Convertible securities offer smoother ride

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Steven T. Goldberg

If I were a betting man, I’d wager that 2011 turns out to be a better year for stocks than for bonds. With the extension of the Bush tax cuts and the clear resolve of the Federal Reserve to spur economic growth, I think that the stock market will do well for the remainder of this year — albeit with its customary stomach-churning dips.

By the same token, economic growth, especially accompanied by the huge federal deficit, likely means higher interest rates on bonds. When bond yields rise, their prices decline.

But I don’t like to bet. And for conservative investors — and most sensible seniors belong in that category — convertible securities offer a wonderful way to make money if the stock market does indeed chalk up healthy gains this year, yet cushion your losses if the economy turns south again.

A convertible security is a hybrid: Neither stock nor bond, it contains something of each. Like a bond, a convertible security pays you a fixed amount of interest regularly. Like a stock, it rises and falls with the fortunes of the underlying company, especially the common stock.

Less volatile than stocks

Here’s the good part: Convertibles typically have provided investors with higher returns than bonds, yet have boasted fewer losses and lower volatility than stocks.

When the stock market goes up, convertibles tend to rise, too, though not as much as stocks. When the market falls, convertibles usually lose ground also, but again, not as much.

Lots of people steer away from convertible securities because they either haven’t heard of them or they don’t understand them. And the truth is that convertibles are complex beasts.

I wouldn’t recommend that anyone but the most sophisticated investors buy and sell individual convertibles. But you can hire a mutual fund manager to do the heavy lifting for you — and not worry about whether you understand all the ins and outs of convertibles.

Two good fund choices

My favorite fund for navigating this tricky sector is Vanguard Convertible Securities (telephone 1-800-635-1511). This fund charges just 0.72 percent of assets annually. For the past 10 years to mid-January, the fund has returned an annualized 7.6 percent — an average of 6.5 percentage points better per year than Standard & Poor’s 500-stock index.

Over those years, the fund ranks in the top 1 percent among convertible funds. It yields 3.8 percent.

Vanguard outsources the management of almost all its actively managed stock funds. Since the 1986 launch of this fund, it has paid highly respected Oaktree Capital to manage it. Larry Keele has been lead manager since 1996.

In January, Oaktree announced it had appointed two co-managers, Abe Ofer and Jean-Paul Nedelec, to help the fund expand its purchase of foreign convertible securities. The fund also employs several analysts.

Keele, 54, has done a terrific job, yet keeps his humility. Of convertible securities, he says: “Convertibles make sense if you don’t know what the future holds, and I don’t know what the future holds.”

Howard Marks, chairman of Oaktree, probably puts it even better. He calls convertibles “equities with training wheels.”

Perhaps Keele’s most notable accomplishment: Since he began running the fund, it has never had a bond issuer default on an interest payment.

But the fund has one big negative. The initial minimum investment is $10,000. Vanguard boosted it that high to keep too much money from pouring into the fund. For the same reason, it’s very difficult to buy the fund via online brokerages.
     A good second choice is Fidelity Convertible Securities (1-800-544-6666). Annual expenses are 0.68 percent, a tad lower than Vanguard’s.

Over the past 10 years, the fund has returned an annualized 6.6 percent — one percentage point per year, on average, less than the Vanguard fund. Manager Thomas Soviero has run the fund since 2005. It yields 3.2 percent

Despite my affection for convertible funds, I wouldn’t make them the only fund you own. Any solid portfolio needs a good mix of bond funds and stock funds.

But keeping a nice 10 to 20 percent of your investments in a convertible fund will likely boost your returns — and may even help you sleep at night.

Steven T. Goldberg is a freelance writer and investment advisor in Silver Spring, Md. He welcomes reader ques­tions. E-mail steve@tginvesting.com or write to Steven Goldberg, 9005 Woodland Dr., Silver Spring, MD 20910. You may also call him at (301) 650-6567.