"Beware: Things may not be as they appear." This is not a tagline for a Stephen King movie, Broadway play, or even a reality television show. It's not exactly what you would expect to see in a mutual fund prospectus, but perhaps it should be.

The convertible security market in the United States is about a third of a trillion dollars. Through May 31, 2008, $47.55 billion in new convertible issues have come to market in 71 new deals. Convertible bonds constitute the largest component of the convertible security market by far, with the remainder being primarily convertible preferred stocks and other hybrid convertible securities. Convertible bond funds are one convenient way for investors and their advisors to access these securities.

When investors consider convertible funds, they have many goals in mind. The operative word for many investors and their advisors might be "bond." Think of "bonds" and naturally the focus is on safety, security, stability, and income.

Others pondering convertible bond funds might think of principal protection or absolute return: some upside, but with the safety and security of bonds, perhaps.

Look closely, however. Things may not be as they appear.

Many of today's convertible bond mutual funds are neither true bond funds, nor absolute return focused. Consider the goal of absolute return: positive returns through both bull and bear markets. Most convertible bond funds have not accomplished this.

Through the end of 2007, there were 21 convertible bond managers listed in Morningstar. 20 of the 21 convertible managers lost money in at least one year of the 2000-2002 bear market. During the last bear market, 19% of the convertible fund managers lost money for at least one year of the 3-year bear market; 37% lost money for two years; and an astounding 44% lost money in all three years of the bear market. Down years in bear markets hardly evidences an absolute return focus.

Likewise, many convertible funds are not bond funds, either. Read the prospectus and you will often find that these funds invest in "convertible securities" - and a fund must be at least 80% invested in convertible securities to be called a convertible fund.

What may not be clear to investors and their advisers is that "convertible securities" can include convertible preferred stocks and hybrid convertible securities that offer no principal protection. Additionally, the convertible bonds that are among the holdings may be so "deep in the money" that they may rise and fall dramatically, in tight correlation with the underlying stock. Not exactly what might be expected for a bond allocation.

Look at one fund in particular, Fidelity Convertible Securities Fund (FCVSX), to see how a convertible fund can really be an equity fund in disguise. To the credit of the manager, FCVSX has admirable one-, three-, five- and ten-year performance returns. But, is this a fund that operates as a bond fund or with an absolute return focus?Let's look more closely at the individual securities this convertible fund invests in.

Although FCVSX owns 153 securities, their top ten holdings represent more than 36% of the fund's assets. Since the fund's top five holdings are about 25% of the fund's assets, let's examine these top five securities.
No. 1 holding (7.62% of total portfolio): El Paso Energy (EP) $49.90 convertible preferred stock
El Paso Corporation is a large, broadly based natural gas company. But, El Paso's $49.90 Convertible Preferred Stock is just that, a stock, not a bond. It is not principal protected in any way, and offers very little downside protection. Trading at $1,603.96, the preferred stock has a low conversion premium of 4.98% and a delta of 90.63. In other words, analysts predict it will participate in almost all of the ups and downs of the underlying EP stock. This convertible stock is rated junk (CCC) by Standard & Poor. Absolute return protection grade: F. Bond protection grade: F.

No. 2 holding (5.25% of total portfolio): Celanese Corp (CE) $1.063 Convertible Preferred Stock
Celanese Corporation engages in the production and sale of industrial chemicals. Again Celanese $1.063 convertible is a stock, not a bond. Like El Paso, it has a very low conversion premium and a high delta, meaning the future destiny of this preferred stock will mirror that of the common stock. Although, neither Standard & Poor nor Moody's rates this preferred stock, Value Line does rate it: as junk. Absolute return protection grade: F. Bond protection grade: F.

No. 3 holding (4.40% of total portfolio): Chesapeake Energy Corp. (CHK) 2.5% convertible bonds due May 15, 2037 Chesapeake Energy is one of the largest independent natural gas producers in the U.S. This convertible security is, in fact, an actual bond, currently selling at 148.11 or $1,481.10 per bond. It has a current yield of 1.69% and a conversion premium of 35.54%. It has a high delta of 84, thus it is expected to participate in much of the ups and downs of the underlying CHK stock. The next put and call are not until May 15, 2017, almost nine years away. If the stock does not go up and the bond gets called, the bond will lose $419.29 per bond, or 28.3% of its value. The put protection also only protects about 70% of the bond's value. The bond is rated junk (BB) by Standard & Poor. Absolute return protection grade: D. Bond protection grade: D.

No. 4 holding (3.98% of total portfolio): Freeport-McMoran Copper & Gold (FCX) 6.75% convertible preferred mandatory convertible due May 1, 2010 Freeport-McMoran Copper & Gold is a large producer of copper and gold. This is a hybrid convertible security, not a bond. Like Fidelity's other top holdings, it too has a low conversion premium (5%) and a high delta of 89; therefore it should closely follow the gyrations of the underlying FCX stock. Mandatory convertibles have no principal protection. This hybrid security must be converted into FCX stock, at its future value, at maturity. It is rated junk (BB) by Standard & Poor. Absolute return protection grade: F. Bond protection grade: F.

No. 5 holding (3.58% of total portfolio): Halliburton (HAL) 3.125% convertible bond due July 15, 2023
Halliburton is a large producer of products and services to the petroleum and energy industries. This convertible is selling for $258.919 or $2,589.19 per bond. At maturity on July 15, 2023, it is guaranteed to pay $1,000.00 per bond. Therefore, the bond has the potential to lose over 60% of its value should the underlying stock fall. The bond is callable on July 15, 2008 at par, thus the convertible should rise or fall in lockstep with the common stock, HAL. This convertible also has puts on July 15, 2013 and 2018, but they offer virtually no principal protection since the put price is only par ($1,000 per bond). Of Fidelity Convertible's top five holdings, this is the only security rated investment grade (A) by Standard & Poor. Absolute return protection grade: D-. Bond protection grade: D-.
Based on the above holdings of the Fidelity Convertible Security Fund, it is no wonder that it followed the equity performance record of the bear market of 2000-2002. An investment in the fund on March 10, 2000, incurred a loss of 32.88% by October 2002. And, it took investors almost 5 years (56.8 months to be exact) to get their money back that they invested in the fund.

Investors and their advisors considering convertible bond funds as part of their bond allocations would do well to find out what the underlying strategy is. Not all convertible bond funds are created equal, and some are really equity-type funds thinly disguised as convertible securities. Funds like the Fidelity Convertible Security Fund often have good track records, but they may be "high risk" (as Morningstar aptly classifies the Fidelity Convertible fund). Many offer little or no bond protection nor achieve absolute returns.

Notes: All holdings of Fidelity Convertible Securities Fund are according to moneycentral.msn.com at 3/31/08. All pricing of convertibles, unless otherwise indicated, were obtained from Kynex on June 2, 2008. Returns of Fidelity Convertible Security Fund are through 5/31/08. The grades for absolute return protection and bond protection represent the opinion of Wellesley Investment Advisors, Inc.

Greg Miller, CPA, and Darlene Murphy, CPA, founded Wellesley Investment Advisors Inc., Wellesley, Mass., in 1991. The firm specializes in managing convertible securities for individual portfolios as well as for other advisors. They launched the Miller Convertible Fund (MCFAX) in December. For more information, contact him at (781) 416-4000 or [email protected], or visit www.wellesleyinvestment.com.