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Fund Spy

Taking the Top Down on Convertibles

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

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%.

No Guarantees
We'd caution investors about taking the defensive attributes of convertibles for granted, though, particularly in the present climate, which has proved challenging for stocks and bonds alike. Convertibles are a quirky lot that come with a unique set of risks, any of which could prevent them from striking that optimal balance between bonds and stocks in the short run. For starters, the convertibles market is small, with a little more than $300 billion in convertible issues outstanding in the United States. That's tiny compared with the $4.6 trillion in U.S. Treasury debt and the $7.2 trillion in mortgage-backed securities outstanding.

That means that factors like a fickle stream of new issues coming to market and hedge fund trading can have a greater impact on convertibles prices for good or ill. New issuance has been healthy this year, led by financial firms such as  Bank of America (BAC),  Fannie Mae (FNM),  Lehman Brothers (LEH), and  Washington Mutual (WM), and some convertibles fund managers we've spoken with have noted that these issues' high coupons and favorable terms look attractive. While it remains to be seen how well these securities will perform in the long run, new issues (not just financials) have generally performed poorly compared with the broader convertibles market so far this year. A Merrill Lynch index that tracks convertibles issued in the past six months has lagged the broader convertibles index by 10% for the year through July 31. And as far as hedge funds are concerned, The Wall Street Journal reported in May that there's roughly $40 billion run by hedge funds that engage in a strategy called convertible arbitrage and that bouts of rampant selling of convertibles by these funds have weighed on the market at times this year.

Furthermore, at this stage in the economic cycle, the added credit risk of convertibles is another cause for concern, because roughly three fourths of the convertibles market could be considered mid- or low-grade. With corporate defaults expected to rise in coming months, many lower-quality issuers could go belly up. Also, a hefty segment of companies issuing convertibles are small and midsize firms (40% of the index), some of which could lack the resources to weather a prolonged economic slowdown.

Choose Carefully
We don't think these near-term or lasting challenges should prevent you from making a small place for a convertibles fund in your portfolio. Indeed, those looking for either a milder alternative to equities or a more aggressive bond substitute may want to make room for a convertibles fund in their long-term asset-allocation schemes. Some diversified funds we like, such as moderate-allocation offerings  T. Rowe Price Capital Appreciation (PRWCX) and  Van Kampen Equity and Income (ACEIX), have also made good use of sizable convertibles stakes in their portfolios over the years. We think both of these options make sound choices for investors who may want a little exposure to convertibles, but who are for the most part content to stick with a traditional mix of stocks and bonds.

These risks do, however, highlight the importance of choosing a fund with skilled managers whose approach also matches your expectations. Not all managers in the convertibles category are as concerned about maintaining an even balance between the protective qualities of bonds and the added kick of equities. Several funds include sizable helpings of common stock, potentially making the fund's returns more equitylike during both up and down markets. Within the convertibles universe itself, some securities can lose their defensive traits altogether if the underlying common stock has a blistering run (at that point, a convertible can end up trading almost in unison with the issuer's stock). If investors looking for a convertibles fund don't read the fine print, they could end up owning an equity fund in disguise. The following two funds illustrate just how differently convertible managers can view risk.

 Fidelity Convertible Securities (FCVSX)
The giant of the group with $3.3 billion in assets, this fund is as bold as they come. For the past three years, manager Tom Soviero has shown he's in it to win it. He'll load up on common stock (as much as 20% of assets) as he sees fit, and he favors the more equity-sensitive convertibles over alternatives that occupy the middle ground. On top of that, he runs a more concentrated portfolio than most rivals, and he's willing to make large sector bets. It's also particularly important that investors don't mistake the fund's recent category-topping returns for innate downside protection. A long-standing bet on the energy and materials sectors (48% of assets as of June 30, 2008, as opposed to 10% in the index) has fueled this fund's recent gains. But as energy prices dropped precipitously in the past month, the fund got hit hard, losing 8.6% in July alone, the worst showing in the category by far.

 Vanguard Convertible Securities (VCVSX)
Manager Larry Keele's emphasis on protecting against losses and homing in on individual convertibles that offer the best of both worlds makes it a top candidate for those interested in a fund that's likely to offer that trademark convertible risk/reward profile. Oaktree Capital Management, the fund's subadvisor, specializes primarily in high-yield corporate bonds, distressed debt, and convertibles, so we like the deep expertise with this unconventional asset class that Keele and his analyst team bring to the table. And unlike Soviero and other rivals, Keele won't dabble in equities. Within the convertibles universe, he sticks with those that offer a mix of downside protection and upside potential, selling individual convertibles that start to behave either too much like equities or bonds. This fund is our top choice for a pure play on convertibles.

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