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Convertibles are hot: Should you hitch a ride?
A bond when the markets are stormy, a stock when the sun shines: Funds specializing in convertible securities are riding high. Here are 5 strong funds to consider.
By Timothy Middleton
This years rally in equity prices has sent funds investing in convertible securities up like Jacks beanstalk, surging an average of 14.4% this year as of July 16. They were also yielding an average of 3.3% at the second-quarter's end, providing reliable income to yield-hungry investors.
The reason, which convertibles and equities anticipated, is that the Federal Reserve in May made clear it was alarmed about deflationary trends and so would abandon its 20-year fight against inflation and push the other way. With returns on risk-free assets approaching zero, the Fed is forcing investors to redevelop their appetite for risk.
As risk goes, convertibles are easy to digest. Their bondlike characteristics protect them in down markets. In the three years ended June 30 -- the worst bear market in generations -- they lost an annual average of only 3.6%, while Vanguard 500 Index (VFINX) was tumbling 11.3%.
Their stocklike attributes, meanwhile, show their stuff when equities are gaining. Over the last 15 years, Morningstar reports, they've advanced an average of 9.6% annually, compared with the far-riskier 500 indexs gain of 11.3%.
There are about two dozen of these funds, not counting separate share classes, and they distinguish themselves mainly in the degree of risk they take in earning their returns. The most volatile take big gambles on what are called busted converts, whose equity claim is so far under water that they're turnaround plays.
Comfort food
Most, however, work in the vast middle, the 80% of converts that combine good credit quality with significant equity upside. Even as the Fed is forcing risk down our throats, we dont have to swallow more than we want, and this middle-ground category is comfort food.
When you approach the market for convertible securities, be glad youve got an MBA with plenty of training in options pricing using Black-Scholes. Thats the tool devised a generation ago at the University of Chicago that netted one of its authors a Nobel Prize.
(That man, Myron Scholes, is also in court in Connecticut currently trying to unravel the mischief created by Long-Term Capital Management, the defunct hedge fund that went broke using Black-Scholes one time when it didnt work.)
Convertible securities are baskets of options, with the convertibility into common stock of the issuer being the Big Kahuna. But there are other important options, most notably the fact that they're callable: Many can force redemption early.
To understand the funds, therefore, it helps to understand these securities. They divide roughly into two camps. One is preferred stock, the other a bond. Mutual funds own baskets of both to balance their distinct characteristics, and to capture their disparate income streams: Preferreds pay dividends quarterly, bonds pay interest semiannually.
A model of the preferred type, taken from the portfolio of Franklin Convertible Securities Fund (FISCX), is Ford Capital Trust Preferred, each share of which has a claim on 2.825 shares of Ford Motor (F, news, msgs) common stock. Meanwhile, it yields a coupon of 6.5% which, because the preferred is trading below par, gives a current yield of 6.8%.
A short shelf life
The preferred stock matures in 2032, but it's callable in January 2007 at a price of $51.63 a share. The current market price, strongly tied to the fortunes of Fords common, is around $44. This ability of the issuer to call the convert, which barring calamity it's likely to exercise, means the security has an effective life of less than four years, rather than nearly 30.
The value of the preferred shares relies on calculations, therefore, of the worth of the yield, the maturity and the convertibility. All are positive. The yield is secure: The preferred is backed by a Ford bond, and the automaker isnt likely to fail. The securities will likely be called in 2007. By then Ford shares, which are trading around $11, near their 52-week high, could put the convertibility feature well into the black.
Another holding in the Franklin portfolio is a bond, a Lennox International (LII, news, msgs) 6.25% note maturing in June 2009. Each $1,000 bond can be converted into 55.287 Lennox common shares, meaning the equity option is worth $720 at the current share price. The bond trades at a 10% premium to par, giving it a current yield of 5.7%.
The Lennox convert yields less than the preferred because, Franklin lead manager Alan Muschott explains, Its a bond, so its higher in the capital structure of the corporation. Yields on preferred are higher than yields on bonds.
Buying these securities directly is beyond the ken, and the budget, of most of us. In the main, they're traded at negotiated prices among institutions. Fully two-thirds of all trading in converts is done by what I call Scholes Sharks, arbitrageurs whose computers continuously crank out the theoretical value of every security, leading the Sharks to snap them up when they fall below that price and regurgitate them when they surpass it.
Sharks in the water
The sharks keep the $300 billion convert pool extremely liquid. The arbs dont know or care about the fundamentals of the companies whose securities they are trading; they assume the market is efficient.
Modern portfolio theory notwithstanding, the market isn't completely efficient. Active managers such as Muschott have ample room to pay a penny more than the arbs when they are bullish on a particular issue; the Sharks diet is pennies. So convertible funds are actively managed; even Vanguard doesnt index the category.
The Franklin fund has one of the best long-term performance records in the group, but several other are notable, as well. I used our Deluxe Screener tool to turn up funds with a combination of good returns and low volatility.
| Low-volatility convertibles funds | | Fund | 5-year annualized return | Morningstar comment | | Nations Convert Sec A (PACIX) | 5.8% | Moderate, dependable | | Northern Income Equity (NOIEX) | 3.2 | Solid offering | | Morgan Stanley Convert Sec D (CNSDX) | 4.6 | Middle of the road | | Victory Convert A (SBFCX) | 2.8 | Conservative | | MainStay Convert A (MCOAX) | 5.6 | Flexible, attractive |
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Sources: MSN Money, Morningstar
Interestingly, all but Northern Income Equity are load funds. There are a number of niches in the fund industry in which load families dominate, and converts happen to be one of them.
With the Fed pushing risk onto investors plates, the menu of 1990s favorites like tech stocks and junk bonds have become steak and Freedom Fries again. Converts are potatoes for those who prefer them mashed.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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