No Wild Ride With These Convertibles

Now that the stock market’s offense is sputtering, it’s time to play a little defense.

If you’re addicted to equities, you may be in the market for something that provides the characteristic safety of a bond but still acts somewhat like a stock.

Convertible bonds are a good option “if you still want to have a hand in the market,” says UAM FPA Crescent portfolio manager Steven Romick, who has gradually increased the convertibles stake in his balanced fund--it invests in stocks as well as high-yield and convertible bonds--from 2% of total assets to 9%.

In case you don’t know what they are, convertibles are bonds that can be “converted” into the issuing company’s common stock. Hence the name.

This conversion option allows companies to pay investors a lower yield than they would if issuing a straight bond, making it cheaper for firms to raise capital this way.

At the same time, this option links the bonds to the price of the underlying stock. Convertibles and their underlying common stock prices generally move in the same direction.

Historically, convertible bonds have come closer to matching the returns of stocks than any other asset class. From 1973 to 1997, for instance, they gained an average of 11.8% a year, versus 13.06% for Standard & Poor’s 500 index of large U.S. stocks, according to a study by Ibbotson Associates for Goldman Sachs.

Granted, that meant leaving money on the table. But in theory, these bonds compensate you with lower risk. For instance, if a convertible’s underlying stock drops in value, the bond tends to lose less than half as much.

Why?

Convertibles deliver something most stocks don’t these days: a decent yield. That extra income provides investors with a nice profit should the underlying stock stagnate, or a cushion should its share price fall.

In the second quarter of 1998, for instance, the bonds in the Salomon Smith Barney Convertible Index fell 0.57% while their underlying stocks dropped 3.43%.

Before you go out and invest in convertibles, you ought to know a few things about them. For starters, there are different kinds.

Some convertible bonds are quite “equity-sensitive,” meaning they closely follow the underlying stock’s price. This type of bond is said to be “in the money” or “deep in the money.”

At the other end of the spectrum are higher-yielding bond-like convertibles, which capture a significantly smaller percentage of any potential gain in the underlying common stock--and also a fraction of the losses should the shares fall.

A convertible that is extremely bond-like is said to be a “busted bond.” You can think of these convertibles as corporate bond substitutes.

A quick way to tell if a convertible is likely to be “in the money” (stock-like) or “busted” (bond-like) is through its so-called conversion premium.

The conversion premium tells you how much more the convertible bond costs, relative to its value if converted into stock.

For example, let’s look at the 5.25% coupon Men’s Wearhouse convertible bond maturing in March 2003. This bond was recently trading for $1,535.

At the same time, a Men’s Wearhouse’s convertible can be traded in for 43.956 shares of common stock. Based on the stock’s recent price of $32.50 a share, each bond was worth only $1,428.57 if converted (43.956 shares x $32.50 per share).

The extra money the bond costs--in this case 7.5%--is the conversion premium.

Bonds with premiums of 25% or less are said to be equity-sensitive, says Richard Russell, president of Ariston Capital Management in Bellevue, Wash.

Convertibles with conversion premiums of 50% or more begin to act bond-like. (The length of time before a bond will be or can be called for conversion by the issuing company will also affect its value.)

Either way, convertibles tend not to fall as much as their underlying stocks--but they can still lose money.

As Anthony Cichocki, executive editor of the Value Line Convertibles Survey, puts it, “You can drown in 3 inches of water just as easily as in 6 feet.”

Because convertibles are bonds, they also are vulnerable to interest rate fluctuations. For instance, in 1994 when the S&P; 500 fell 1.32%, the Morgan Stanley Dean Witter convertibles index fell 4.7% as rates surged.

That’s why Ariston’s Russell cautions against thinking of converts as inherently safe. “They are ‘relatively safer’ than stocks,” he says.

Convertible Funds

Because of their complexity, individual investors may prefer to invest in convertibles through a mutual fund.

To identify some promising convertible bond funds, we started with a simple premise. Since convertible bonds typically rise two-thirds or more of the upswing in a stock, we wanted only those funds that have, over the last three years, delivered at least two-thirds of the three-year annualized total return of the typical domestic equity fund.

This left us with just 17 portfolios out of Morningstar’s universe of 53 convertible bond funds.

Next, we eliminated the funds that weren’t at least a third less volatile than the typical domestic stock fund, based on Morningstar’s calculation of their three-year beta scores.

(Beta measures a fund’s volatility against the volatility of the stock market. A beta score of 1.0 indicates an investment that will rise and fall about as much as the overall stock market when it rises and falls. A beta of 1.1 indicates a fund that will bounce 10% more in either direction than the stock market when it moves.)

Next, we eliminated funds that Morningstar considers to be riskier than the category average.

That left us with nine funds. (For funds with multiple share classes, we list information based on Class A shares below.)

* Northern Income Equity (no load; $2,500 minimum initial investment; [800] 595-9111). Some fund managers seek out only the most equity-sensitive convertibles. Not Ted Southworth, manager of this $117-million portfolio.

Southworth is willing to buy convertibles that will capture as little as 60% of the rise in its underlying common stock--provided it participates in no more than 40% of the stock’s slide.

Argues Southworth: “If I were seeking convertibles that were completely equity-sensitive, why would I own the convert? Why wouldn’t I just buy the stock?”

Thanks to his relatively conservative approach--for instance, Southworth invests only in investment-grade bonds--the fund is 57% less risky than the typical domestic equity fund, according to Morningstar.

Yet you can hardly tell, based on the fund’s long-term performance. Over the last three years, Northern Income Equity has gained an annualized 18.2% through Friday.

