COLUMN-Use convertibles to straddle stock and bond markets

Tue Sep 3, 2013 12:25pm EDT

By John Wasik

CHICAGO, Sept 3 (Reuters) - As bonds that can be converted into stocks, convertibles are securities that long-term investors can learn to love.

Just like regular bonds, convertible bonds have a maturity date, coupon payment and face value. As an enticement to investors, though, they can be converted into common stocks at a later date. While their yields are not as high as conventional bonds, the conversion feature offers you a potential stock play at lower risk.

With anxiety mounting over the Federal Reserve's next Open Market Committee meeting - and whether it will back off its bond-buying program - convertibles may represent a little-known sweet spot between pure income investing and the stock market.

Unlike bonds, convertibles are having a great year as the market agonizes over higher interest rates. Volatility in the conventional and high-yield bond markets has increased, so lower-risk convertibles have become more desirable. Issuing companies have sold more than $23 billion in convertibles this year, which may top last year and turn in the best showing since 2008, according to Dealogic.

Convertibles, however, are difficult to buy on your own and are best held through exchange-traded or mutual funds.

The SPDR Barclays Convertible Securities ETF, for example, is up 19 percent for the year through Aug. 30. That's remarkable considering that the S&P 500 stock index is up 16.7 percent and a broad-basket bond fund like the iShares Core U.S. Total Bond Market ETF is down nearly three percent during that period.

Don't rely upon convertibles to be substitutes for either stocks or bonds. They occupy a middle ground that pays relatively low yields with modest upside appreciation.

Keep in mind that the bonds can also be "retired" by companies, which reduces their supply. While less volatile than stocks and paying lower rates than most corporate bonds, convertibles still pose risks not associated with pure bonds. The Vanguard fund, for example, lost almost 7 percent in 2011 and nearly 30 percent in 2008.

Convertibles may gain even more favor if bonds remain volatile and the Fed acts to curtail or "taper" its bond purchases.

"The taper is good for convertibles," said Gary Black, global co-chief investment officer of Calamos Investments, which is based in Naperville, Illinois, and manages several top-performing convertible funds. "There will be more issuances with a better risk/reward ratio."

The iShares Core U.S. Total Bond Market ETF, representing an index of convertibles, holds companies like General Motors Co , Wells Fargo & Co and Bank of America Corp. . The fund yields 2 percent and charges 0.40 percent annually in expenses.

A worthy alternative is the Vanguard Convertible Securities fund, a mutual fund that holds lesser-known companies such as Cobalt International Energy, Salix Pharmaceuticals and Omnicare Inc.

The Vanguard fund offers about the same yield than the iShares fund, but charges more at 0.52 percent annually. But it's rated four out of five on total return as well as consistent return by Lipper, a fund rating service owned by Thomson Reuters. The fund has gained 16 percent in the past year through Aug. 30.