Convertibles in the Fast Lane?


By Richard Diennor Convertible securities and mutual funds that invest in them have had a tough time this year, but money managers say that's given them incentive to buy. The 30 convertible securities funds tracked by Standard & Poor's were down an average 2.3% through June 30. By comparison, domestic stock funds slid 0.3%, and high-quality corporate bond funds rose 1.5% on average during that span.

"It's been a difficult year," Stephen Boesel, manager of the $6 billion T Rowe Price Capital Appreciation Fund (PRWCX), says of convertibles, which account for about 15% of its assets.

Convertibles are bonds or preferred stock that can be converted into a predetermined number of shares of common stock. The hybrid securities typically have lower dividend yields than regular bonds, but they can make money because of the underlying stock.

JUNK FACTOR. The asset class suffered in the first half of the year, because the stock and bond markets were relatively weak for large chunks of the period, Boesel says. Convertibles went through "something in between a sharp correction and a bear market" that started in mid-March and ran through the second quarter, says David King, lead manager of the $700-million Putnam Convertible Income Growth Trust/A (PCONX).

King notes that convertibles took a hit when the bonds of giant auto manufacturers General Motors (GM) and Ford Motor (F) were downgraded to junk status in May. Both are heavy issuers of convertible securities, he says.

Hedge fund activity also pressured convertibles early this year, according to Boesel and King. Managers of these funds began to give up on convertibles when returns from so-called convertible arbitrage began to shrink, King says. The convertible arbitrage strategy involves holding a long position in a convertible security and a short position in its underlying stock.

BUYING SPREE. Investors have also been pulling money out of convertibles funds lately. The funds, which took in $644 million in 2004 and about $3 billion in 2003, suffered outflows of $744 million through June this year, according to Financial Research Corp.

However, because the convertible market has taken a hit, valuations have dropped to attractive levels, Boesel and King say. Financial planner Steven Podnos also thinks convertibles are cheap. As a result, Podnos, a principal of WealthCare LLC in Merritt Island, Fla., says he has been buying closed-end convertible bond funds for himself and and clients.

The stock market's rally in recent weeks has added to the allure of convertibles, according to Boesel and King, who say they have been increasing their funds' stakes in the hybrids.

THE RIGHT FORMULA. "I think if you get involved in convertibles now, you're not too late," King says. "I think between now and, say, the end of next year, you will have made a pretty good investment decision, in all probability."

Podnos recommends that investors limit their investments in convertible securities to about 5% of their portfolios, because the securities can be more volatile than regular bonds. For the same reason, investors should cap their exposure to the sector at 5% to 10% of their holdings, says Roseanne Pane, a mutual fund strategist with Standard & Poor's.

"You want to get your stock returns from stock funds, and your bond returns from bond funds," she notes. Diennor is a reporter for Standard & Poor's Fund Advisor


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