3 Convertibles Funds Offer Smooth Rides
Muschott said that the characteristics of convertibles can change. Sometimes a balanced convertible can begin to act more like equities. When that happens, Muschott sells. To appreciate why his strategy can work, consider that in a typical deal an investor might pay $12,000 for a security that can be converted into stock worth only $10,000 today. The premium is justified because convertibles can pay off under a variety of scenarios. If the stock skyrockets, an investor can convert the security to common shares and record a nice gain. If the stock goes nowhere, the investor still collects fixed yields, which are typically higher than stock dividends.
Now suppose the stock climbs. The price of the convertible will rise, and the yield will drop. It will soon pay to change the convertible into stock, and investors will begin viewing the security as an equity substitute -- not as a balanced convertible. In a rising market, an equity-like security will outdo a balanced convertible. But if the market collapses, the equity-like security can drop sharply and trail balanced securities.
To limit risk, Muschott sells securities as they become more equity-like. He shifts assets back to balanced convertibles. As a result, the fund is constantly selling high flyers and buying middle-of-the road choices. Muschott says that the strategy tends to make the fund steadier and boost returns over the long term. "Toward the end of a bull market, we tend to be selling equity-sensitive securities, and that provides protection," he says.
Muschott also steers away from depressed securities that are known as busted convertibles. Investors have abandoned hope that the busted securities will ever appreciate and make a conversion profitable. As a result, the securities trade like bonds. While the busted securities can pay nice yields, they tend to lag during bull markets.