3 Convertibles Funds Offer Smooth Rides
NEW YORK (TheStreet) -- In recent years, convertibles funds have delivered compelling returns. During the past decade, the funds returned 6% annually, outdoing the S&P 500 by 2 percentage points while taking much less risk, according to Morningstar. Can convertibles continue outpacing stocks? Maybe not. But convertibles are worth considering because they can diversify portfolios.
Convertibles are bond-like securities that can be converted to stocks. Yields on the securities currently range from about 2% to 5%. The yields cushion performance in downturns. As a result, convertibles outdid the S&P 500 during the market collapses that occurred after the Internet bubble burst in 2000 and in the financial crisis of 2008.
Convertibles come with a variety of different characteristics. At one end of the spectrum are volatile securities that track stocks closely. At the other extreme are bond-like securities that rise and fall with fixed-income markets. Many top-performing funds favor balanced convertibles, which fall in the middle of the range and have characteristics of both bonds and stocks. Balanced securities tend to avoid big losses in downturns and record decent gains in bull markets.
For a solid fund that focuses on balanced securities, consider Franklin Convertible Securities , which returned 6.9% annually during the past 10 years, outdoing 86% of peers. Franklin portfolio manager Alan Muschott looks for convertibles that would only lose half as much as stocks in downturns and deliver 75% of the gains in rallies. Muschott avoids convertibles that track equities too closely. Such securities can excel in rallies, but they can also suffer steep losses in downturns. "We prefer the balanced securities because they have favorable characteristics on the upside and the downside," he says.
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.