* Nicholas-Applegate Convertible (5.25% load; $2,000 minimum initial investment; [800] 551-8043). Before the managers of this $50- million fund, which used to be called Nicholas-Applegate Income & Growth, buy a convertible bond, they first investigate the issuing company’s common stock.

“We’re not going to pick a convertible unless we absolutely like the stock,” says lead manager Sandra Durn.

Once satisfied that the common shares are set to rise, they seek converts that can capture 70% to 80% of that upswing. Recently, this has led the fund to issues such as Apple Computer’s 6% coupon bond, due June 2001, with a low 10% conversion premium.

“Most people associate defensive plays with things like utilities,” says Durn. “But with this bond, you have a defensive play on Apple, a company experiencing positive changes, and you get a decent yield on your investment while you wait for the stock to move.”

* Calamos Convertible (4.75% load; $500 minimum initial investment; [800] 823-7386). Of the two convertible funds that Nick Calamos co-manages, this $67-million portfolio is the more conservative.

For this fund, Calamos seeks bonds with conversion premiums of roughly 30%. This makes the portfolio somewhat less equity- sensitive than its peers.

Calamos currently likes convertibles in the financial sector, due to the low interest rate environment, and consumer-oriented industries, including retail, recreation and entertainment. Notes Calamos: “We are in one of the strongest cycles of consumer spending post-World War II.”

* Calamos Growth & Income (4.75% load; $500 minimum initial investment; [800] 823-7386). This $15-million fund is like Calamos Convertible--only more aggressive.

Although the convertible fund’s average conversion premium is 30%, this fund’s average is closer to 20%, making it that much more equity-sensitive.

* Putnam Convertible Income-Growth Trust (5.75% load; $500 minimum initial investment; [800] 225-1581).

In addition to owning small- and medium-cap names, which make up the bulk of the $175-billion convertibles universe, this $1.5-billion fund has about a third of its assets invested in larger-cap convertibles, which has helped it beat the majority of its peers in 10 of the last 11 calendar years.

Yet the fund is less risky than the typical convertible fund, according to Morningstar.

About 10% of its assets are in so-called busted bonds, and the fund delivers a yield 27% higher than the typical convertible bond fund.

* Victory Convertible Securities (no-load; $500 minimum initial investment; [800] 539-3863). About a third of Victory Convertible is invested in busted bonds; another third is in somewhat equity-sensitive issues; and the final third is in bonds that are truly “in the money.”

This balanced approach consistently leads Victory Convertible Securities to good, if unspectacular, results, which suits many risk-averse convertible investors just fine. Over the last three years, Victory Convertible has been 30% less risky than the average convertible fund, according to Morningstar’s volatility measurements--the least risky fund on our list.

* Value Line Convertible (no-load; $1,000 minimum initial investment; [800] 223-0818). Despite frequent manager turnover, this fund keeps rolling along, beating the majority of its peers in nine of the last 11 calendar years.

The team-managed fund uses a quantitative approach, based on computer models, to assess convertible bonds. The fund also favors bonds whose underlying stocks are considered by Value Line to be timely, based on its stock rating system.

This unique approach has delivered a respectable total return of 13.5% over the last 12 months.

The last two funds have strong long-term records but are weaker in the short term, having taken defensive steps recently.

* Pacific Horizon Capital Income (5.5% load; $500 minimum initial investment; [800] 332-3863). Here’s a fund that’s beaten the majority of its peers in every full calendar year since its inception in 1987. And in seven of the last 10 years, Pacific Horizon Capital Income beat more than 75% of its peers.

Yet, you’d hardly know it, based on the fund’s less-than-spectacular 4.2% 12-month return.

Two major factors contributed to this underperformance. Until recently, this $406-million fund had 12% to 15% of its assets in the energy sector. The decision to overweight the sector proved profitable last year, but it hurt this year’s returns as oil stocks suffered in the first quarter.

Fund manager Ed Cassens, who usually looks for bonds with conversion premiums of 20% to 25%, also chose to “dampen down the equity-sensitivity of the fund” recently, fearing a more severe correction.

“I’m having a tough year this year,” Cassens admits.

But who knows. His decision to play it safe--seeking out higher-yield, investment-grade bonds--may prove to be smart.

* Davis Convertible Securities (4.75% load; $1,000 minimum initial investment; [800] 279-0279). Over the last three years, Andrew Davis’ $147-million fund has delivered annualized returns of 19.8%--outstanding by any measure for a convertible fund.

Yet, his fund has lost 2.1% so far this year. Why?

Like the Pacific Horizon Capital Income fund, Davis Convertible bet on the energy sector. Also, Davis, known for being a disciplined value investor, hasn’t rushed to invest income, which explains the fund’s 22% cash stake. Though this hurts current performance, it may help the fund should the market continue to correct.

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The Next Best Thing to Stocks

You may not be impressed by the one-year performance of the following nine convertible-bond funds. But over the last three years through Friday, even the worst performer on our list delivered 80% of the total returns of the average domestic stock fund--with less risk, according to Morningstar.

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1-yr. 3-yr. Fund tot. ret. tot. ret. Yield Calamos Growth & Income A 18.2% 22.6% 2.0% Nicholas-Applegate Convertible A 16.0 20.5 1.5 Davis Convertible Securities A 5.2 19.8 2.8 Calamos Convertible A 13.1 18.7 3.0 Northern Income Equity 12.4 18.2 3.0 Pacific Horizon Capital Income A 4.2 17.5 3.0 Putnam Convertible Income-Growth A 7.2 16.1 4.0 Victory Convertible Securities 5.4 15.3 3.7 Value Line Convertible 7.2 15.2 4.4 Average convertible fund 7.2 14.5 3.1 Average domestic equity fund 10.1 19.1 0.5

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Note: Returns through July 31.

Source: Morningstar Inc.