Convertibles Offer Bond-Like Yields, Stock-Like Potential

Historically, the stock market has offered excellent long-term returns to investors. The historic record, though, may offer scant consolation when stocks skid by 5%, 10%, or even more. Wary investors can turn to bonds or cash equivalents, but yields are depressingly low now.

One possible solution is to invest in convertible securities. Converts, as they’re known, may be issued as corporate bonds or shares of preferred stock. Either way, they generally pay a fixed yield that is comparable to bond market payouts. Moreover, as the name indicates, these securities can be converted to common shares, which have the potential to deliver outstanding returns. Advocates claim that convertibles have 75% of the stock market’s upside potential but only 50% of the market’s exposure to bear market losses. When stocks head south, the relatively high yields offered by convertibles may keep some investors from selling and thus support trading prices.

History lesson
Does the record support this favorable upside-downside outlook? Judging by the last two bear markets in stocks, the results have been mixed. Convertibles held up well in the stock market crash of 2000– 2002, after the technology bubble collapsed. However, they provided little help in the financial crisis of late 2008 and early 2009.

From 2000–2002, the broad U.S. stock market, as measured by the S&P 500 Index, lost 9%, 12%, and 22% in successive calendar years. Mutual funds holding convertibles actually gained 2.5% on average in 2000, according to Morningstar. These funds lost less than 7% in 2001 and less than 8% in 2002, far outperforming stocks in those years as well. (You can invest in individual convertible issues, but they can be difficult to evaluate. Accordingly, many investors prefer the diversification and professional management of mutual funds.)

Convertibles funds delivered solid gains throughout the bull market of 2003–2007. In 2008, however, the average convertibles fund lost more than 33%, nearly matching the 37% loss of the broad U.S. stock market. During the worst of the financial crisis, converts provided little shelter.

Affected by arbitrage
Many observers believe that convertibles’ poor record in the last bear market was an aberration. In the years immediately preceding the meltdown, hedge funds invested billions of dollars in convertible arbitrage. That is, these funds would buy the convertible and sell short the underlying common stock, hoping to make money if the convert outperformed the stock. Hedge funds often borrowed money to buy more converts and increase their profit potential.

When the financial crisis emerged in late 2008, banks called in their loans, some investors bailed out of hedge funds, and hedge funds had to sell their converts to raise the cash they needed. This increased selling contributed to the poor performance of convertibles in 2008.

After the deluge
Since the debacle of 2008, convertibles funds have posted strong years in 2009 and 2010. As of this writing, these funds are showing substantial returns for 2011 as well. Apparently, hedge funds have pulled back from convertible arbitrage and the converts market has generally returned to normalcy. Convertibles funds now yield 2.8% on average, far higher than the 0.5% average yield of domestic stock funds and nearly as high as the 3.3% average yield of general bond funds. Consequently, investors can get current cash flow that’s comparable to the interest from bonds while waiting for the long-term results that stocks might provide.

Therefore, you might want to include convertibles in a diversified portfolio. Converts have risks and are not for everyone, but some investors may appreciate the combination of significant yield and potential stock market gains.