Chip Carlson banks on an offbeat breed of bond to boost his fund's return.

    The 45-year-old manager of the Greenspring Fund-named for the picturesque Greenspring Valley area outside of his firm's home office in Baltimore-has been using busted convertible bonds for nearly 15 years. The bonds began to pique his interest in the 1980s, when he began shifting money into what were then the under-followed, deeply-discounted securities. Today, the fund he has managed since 1987 has nearly half of its assets in them.
    "Greenspring's objective is steady, consistent performance in all types of market environments, and busted convertibles tie in well with that," he believes.
    Convertible bonds become "busted" when the company's common stock price falls below the conversion value of the bonds, rendering the conversion feature less valuable. When that happens, the bonds trade more on their profile as income-producing securities than as a play on the underlying equities.
    A number of possible scenarios can play out after an investor purchases a busted convertible. The securities can simply mature, so that the investor earns a yield-based return. According to Charles "Chip" Carlson, the busted convertibles in the portfolio sport yields of around 5.5% to 6%. If there is a put feature, the issuer can buy the bonds back, usually at a premium to par, to shore up its balance sheet. Many convertibles are issued with a change-of-control put feature, which specifies that if the issuer is acquired by another company, convertible bond holders have the right to force the acquirer to buy the convertible bond from them at a stated price, usually a premium to par. Or, in a best-case scenario, the stock could rebound and the bond's price would jump with it.
    Carlson likes the fact that the underlying stock does not necessarily have to go up for him to make money. In line with that view, he bases most of his analysis on a company's financial strength and how well it is able to cover its debt, rather than whether or not the underlying stock is poised for a rebound.
    "We are typically indifferent to stock price," he says. "Obviously, it's better if the stock goes up after we buy the bond because that benefits the price of the convertible. But that doesn't have to happen. In fact, most of our incremental returns have been coming from early redemptions."
    Sometimes, a dip in a stock's price because of disappointing earnings or other negative announcements prompts him to take a look at the convertible bond the shares are associated with. But he won't necessarily rule out convertibles when he considers the underlying stock to be richly valued. "We're looking for an "acceptable base case," which is basically clipping the coupon and letting the bond mature," he says. "Anything beyond that is icing on the cake."
    While he points out that some of the companies issuing the bonds "aren't household names," he insists that they are financially sound. "There's a broad spectrum of quality in the world of busted convertibles," he says. "Some of the issuers are financially troubled, and others are quite secure. We look at the safer end of the spectrum for characteristics such as healthy balance sheets and good cash flow."
    According to Carlson, semiconductor equipment manufacturer Brooks Automation has those characteristics. He recently added to his position in the company's busted convertibles, which he began buying about three years ago. "At one time the stock sold in the fifties and it's down to $13 a share," he says. "But the company has a strong balance sheet, with over $350 million in cash and just $175 million in debt." The convertible bonds are scheduled to mature in 2008 and yield around 6%.
    He usually buys older bonds that are close to maturity or have a near-term put feature, and the fixed-income side of the fund has an average duration of two years. "Keeping duration short has been an effective way to limit interest rate risk," he says. "The impact of 11 increases in the Fed Funds rate of the last 18 months has been minimal."

The Challenge From Arbs
    The characteristics that appeal to Carlson have not gone unnoticed by other investors. Today, with more investors pouring money into convertible bonds, the market has become more efficient and it's harder to find bargains than it was just a couple of years ago, he admits.
    The proliferation of hedge funds that use a convertible arbitrage strategy also has increased short-term volatility. The funds buy convertible bonds of a company while at the same time selling short an offsetting amount of the common stock of the same company, with a goal of generating a consistent level of positive return regardless of whether the company's stock is headed. If the stock goes up, they make money on the convertible bond, but lose a lesser amount of the short stock position. If the stock moves down, they make more money on the short position than they lose in the value of the convertible bond.
    But as hedge funds began to exploit the strategy in increasing numbers, the arbs stretched into riskier issues. Some purchased busted convertibles, even though their lack of equity sensitivity made them less appropriate for a convertible bond arbitrage strategy. When returns suffered earlier this year, investors began to withdraw money and the funds were forced to liquidate some of the holdings in their portfolios.
    Although the redemption-related selling pinched bond prices, Carlson says it also created a buying opportunity for his fund. "As long as a company's operating fundamentals have not changed significantly, or the company is not dependent upon speedy access to the capital markets, the issuing company's ability to service its debt is not affected by the short-term dynamics of the bond market," he says. "When the research shows there is no fundamental change in a company's ability to service its debt, the markdown creates a buying opportunity." Buys created by the short-term dynamics of the market have included busted convertibles of King Pharmaceuticals and Millennium Pharmaceuticals.
    On the equity side, Carlson favors "companies in inefficient sectors that are not well covered by Wall Street." Although the fund has no restrictions on company size, the focus on off-the-radar securities almost always leads its manager to smaller companies whose stocks are selling at a discount to their industry peers or their historical prices, and that have ample free cash flow and an established position in their industries. He also likes to see a catalyst for change, such as new management, new products or a change in corporate structure.
    Recent purchases include Rush Enterprises, the only publicly traded network of truck sales and service centers. The company, which has a $355 million market capitalization, trades at about nine times estimated earnings for 2005. "That's inexpensive compared to the half-dozen publicly traded auto dealers, and the company is only covered by analysts at two investment banking firms," says Carlson. Another recent buy, KMG America, provides insurance products to employees through payroll deduction plans. The company, which has a market capitalization of just $180 million, has a new management team that is expanding its product line.
    "These are companies that are not well covered but have strong cash flows, solid market positions and great management teams," says Carlson. "The fact that we are not part of a larger fund family gives the fund the flexibility to move into the more under-followed, inefficiently priced areas of the market."
    Greenspring's quirky mix of busted convertible and small-caps has produced returns that often do not dance to the same tune as the stock market or funds that invest in both stocks and bonds. In the late 1990s, its performance placed it near the bottom of its Morningstar moderate allocation category, and it also trailed the S&P 500 Index by a significant margin. Between 2000 and 2003, however, Greenspring's returns trounced those of both its category competitors and the index.
    Morningstar fund analyst John Coumarianos thinks the fund's unusual approach holds appeal for those willing to deviate from the mainstream. "The mix of unloved, out-of-the-way small-cap stocks and broken converts won't please investors seeking a balanced fund with large-cap stocks and high-grade bonds," he notes in a recent report. "Besides the added credit risk of the bonds and the volatility of the stocks, small-caps and converts have had strong runs the past few years, making them more expensive than they have been recently. However, this unusual fund can be a very nice complement to a large-cap heavy portfolio."