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.

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