At a time when investors are nervous about stocks and bond yields are at historic lows, many advisors have looked to alternative investments to reduce risk and generate decent returns for their clients. Among these alternative options are convertible bonds.

These securities offer investors equity-like returns with less volatility than traditional stocks. They can also be used to increase the returns of traditional fixed-income portfolios while cutting down on interest-rate risk. Or they can be used as an alternative strategy to generate steady returns with low correlations to traditional investments.

"Convertible bonds can address multiple allocation goals," says John P. Calamos Sr., author of the book Convertible Securities (McGraw-Hill, 1998) and founder of Calamos Investments in Naperville, Ill. "We're in very uncertain times. In times like these, low volatility strategies, which use convertible bonds, are crucial." Calamos manages $31 billion in assets, $6.7 billion of which is in convertible securities.

Historically, convertible bonds have done well in sideways, volatile markets such as those of the late 1970s and early 1980s, says Calamos. While the bond market during that period fell in the face of double-digit inflation, convertibles rose in value along with their equity components.

But convertible bonds have also performed well in the past ten years-this time during a tough decade for U.S. stocks. While the S&P 500 lost a cumulative 7.37% in the ten years ended in July 2010, the Bank of America/Merrill Lynch All Convertible index returned 32.64% cumulatively.

This performance doesn't mean convertible bonds are immune to market crises. In 2008, the Barclays Capital U.S.
Convertible Bond index fell 34.59% as credit dried up and hedge funds dumped entire convertible portfolios on the market. And yet the once-in-a-lifetime values created by the vast sell-off led to a counter surge of buying that drove convertibles up 50.7% in 2009. Prices have stabilized this year, and convertibles have risen only a modest 4.3%  while the Barclays Capital U.S. Aggregate Bond index has risen 6.46%. The S&P 500, meanwhile, has fallen 0.11%.

Still, convertible bonds remain decent values, according to money managers, currently selling at discounts of 1% to 3% of their theoretical value. Historically, they have traded between 3% rich and 3% cheap, according to AQR Capital Management, a Greenwich, Conn.-based firm that manages $23.7 billion in assets, including $3 billion in convertibles. Moreover, there's a great disparity in the prices among convertible bonds, which means good opportunities to build portfolios with much bigger discounts, says David Kabiller, a CFA and founding principal at AQR.

While 2008 and 2009 damaged convertibles' reputation as low-volatility investments, their long-term returns remain attractive, and their unique characteristics still make them useful for investment portfolios. But what role should they play? Where do they fit in an asset allocation scheme?

Neither fish nor fowl, convertible bonds have characteristics of both stocks and bonds. On the one hand, they are fixed-income securities with all the same contractual obligations to repay debt as bonds. But on the other, investors can convert them into shares of issuer stock. That feature generally makes the bonds sensitive to moves in the company's stock. If the stock price falls well below the conversion price, however, the instrument will trade on its fixed-income attributes only. Such "busted converts" were ubiquitous after the dot-com bubble burst in early 2000.

The strategy favored by Calamos and several other managers is to use convertible bonds as a low-volatility, defensive equity alternative. That might seem counterintuitive, since these are bonds. Yet the returns track stock indexes more closely than their bond counterparts. The returns of the Bank of America Merrill Lynch All Convertible Index, for example, have a 0.88  correlation to the returns of the S&P 500 over the last ten years, according to Morningstar data.

Furthermore, if they track the equity market it's with less volatility. Over the last ten years, the standard deviation of the Bank of America Merrill Lynch All Convertible index was 15% less than that of the S&P 500-13.94 versus 16.31. Moreover, in the last 12 months, as stock market volatility has remained high, the standard deviation on the convertible index has actually shrunk, and is now 11.82-or 30% lower than the S&P 500's. "The strategy exhibits defensive characteristics when you want it most," says Calamos.

The fixed-income features of convertible bonds-their maturity and interest income-act as a floor for their market value, while the stock conversion feature gives these securities upside potential straight bonds cannot match.

"Convertible bonds are a smarter, less volatile way to get equity-type returns with less risk or volatility," says Larry Keele, the principal and co-founder of Los Angeles firm Oaktree Capital Management, which manages $75 billion in assets, including $1.6 billion in the Vanguard Convertible Securities fund.

Managers using convertible bonds as an equity alternative look for bonds that will capture a high percentage of the issuer's stock appreciation but limit investor exposure to declines in price. In search of those advantages, managers combine credit analysis, equity analysis and option pricing.

For Keele, the "sweet spot" is a convertible bond issued at around par value with reasonable yields-3% to 6% in today's rate environment-and a low-to-moderate conversion premium of 15% to 30%. By focusing first on the bond's fixed-income characteristics, Keele sets the floor on his returns over the life of the bond. A low-to-moderate conversion premium and call protection gives him what he considers reasonable upside participation. Over the last ten years, the Vanguard Convertible Securities fund has returned 4.52% annually, according to Morningstar.

