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Taking the Top Off Convertible Funds

Convertible bonds offer equity upside with downside protection.

As the equity market zigs and zags and bond investors earn minuscule yields while waiting on the Fed to raise interest rates, convertible bonds have become an increasingly appealing option for income-focused investors. A convertible security is a bond that also has the right to buy the stock of the issuing firm once it hits a certain (conversion) price. As a result, convertible funds provide much, but not all, of equities' upside with less of the downside risk, though much of this profile depends on the underlying characteristics of the convertible bonds in the portfolio.

Convertibles can be busted, equity-sensitive, or balanced. Prices for busted convertibles are below the securities' par value and they tend to act more like a firm's bonds; equity-sensitive convertibles will have prices above par and tend to trade in line with a company's common stock; and balanced convertibles generally have characteristics of both, including some downside protection and upside potential.

For the most part, the returns of convertible funds tend to follow a similar return pattern to the equity market's, though often less volatile. For example, the average convertible fund lost 33% in 2008's market crash, less than the S&P 500's 37% loss. During the 2009 and 2010 stock market rebound, the average convertible fund gained 41% and 17%, respectively, much better than the S&P 500's gain of 26% and 15% in those calendar years. Those years were somewhat of an oddity as the outperformance can also be attributed to a dwindling supply of convertible bonds (firms preferred to issue straight debt over debt with an equity option, as it was cheaper and they didn't have to give up equity in the firm, which would dilute shareholder value) and near-zero interest rates, which pushed investors to higher-yielding securities, including convertibles.

This year has also been somewhat unusual in terms of relative returns as the upside potential hasn't been on display--the average convertible mutual fund lost more than 1% for the year to date through October, versus a gain of nearly 3% for the S&P 500. Much of this has to do with the types of convertibles typically held in mutual funds, which tend to lean toward securities with balanced characteristics over more equity-sensitive securities. The typical balanced convertible lost over 1% for the year to date through October, while equity-sensitive convertibles gained more than 5%.

Choosing a Convertible Fund Morningstar rates four convertible open-end funds; two earn Morningstar Analyst Ratings of Bronze, and two are rated Neutral. The table below lists the performance of those rated funds, the category average, and the Bank of America Merrill Lynch All Convertibles All Qualities Index, a widely used benchmark. It also displays the upside and downside capture ratios versus the S&P 500, which provide context around the manager's ability to capture some (but not all) of the equity market's up movements and protect on the downside when the S&P 500 falls. This is often used as a selling point from convertible fund managers.

The typical firm that issues a convertible bond is rated below-investment-grade; therefore, deep credit analysis is required to understand the firm's ability to pay the debt. In addition, the equity upside requires analysis of the firm's stock. For these reasons, convertible fund managers often work closely with a firm's equity and fixed-income analysts and portfolio teams. This is the case at Bronze-rated

While many convertible funds err on the side of conservatism, favoring balanced convertible securities, this is not always the case. Some funds also hold a decent chunk of common stock. Neutral-rated

The upside and downside capture ratios are also an indication of how "conservative" a convertible fund may be. Sticking with Fidelity Convertible Securities, the fund had higher upside and downside capture ratios than the other rated funds and the category average over three- and five-year periods, indicating a more volatile ride. Vanguard Convertible Securities, however, has the lowest upside and downside capture ratios compared with its rated peers and the category average, mostly because of the bottom-up, value-driven process that helps the fund avoid volatile equity-sensitive bonds.

Finally, some convertible funds invest mainly in the United States while others invest globally, which can also affect a fund's relative return pattern. For example, Vanguard Convertible Securities had a third of its assets in non-U.S. convertible bonds as of September 2015, while Neutral-rated

All told, these funds are a worthwhile option for income-seeking investors, but given the typically wide range of outcomes for this group of funds, it's important to distinguish between the types of convertibles targeted by each fund when considering an allocation.

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