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."