Convertibles, a Little Of This, a Little of That
Neither the best nor the worst of stocks and bonds
"Rose," as Jazz Age poet Gertrude Stein wrote, "is a rose is a rose is a rose."
But in the world of high finance, a convertible security is something more: not just a bond, but also a stock, a bond, a stock, a bond....
A convertible security may also represent an attractive way to play financial markets right now, if you are concerned about high stock valuations, soaring market advances, and uncertainty about interest rates.
A convertible security is exactly what it sounds like: a security with the potential to convert from one guise to another. It generally comes in two forms: preferred stock or corporate bonds, which can convert to common stock.
An example: US Office Products has issued a $1,000 bond paying 5.5 percent that matures in February 2001. But the bond also has a "conversion price" of $28.50 that allows a bondholder to convert the bond into about 35 shares of common stock. The company's common stock now trades at slightly over $26.
A variation on that theme is preferred stock, which pays a high dividend but usually turns in lackluster share-price gains. But convertible preferred can switch into regular, common stock - usually when the stock hits a certain price.
The investor makes money through dividends paid by the preferred stock plus price appreciation of the common stock.
"Convertible securities are very good for conservative investors who want to play the stock market but are concerned about a market downturn," says William Rocco, who tracks convertible-securities mutual funds for Morningstar, the mutual fund tracking company in Chicago.
"In up markets, convertible securities will rise, but not as fast as equities in general. But in down markets, they tend to drop less steeply than equities," Mr. Rocco says.
But while some investors favor convertibles because they act like both stocks and bonds, others shy away because they act like neither.
In a nutshell, convertible preferred stock pays higher dividends than common stock but turns in lower profits.
Convertible bonds deliver more price appreciation than regular bonds, but pay lower yields.
Still sound appealing? Then they're available through either a broker or a mutual fund.
If you are new to convertible securities, a mutual fund offers the safest route, experts say.
Convertible funds provide instant diversification, Rocco says, with a range of both bonds and stocks. And you don't have to worry about whether - or when - to make the conversion to common, or what to do if a bond has a call option. That allows bond issuers to retire bonds with high interest rates with new bonds that carry lower rates. The fund manager deals with such nuances.
But even if you don't own a convertible fund, you might own some convertible securities.
Growth and income funds, in particular, like to hold convertible securities, says Rocco, because they provide both an income stream (dividends) and growth (stock appreciation).
While most convertible funds are fairly small in valuation, under $50 million, a few are quite large. The Fidelity Convertible Securities Fund (800-544-8888), for example, has $1 billion in assets. The fund is up 4.9 percent through May 30, with a yield of about 3 percent.
The average convertible fund is up 6.69 percent this year, according to Morningstar. The top-performing convertible funds are in the accompanying chart. Over the past five years, another standout is Davis Convertible Securities Fund (800-279-0279), up 16.75 percent a year.
Since convertibles generally come from smaller companies, "one advantage of convertible securities mutual funds is that they give you access to the small- and mid-cap stock sectors," says Kevin Putt, vice president of Lynch & Mayer, which manages the Lincoln National Convertible Securities Fund, a closed-end fund on the New York Stock Exchange.
Lincoln National, for example, joined the small-cap sector for a dismal performance earlier this year but rallied in late April and May.
It's now up 6.8 percent through May 30. The Russell 2000 small-cap index, by comparison, is up 5.70 percent through June 3.