Investors afraid of getting caught between a stock market battering and a bond market bungle have an alternative that combines some of the features of both asset classes. Convertible bonds offer a shot at a decent chunk of the stock market's upside while muting some of its downside risk, according to Edward Silverstein, manager of the MainStay Convertible Fund. They also provide some ballast to a portfolio at a time when investors are becoming increasingly concerned about a market downturn. "At some point, $100-a-barrel oil and the mortgage mess will catch up with consumers," he says. "Coming out of the fifth year of an up stock market, it seems inevitable that the good times will be ending. And if the market does well, convertible bonds still allow investors to participate in much of the upside."

As the name implies, convertible securities can be converted into a predetermined number of shares of common stock. They pay interest and have a maturity date, but also offer growth potential linked to the performance of the underlying stock. As the price of that stock rises, the value of the convertible will also increase to a lesser extent. If the stock's price declines, the fixed-income component helps cushion the impact on the bond's price, although investors still have exposure to risks from interest rate fluctuation, default or a credit downgrade. They typically yield less than straight bonds. If a company's regular bond yields 7%, the yield on the convertible might be in the 3% area, says Silverstein.

In a generally rising and volatile market, convertible bonds have looked more like stocks than bonds in recent history. According to a white paper recently released by MacKay Shields, the MainStay fund's investment subadvisor, convertible securities posted returns nearly equal to those of the Standard & Poor's 500 index with a slightly lower standard deviation over the 15 years from 1992 through 2006. During the period, the Merrill Lynch All Convertibles Index had an annualized return of 10.42% and a standard deviation of 12.55%, compared with an annualized return of 10.64% and a standard deviation of 14.87% for the index. Long-term corporate bonds posted an annualized return of 8.05% and a standard deviation of 6.5%.
Convertibles can also lower volatility a bit in a balanced portfolio, the study noted. A 60/40 mix of large company stocks and bonds produced a 15-year annualized return of 9.34% with a standard deviation of 8.72%. A 40/40/20 split of large-cap stocks, bonds and convertibles delivered an annualized return of 9.30% and brought the standard deviation down slightly to 8.03%.

The convertible strategy has muted both the downside and upside for the MainStay fund as well. In 2002, when the Standard & Poor's 500 index plunged 22%, the fund's Class B shares dropped less than half as much. In 2006, the fund's 9% total return lagged the index's returns by about 7 percentage points. In 1999, the fund defied traditional convertible bond comparisons by shooting up 33%, beating the index by nearly 12 percentage points. Through mid-November, the fund was up 13.18%, versus 9.17% for the S&P 500 index.

Silverstein may need to tap into convertible bond resiliency as he navigates the fund through the subprime mortgage damage to Merrill Lynch, its largest financial holding. He acknowledges that the stock has been decimated, along with other financials, but points out that the convertible bonds the fund owns have fallen less than 2% in value since he bought them, thanks to a put feature that lets investors sell the bonds back to Merrill in 2008 at $109. Silverstein, who bought the bonds in September at $111, says that the safety net from the put feature is accompanied by a shot at upside potential if the stock gets cheap enough to attract a potential acquirer, such as a foreign bank.

Long-time energy holding Halliburton has been among the fund's stronger performers, and Silverstein recently added to the position during a temporary pullback of the stock. "The stock is trading at 14 times next year's earnings compared to 21 times earnings for Schlumberger. The difference in valuation is unwarranted," he says. He thinks the underlying equity could move 30% higher over the next year, and even if the price of oil drops to $75 a barrel, "there is still a huge incentive to expand the search for new energy sources and exploit existing ones at a time when the easy energy in the world has been found."

Another recent purchase, Covanta Holding Corp., has a feature that allows investors to put the convertible bond to the company at par in 2012. The company, the nation's largest operator of waste-to-energy facilities, specializes in generating electrical power by burning waste and has a strong presence in the Northeast. Silverstein purchased the bonds over the summer at par when the stock was trading at $24 a share. By early November, the stock had risen to $27 and the bonds were trading at about $111. He says that even if the stock plunged to $10 the bonds would be unlikely to fall below $80, and could trade as high as $180 if the stock doubles in value.

Vastly Underused

Silverstein's goal is to generate about 60% to 80% of the underlying stock's price appreciation while limiting downside participation to less than 30% to 40%. He argues that despite their appealing characteristics, convertible bonds are a vastly underused asset class. His contention is backed by Morningstar's database, which lists only 21 convertible bond funds, compared with a universe of 670 large-cap blend funds.

"Financial advisors like to put things into easily identifiable asset class baskets, and convertible bonds don't fall neatly into any of them," says Silverstein. He feels they are particularly appropriate for clients over age 45 seeking investment growth with limited risk, and he recommends a 20% allocation, either directly to convertible bonds or to a fund that invests in them. "This is a very attractive product to those with a high fixed-income asset allocation concerned about lower expected returns in the equity markets, especially those nearly or already in retirement," he says.

Silverstein looks for bonds, such as Merrill Lynch, that have a put feature to mitigate downside risk. He likes bonds with a healthy dose of equity sensitivity and won't invest in "busted" convertibles, where the stock has dropped so much since the bond was issued that even a significant increase in its price would have little impact on the bond's value. He also avoids "deep in the money" convertibles, which also have limited upside since the underlying stock has already risen significantly above its price when the bond was issued.

His buying sweet spot is in the middle of those two extremes, when the convertible has both downside protection and room to grow. Silverstein seeks out companies whose price could be driven up by catalysts, such as new product development, changes in management or ownership, stock buybacks, a discount to private market value, and shifts in competition. They must have above-average earnings growth, attractive price-to-earnings ratios, positive free cash flow, consistent dividends and low valuations. He also assesses the bond's value based on its call protection, credit risk, projected interest return, the volatility of the underlying stock and the convertible's premium relative to the underlying common stock.

The fund invests in a broad mix of companies and its 80 or so holdings include securities in both the growth and value categories. About 73% of its assets are in convertible bonds, followed by 13% in convertible preferred stocks and 12% in common stocks. The consumer noncyclical and energy sectors each account for roughly 21% of assets, followed by industrials at 16% and financials at 13%.

The fund recently established a position in the convertible preferred stock of General Motors. This type of convertible is a preferred stock that shareholders can exchange for common stock, allowing them to benefit if the latter increases substantially in value. Convertible preferred stock generally has a much higher dividend yield than a company's common stock.

A 6.5% dividend yield helps support the price of GM's convertible preferred shares on the downside, says Silverstein. At the same time, the common stock stands to benefit from a new agreement with the United Auto Workers that should lower the company's pension and health-care costs. "American auto companies produce very good cars, which was not necessarily the case a decade ago," he says. "With these cost reductions, they are on a more level playing field with foreign competitors such as Toyota." If the common stock moves from its current level of around $40 a share to $70 a share over the next couple of years, which Silverstein thinks is "not an unfair valuation," the preferred stock would increase from a recent price of about $25 to $37. And with the support of a high dividend, he believes it is unlikely that the convertible preferred stock would fall below $20 a share.