The fund has also delivered equity-like returns, with average annualized returns of 5.64%, 8.05% and 6.88% over three, five and ten year periods that ended December 31, 2010. By comparison, the Dow Jones Total Stock Market Index has posted annualized returns of -1.56%, 3.17% and 2.64% during the same periods.
Despite their stock-like behavior over the last few years, the securities should continue to live up to their reputation for providing attractive returns with less downside risk than stocks, says Keele.
"The basic premise for investing in convertibles remains the same as always-to capture a reasonable amount of equity upside and less of the downside," he maintains. "If stocks are up 10%, the fund will likely rise 7% to 8%. If stocks fall 10%, we'll probably be down 4% or 5%." He anticipates that fund returns in the high single digits are "certainly achievable" for 2011.
Since the fund's current 30-day SEC yield of just under 3% is considerably lower than its long-term historic yield of around 5%, it's especially important for the bonds' equity kicker to make a mark this year. Keele anticipates that about two-thirds of fund returns will come from a push from the equity market, with the fixed-income side accounting for the rest.
Over the last few years, the impact of falling interest rates on bond prices hasn't been much of a concern for convertible managers. But this year could be a different story.
Like other bonds, convertibles are susceptible to fluctuations in interest rates, although a rising stock market would help offset the impact of higher interest rates. Keele points to other portfolio risk modifiers such as a relatively short duration of 4.5 years and diversification among over 100 different names in 40 industries. To further minimize risk, he emphasizes convertible securities with loss-preventive features such as the right to "put" a security back to the issuer within a few years.
He also keeps about half the benchmark weighting in convertible preferred securities, which are usually more sensitive to interest rate fluctuations than convertible bonds. At the end of 2010, the fund had 83.5% of its assets in bonds, 14% in preferred stocks and the remainder in cash equivalents.
Going Global
A major expansion of the fund's investment parameters into international securities this year should spice up the growth side and provide additional ballast to the portfolio. The international sleeve, now at 10% of assets, is absorbing most new inflows. The goal is to have a 30% allocation to international convertible bonds by the end of the year.
Although international convertible bonds are newcomers to the Vanguard fund, Abe Ofer and Jean-Paul Nedelec have been mining that largely neglected territory for Oaktree's institutional clients since 1995. "At about $250 billion, the non-U.S. convertible market is as big as the domestic market, so this addition adds a lot of diversification to the portfolio," says Ofer. "And historically, non-U.S. convertibles have been more attractive than their U.S. counterparts in terms of fixed-income characteristics, equity participation and credit quality." To achieve the goal of being currency-neutral, the managers hedge foreign currency exposure to the U.S. dollar.