How to Be Bullish Without Being Stupid

The recent rally may have surprised investors who stayed on the sidelines. If you're trying to figure out how to get back into the market, your biggest fear may be buying shares at exactly the wrong time -- and falling for what some still believe is a sucker's market.

One type of investment, though, can give you exactly what you're looking for: a chance to earn profits if the market continues going up, but without the full exposure to stock losses if the economy turns south once more.

Convert to gains
Convertible securities combine the lower volatility of an income investment with the chance to earn big gains. These hybrid securities, issued by companies and typically structured as either bonds or preferred stock, have two attractive attributes: They pay dividends or interest payments on a regular basis, but they also give investors the option to swap them for a certain number of shares of the issuer's common stock.

That combination makes prices of convertible securities behave in an attractive way. When the price of the underlying stock rises sharply, convertibles typically follow suit. But if the associated shares drop, then the bond-like feature of the convertible kicks in, usually softening the blow compared to what shareholders experience.

Convertibles in action
Luckily, recent market moves give you great examples of how convertible prices move up and down with the market. Consider how these mutual funds that hold convertibles performed, both during the down year of 2008 and since the early March lows:

Source: Morningstar.

Of course, that doesn't mean that all convertibles will earn you great returns. For instance, Fidelity Convertible Securities (FCVSX) lost nearly 48% last year, as a large position in Bank of America (NYSE:BAC) convertibles certainly didn't contribute to returns.

Reaping the rewards
The amazing thing about convertibles is just how well they've done so far this year. Most funds that specialize in convertibles are up by double-digit percentages in 2009, and none of the funds that Morningstar tracks are down for the year.

That may surprise you, since the stock market just recently turned positive for the year. But the types of companies that issue convertible securities may help explain the big gains.

If a company has a strong credit rating and good access to credit markets, it can issue debt without having to add the equity kicker that a convertible security includes. That helps protect existing shareholders from dilution, and preserves a company's power to do public offerings of equity in the future.

But the credit markets haven't functioned perfectly lately, effectively closing off access to more marginal borrowers. Those companies have thus needed to resort to convertibles. Many companies on the margin have seen their stocks do extremely well recently, as it becomes clearer that while the recession may be severe, it's unlikely to force most companies out of business. That's behind the huge rebound in the Fidelity fund mentioned above, which is up almost 40% since early March -- thanks largely to its big bet on financials.

Pros and cons
Clearly, 2008 proves that while convertible securities can cushion the blow of a bear market, they won't prevent losses entirely. Moreover, while it's possible that the bounce from March's lows could continue, the huge relative gains that convertibles have experienced may not repeat themselves.

Nevertheless, investing in convertibles gives you a middle-of-the-road option between staying on the sidelines and investing directly in stock. The ability to hedge your bets with a security that combines some of the best features of bonds and stocks may be just what you need to get you back into the market.

More on investments that combine growth and income:

• The best stock you can own.
• Don't count on these stocks keeping their dividends.
• Five unbelievably solid companies.