More participation on the upside, less risk on the downside." That's exactly how Alan Mus- chott, portfolio manager of the Franklin Convertible Securities Fund, describes the advantages of convertibles securities. Until 2008, those virtues were obvious.
When the market plunged, however, convertibles fell as sharply as stocks. After a robust recovery, though, convertibles may be ready to resume their traditional role: playing a balancing act in a diversified portfolio.
Converts, as they're known, are a basic hybrid security. Issued either as bonds or preferred stock, they typically offer a substantial payout. In today's low-yield environment, convertibles mutual funds are yielding around 3%, similar to bond funds and higher than all categories of equity funds except for utilities, which pay slightly more, according to Morningstar.
As the name suggests, these bonds and preferred stocks can be converted into a certain number of shares of the issuer's common stock. If the price of the common stock rises, the conversion feature becomes more valuable, providing investors with a chance to participate in stock market appreciation. But if the stock price falls, the attractive yield promises to put a brake on the skid.
Muschott thinks that convertibles offer 75% of stock market gains with only 50% of the risk of losses in a bear market. "That's a strong risk-adjusted return," he says.
YEARS OF PROTECTION
The ability of convertibles to tame bear markets was generally evident in the early years of this century. After the tech-fueled boom of the 1990s came crashing down, the S&P suffered three straight down years, from 2000 through 2002, losing 14.6% annually for the period, according to Morningstar.
"There are 15 convertibles funds in our database that were around in the early 2000s," says Courtney Goethals Dobrow, a mutual fund analyst at Morningstar. "They had a median return of -2.8% for those three calendar years."
During the months of the bear market, which ran from March 2000 to October 2002, the results still demonstrate that converts can contain the carnage. From peak to trough, the median annualized return of convertibles funds was -11.4%, compared to -16.7% for the S&P 500.
If convertibles kept investors from suffering the worst of that stock market collapse, did they also provide exposure to the subsequent recovery? Definitely. From 2003 through 2007, convertibles funds were up each year. The average return was over 26% in 2003, the best year of this decade for U.S. stocks, nearly matching the S&P 500's return of less than 29%. Convertibles funds actually topped the S&P 500 in 2007, returning 7.5%, on average, vs. 5.5% for the large-cap benchmark.
CLIPPED BY HEDGE FUNDS
Ironically, the outperformance of convertibles in 2007 was a precursor of a disastrous 2008. "Arbitrage by hedge funds had a huge impact on the overall convertibles market," Muschott says.
Arbitragers try to put a "fair value" on the convertibles: the value of its fixed-income component plus the value of an option on the common stock, says Muschott. "If the convertibles were trading for less than fair value, a hedge fund might go long, buying the convertibles. At the same time, it would hedge that exposure by shorting the underlying stock."
Hedge fund buying of convertibles may have contributed to the relatively strong results of 2007. Many funds borrowed heavily to buy convertibles, dissatisfied with the ordinary discount-or "cheapness value"-of around 1%-2%.
As a result, highly leveraged hedge funds held much of the convertibles market in late 2008. During the financial crisis, banks pulled back on lending at the same time investors were cashing out to cover their own obligations. Hedge funds were forced to sell assets, including converts, and this heavy selling drove down their price.
Because of this downward pressure on prices, convertibles did not perform as well as expected. Rather than delivering 50% of the downside, convertibles saddled investors with 100% of a bad year. According to Morningstar's Ibbotson subsidiary, the UBS U.S. Convertible Index had a total return of negative 36% in 2008, almost matching the 37% loss of the S&P 500. The median convertibles fund did a little (very little) better, losing more than 32% in 2008.
Drilling down, though, convertibles funds did provide some relief in the last stock market fiasco. When Dobrow expanded the data to look at the entire October 2007-March 2009 bear market, not just 2008, she found that while the S&P 500 lost almost 42%, the 17 convertibles funds Morningstar followed lost only a little more than 28%. When the going got tough, convertibles got their defenses going.
And no matter how the downturn is dated, the last two years have been good ones for converts. "At the peak of the selloff, convertibles had cheapness value as high as 9%, by some measures," Muschott says. As was the case with many asset classes, overselling in late 2008 and early 2009 led to great values and a subsequent buying surge that drove prices back up. "We saw a terrific snapback in 2009," Muschott says.
In that recovery year, Ibbotson's data shows that the UBS convertibles index gained 50%, nearly double the 26.5% of the S&P 500. The median convertibles fund gained almost 41% in 2009. Instead of the textbook 75% of stocks' upside, convertibles delivered 150%-200% of the broad stock market's return in 2009. The good times continued in 2010; in the first 11 months of last year, converts gained 11%, by Ibbotson's reckoning, while the S&P 500 returned less than 8%.
