they have delivered admirable results, convertibles receive little media coverage and tend to be overlooked by investors. Part of the reason is that it's a quirky investment class that may appeal mostly to sophisticated investors. In addition, the convertible market is relatively small in size.
That shouldn't deter investors, however. The amount of new issuance in the convertible market has increased dramatically in recent years. In fact, 2001 witnessed a record level of new issuance as 210 deals came to market with proceeds of $105 billion. Though the issue calendar has cooled in 2002, there were still 93 deals totaling $44 billion that came to market. More important, companies of various sizes across different industries have turned to the convertible market. Auto companies Ford F and General Motors GM, for example, had two of the largest deals this year. Consequently, unlike a few years ago when the majority of the convertible market was dedicated to low-credit-quality tech and telecom issues, today's market is in better shape.
These complex securities are extremely tricky to analyze and often not accessible to individual investors. Therefore, individuals interested in investing in this asset class should stick with mutual funds. Morningstar currently tracks 27 funds in the convertible category. The majority of which follow a typical approach of trying to strike the optimal balance between upside potential and limiting downside protection. That said, investors should still look under the hood as a few of the group's entrants, such as Fidelity Convertible Securities FCVSX, take a slightly more aggressive tack. Though these revved-up offerings can produce bigger gains, they're also more vulnerable to stock market woes.
Convertibles can play a couple different roles in an investor's portfolio. They could be used as a safer play on stocks, or an aggressive bond alternative. Individuals in search of income, however, should note that convertibles tend to yield less than regular corporate bonds.