Because of their equity characteristics, convertible bonds can also be used to diversify a fixed-income portfolio and increase returns, which is how Oaktree uses them for some of its clients. While the coupons on convertible bonds tend to be lower than the same issuers' straight debt, the convertibles offer higher potential total returns, and over the long term should generate returns in the high single digits, says Keele.

The Vanguard Convertible Securities fund has generated annual returns of 8.32% in its 24 years in existence. That's attractive when high-grade fixed-income securities are returning only about 5%, Keele says.

Investors need to keep in mind that the average rating on convertible bonds is triple-B, the lowest tier of investment grade bonds. Convertibles can also help insulate traditional fixed-income portfolios from the effects of rising interest rates-with the equity conversion option, they tend to do better than traditional bonds in environments where the economy is growing and inflation expectations are rising, says Calamos.

Paul Whaley, a branch manager who oversees $20 million in client assets at Pinnacle Bank Corp. in Beatrice, Neb., uses convertible bonds to diversify his clients' fixed-income portfolios. He notes that these portfolios tend to be run very defensively even in good markets, but he'll allocate up to 20% of fixed-income assets to convertible bonds.

"I use them to increase the potential growth for clients who are extraordinarily nervous about growth," he says. "Health-care costs continue to go up."

Convertibles can also be used in higher octane fixed-income strategies. Busted converts, which make up about a third of the market today, are typically used in high-yield fixed income strategies.

Because they are hybrids, some advisors lump convertibles in with the alternative class. That makes sense given that long-only convertible bond portfolios are an alternative to traditional corporate bonds, as well as an alternative equity investment.

Treating convertibles as alternatives makes particular sense if the bonds are managed using a relative value or arbitrage strategy. In convertible bond arbitrage, a manager seeks to profit from the cheapness of the bonds, buying the convertible at a discount to theoretical fair value and shorting the underlying stock. Arbitrageurs can also hedge the credit risk and interest rate risk by buying credit default swaps and Treasury futures. The goal is to profit from the anticipated closing of the discount in the value of the bond when it reaches maturity.

In essence, this is a conservative strategy and should over the long term provide returns of 4% to 6% annually, according to Calamos. The Calamos Market Neutral fund, which uses convertible arbitrage and is not leveraged, has returned 3.87% annually over the last ten years. Moreover, the strategy has low correlations to traditional markets. The HFRI Convertible Arbitrage index has a 0.4 correlation to the S&P 500 and a 0.2 correlation to the Barclays Capital Aggregate Bond index, according to AQR.

"This is where the real value is," says AQR's Kabiller. "Investors already have equity and bond exposure. Convertible arbitrage offers risk and returns that investors are not already exposed to," he says.

The risk in the strategy comes when money managers load up on debt to turbo-charge returns. Many hedge fund managers cut their teeth on convertible bond arbitrage, and because convertibles' components are relatively easy to hedge, these funds often carried debt levels three to five times more than their assets. By the beginning of 2008, 75% of convertible bonds were held by hedge funds, according to AQR's 2009 report, "The Limits of Convertible Bond Arbitrage: Evidence From the Recent Crash." The credit crisis in September 2008 led many hedge funds to dump their convertible bond portfolios as financing was withdrawn.

This was not the first time the convertible market had been hit by waves of selling prompted by hedge fund activities. The market went through similar rough patches in 1998 and 2005.

Today, Keele and other convertible bond managers say that hedge funds play a less significant role in the market. "There's definitely been a sea change in the last couple of years," he says. Still, because the convertible bond market is small next to the markets for straight corporate debt or equity, it is risky for its illiquidity and the role hedge funds play in it.

As a mutual fund, AQR's Diversified Arbitrage fund is limited in how much debt it can use, says Kabiller. Leverage is generally kept under 1.2 times assets. Of course, less debt means lower returns. While the firm's convertible arbitrage hedge fund is up 7.5%  year to date, the multi-strategy mutual fund is up only 2.75% . The fund includes several arbitrage strategies in addition to convertible bond arbitrage. It is targeted to earn 4% over Treasurys annually, according to AQR.

Despite the recent troubles, convertible bonds still have supporters. "Market events like 2008 are few and far between," says Keele. "If you look at the long-term performance of convertible bonds, they're still very compelling."

"This is a good time to consider convertible bonds," adds Whaley. Companies will have a tough time growing their top line, yet many are in excellent financial shape. Slow growth and low inflation is a good environment for bonds. At the same time, convertible bonds typically do well coming out of recessions. As the recovery takes hold, stocks-and convertible bonds-should move up. "If that doesn't happen, you clip your coupon," says Whaley. "It's a great trade-off."