After this fall and rise, convertibles may no longer be a screaming buy, but they still may be a prudent purchase. Muschott says the convertibles market is "relatively normal" now. The cheapness value is back to 1%-2%. Issuance is down, perhaps because interest rates are low; companies can borrow money or issue straight debt at low nominal yields, so they may not need to issue convertibles. In addition, with interest rates low, convertibles' yields may appeal to investors.
SOMETHING FOR EVERYONE
Converts appeal to planners looking for balance. "I believe that convertibles offer an opportunity for all investors," says Steve Stanganelli, principal of Clear View Wealth Advisors in Amesbury, Mass. "They can provide the best of both worlds, so they fit well for either conservative or more aggressive investors."
Stanganelli expects rising interest rates, with or without inflation. He sees volatility continuing through 2016, which makes converts even more valuable. "While the value of government and high-quality corporate bonds will suffer when interest rates rise, convertibles bonds will likely hold their value, continue to pay out interest and offer the potential of greater returns from conversion to stocks."
The advisor's clients typically allocate 10% of their portfolio, not including cash, to convertibles. "For clients who have relatively small accounts, say $20,000 or less, I can justify a 25% allocation," he says. "These investors really want to protect what they have, and there are risk-reduction benefits that convertibles offer."
But some advisors have changed their minds about converts. Ray Julian, executive vice president of Winslow, Evans & Crocker, an investment firm in Boston, formerly recommended a 10%-15% allocation to convertibles, to increase potential returns for conservative clients and reduce risk for aggressive clients.
Beginning in August 2008, Julian changed his strategy, and he no longer has any allocation in convertibles. Gradually, he moved that money into global commodity markets, which are "a more interesting story," he says. "Among compelling investment themes for commodities are the emerging-markets' growing middle class and the resulting demand for industrial materials, agribusiness resources and precious metals."
WHAT TO BUY?
Financial planners who appreciate the virtues of convertibles have many ways to place them in clients' portfolios-from individual issues to exchange-traded funds (ETFs), from mutual funds to managed accounts. "For diversification purposes-and because I lack the research team and time-I rely on mutual funds for most clients," Stanganelli says. "For much larger clients I use separately managed accounts," which provide access to money managers who specialize in convertibles.
Planners who prefer the diversification of convertibles mutual funds have many choices. There is at least one ETF that holds convertibles: SPDR Barclays Capital Convertible Bond. The Barclays index that it tracks includes convertibles bonds with outstanding issue sizes greater than $500 million.
"Our ETF covers the most liquid portion of the convertibles market," says Tom Anderson, global head of ETF strategy and research at State Street Global Advisors. "With an expense ratio of 40 basis points [0.4%], it costs a lot less than separately managed accounts or mutual funds." Morningstar reports that expense ratios for convertibles mutual funds range from 0.65% to 2.05%, with an average of 1.44%.
"Some advisors use our ETF because they don't want to deal with the volatility of active management," Anderson says. "Others use an actively managed convertibles fund and also use our ETF, to provide some protection against the volatility of active management." This ETF, with over 100 holdings, has returned about 25% since its inception in April 2009 through the end of 2010.
Advisors seeking active management can participate via closed-end funds; at year-end 2010, online.wsj .com listed 11 closed-end convertibles funds, all trading at discounts to net asset value ranging up to 8.5%. Closed-end convertibles funds may be leveraged or unleveraged. Leverage, while adding risk, also can boost yield: Advent Claymore, for example, has two leveraged entries with current yields of 6.2% and (for a global fund) 8.6%, according to Nuveen Investments' cefconnect.com.
Performance varies widely among the 17 open-ended mutual funds that Morningstar tracks. One small fund, Alger Convertible, actually made money in the 2000-2002 bear market, according to Morningstar, while a pair of funds suffered annualized losses that topped 20%, peak to trough, which lagged the S&P 500 by several percentage points.
In the 2007-2009 bear market, Calamos Convertible provided the greatest downside protection, holding losses to less than 22%, about half the loss of the S&P 500. Among other widely held funds, Vanguard Convertible Securities was a close second, losing 24%.
Fidelity Convertible Securities, on the other hand, provided no defense at all, losing nearly 43% from the 2007 peak to the 2009 bottom. Yet the Fidelity fund was by far the biggest winner in the subsequent rebound; its 64% return in calendar year 2009 was more than 10 percentage points higher than any other convertibles fund.
Convertibles funds will have different holdings, leading to variable results. "Advisors should look for management that's experienced in convertibles," Dobrow says. "In addition, they should see exactly what a fund is holding. Some own common stocks or straight bonds, for example."
Bonds might reduce volatility, while stocks could add volatility but also stretch returns in bull markets. There also may be differences in the credit quality and the sector mix of the convertibles a fund holds. Moreover, some funds hold "equity-sensitive" converts--those that are priced above par value and thus trade in line with the underlying common stock-while other funds might hold "busted" converts, which have scant hope of conversion and thus trade like bonds.
Financial planners might not have to master the minutiae of convertibles securities. But they should know if a convertibles fund is more likely to act like stocks or like bonds.