Skip to Content
Fund Spy

Taking the Top Down on Convertibles

There's more to choosing a convertibles fund than meets the eye.

Mentioned: , , , , , , ,

With large, capital-starved financial firms turning to the convertibles market to rebuild their balance sheets, this obscure asset class and the funds that invest in it have garnered some attention lately. As investments, convertibles are frequently touted for their appealingly lopsided risk/reward profile, which allows them to participate in much of the broader stock market's upside potential but less of its downside risk. We've gone into detail elsewhere about the mechanics of this obscure asset class, but here's the gist: Convertible bonds are hybrid securities that incorporate both bond and equity features. As investors have the option to exchange these securities for shares of common stock at a preset price, the value of that option, and the convertible itself, increases as the stock price climbs. But if the stock gets hammered, the convertible's interest and principal payments help limit losses. (Convertible preferred shares, a smaller portion of the overall market, also share similar traits).

The appeal of convertibles isn't all academic, either. In tough markets, convertibles have often held up better than stocks, and that appears to be the case this time around. For the nine months ended July 31, 2008, the S&P 500 Index dropped 17%, but the Merrill Lynch All U.S. Convertible Index, a common index for convertibles funds, lost roughly 11%. The 21 funds in Morningstar's convertibles category, while a motley crew, have fared about as well as the index, on average, during this stretch. And although all 21 landed in the red over these nine months, only one lost more than the S&P. Convertible funds also held up well in the last downturn. When the S&P 500 shed 22% in 2002, the typical convertible fund lost just one third as much.

On the other hand, convertibles don't offer as much protection as straight bonds, which have a higher priority claim on the issuing company's assets, and they court more credit risk than debt backed by the U.S. government or one of its agencies. As a result, it's not surprising to see high-quality bonds and even high-yield corporate-bond funds beating convertibles during this period. The Lehman Aggregate Bond Index, a broad measure of the U.S. high-quality bond market, gained 3% over these nine months, and the CSFB High Yield Index lost just 4%.

Miriam Sjoblom does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.