Forget Treasuries. Buy Convertibles Instead.

The recent pullback in the stock market has many investors running for cover. Meanwhile, fear of an imminent double-dip recession and concerns about renewed pressure in the housing market has pushed bond prices to historic highs, reducing bond yields and creating an income crunch for savers. Throughout 2010, billions of dollars have gone into bond mutual funds, and the trend shows no sign of reversing anytime soon.

But with many starting to warn of a possible bond bubble, you may not be entirely comfortable with bonds or stocks right now. If you want an investment that can give you the benefits of both stocks and bonds, though, look no further than convertible securities. They're not a fail-safe way to play the financial markets, but they have some attractive traits you won't find anywhere else.

The ins and outs of convertibles
Convertible securities combine elements of both stocks and bonds. Some convertible securities are technically bonds, while other companies issue them as preferred stock. In either case, they give investors a higher priority in a company's capital structure than common shareholders.

Regardless of whether they're technically preferred stock or bonds, convertibles typically make distributions to their owners on a regular basis. Most convertibles have a maturity date, just like a regular bond does, at which point investors get the face value of the convertible back.

What gives convertibles their unique properties, however, is the ability for their owners to convert their securities. Although the specific terms vary from security to security, investors in convertibles generally have the ability at some point to exchange their securities for shares of the issuer's common stock. Often, though, you never have to convert to common stock if you don't want to. That essentially gives you the equivalent of a call option on the company's shares; if the stock rises, then converting makes sense and you'll earn a profit. If the stock falls, then you'll just take your money back at maturity rather than converting into shares that are worth less.

In practice, a Merrill Lynch survey said that convertibles provide 70% of a stock's upside while providing much greater protection against falling share prices. Right now, I bet plenty of people would give up 30% of any potential gains for a floor underneath their investment.

Boosting yields
Another attractive feature of convertibles is their yield. Sometimes, convertibles pay higher dividends than the same issuer's common stock. Take a look at these convertibles, all of which pay much higher yields on their convertible preferred shares than their common stock:

Issuer

Yield on Common Stock

Yield on Convertible

Chesapeake Energy (NYSE: CHK  )

1.5%

5.3%

Bank of America (NYSE: BAC  )

0.3%

7.6%

Ford Motor (NYSE: F  )

0%

7%

KeyCorp (NYSE: KEY  )

0.6%

7.5%

El Paso (NYSE: EP  )

0.4%

6.4%

Source: Yahoo Finance, Quantum Online.

That won't always be the case, though. Both Annaly Capital (NYSE: NLY  ) and Anworth Mortgage (NYSE: ANW  ) , for instance, have convertible preferred issues outstanding. Yet neither of them pays anything close to the dividends that the common stock pays.

Where to buy convertibles
The problem with trying to buy convertibles, though, is that they tend to be thinly traded. Some issues don't have any volume at all on some days. That's why many investors who want to buy convertible securities use mutual funds or ETFs. The SPDR Barclays Convertible Securities ETF (CWB) holds over 100 different securities, including several of the ones mentioned above. Since the ETF started in April 2009, the shares have gained 26% -- only a bit under the 31% gain in the S&P 500 over the same period.

If you prefer a longer track record, many mutual funds focus on convertibles. Calamos Convertible (CCVIX), for instance, has been around since 1985, and it's given long-term investors a 9.7% annual return since then. Although the Calamos fund charges a sales load, you can find a host of other funds from other providers.

Are they right for you?
It's unclear whether the bond market's dramatic rise is in its final stages or just getting started. But if you're wary of ultra-high bond prices that could reverse quickly when the economy starts getting stronger, then convertibles will give you a lot of benefit from a stronger stock market while also giving you some of the protection of a fixed-income investment. That may be just the combination you're looking for.

If you think the economy is doomed, you might want to think about selling stocks short. Matt Koppenheffer was a skeptic, but read what he learned about short-selling.

Fool contributor Dan Caplinger has owned convertibles for over 20 years and doesn't mind dropping the top on a warm summer day. He owns shares of Chesapeake Energy. Ford Motor is a Motley Fool Stock Advisor selection. Chesapeake Energy is a Motley Fool Inside Value recommendation. The Fool owns shares of Annaly Capital Management and Chesapeake Energy. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy will never try to convert you.


Read/Post Comments (2) | Recommend This Article (7)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 30, 2010, at 5:05 PM, HY4all wrote:

    I had a sizeable convertible portfolio when the market busted. I too thought it would protect me. The problem was that it certainly did not in the near term since almost all issues were basically

    illiqued after the crash. It took several months for them to start to become liqued enough to get out of some them that needed to be swapped without

    taking big trading hits.

  • Report this Comment On October 15, 2010, at 7:13 PM, anotherbodhi wrote:

    Morningstar, "Our Favorite Convertibles" <http://news.morningstar.com/fundanalystpicks/printNews.asp?i..., recommends Vanguard Convertible Securities (VCVSX) in addition to the Calamos fund.

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