Scared? Take a safe ride in a convertible

If you can't decide where to put your money in market times as confusing as these, you might consider picking "an investment vehicle for the undecided."

Given all of the recent talk about a bubble forming in the bond market, framed in the undeniable volatility of the stock market, it's not surprising that investors are waffling on where to go.

Funds don't market themselves as being for "the undecided," of course, but convertible securities have long been thought of as an investment vehicle for people who are unsure of just where they want to be in the market, but who hope to ride the fence of indecision to a "best of both worlds" performance.

That said, convertibles have a lot of appeal in the current market, not necessarily as a core holding but as something that puts some variation into a standard portfolio, in the hope of smoothing out the ride.

Convertible securities — tagged in the mid-'90s by a major financial planner as the investment for the undecided — are hybrids, typically interest-paying bonds (but sometimes preferred stock) that can be swapped for shares of the issuing company's stock at a predetermined price.

The bondlike yield facet of a convertible protects against stock declines, while the ability to convert into stock offers shelter against falling bond prices.

Convertible-fund investors, therefore, hope to put the top down and enjoy the ride when the sun shines and cover up for protection when things get stormy.

Supporters suggest that convertible funds deliver about two-thirds of stock-market returns with half of the downside risk, making them attractively conservative.

In theory, a convertible fund would gain 6.6 percent for every 10 percent market rise, but fall just 5 percent during a 10 percent market correction.

In practice, it doesn't always turn out that way, which is one of three reasons why convertibles haven't always been a popular choice.

The other issues: They're complex, so they fall outside of the buy-what-you-understand horizon of the typical investor and they're built to lag the market, when most investors still prefer to attempt to beat it.

Actually, the first issue — complexity — is precisely why an investor looking for diversification might consider a fund; holding convertibles directly is not for the novice, but hiring a solid low-cost manager — and Vanguard Convertible Securities (VCVSX) just reopened to new investors and is one of several solid low-cost options — makes some sense here.

On the whole, the convertibles market is small — under $250 billion — and most of the issues carry investment ratings that are below investment grade; defaults are not all that common, but having the diversification of a fund — and a professional manager — helps to insulate shareholders from the pain if/when an issue does go bad.

Performance also has justified owning convertible funds.

Over the last five years, according to Lipper, the average convertible-securities fund returned just under 3.5 percent, compared to the average large-cap growth fund generating just 0.38 percent in return.

That said, because convertibles have a specific role to play — and because they are a hybrid that crosses category lines — it's important to look at the numbers from a lot of angles and in different market conditions.

Aside from the five-year comparison to the broad equity market, convertibles funds were down a bit less than their peers in 2008 (a 33 percent loss versus the market's drop of 37 percent), and up more during the rebound ( about 40 percent compared to nearly 29 percent for the broad market). But when you compare convertibles to junk bonds — which also have the characteristics of both equities and low-credit-quality fixed-income securities — things don't look quite as good. On average, high-yield bond funds lost roughly 26.5 percent in 2008 and followed that with a gain of nearly 47 percent a year ago.

The high-yield numbers are why some experts, such as Mark Salzinger of the No-Load Fund Investor newsletter, prefer to avoid the hybrids.

"High yield is more simple and diversified," Salzinger said, "therefore, I favor straight equity funds and, when the time seems right to me, high-yield bond funds over investing in convertible bond funds."

But for investors who want a manager to take a bit more control, and who are scared of making asset-allocation choices into junk bonds, convertibles may be a reasonable way to diversify. While the timing isn't perfect — buying into convertibles at last year's lows would have been brilliant — convertibles are more about asset allocation than maximum short-term profitability.

With that in mind, Gregg Brewer, director of equity research at Value Line, says that convertibles have a place for today's nervous investors.

"Viewed from the dual nature of the securities, with some bond protection coupled with some equity participation, [convertibles] may be a good place for people to put some money," said Brewer, who noted that he invested in a convertibles closed-end fund in 2009.

"I might slice some off of both the bond and equity components to put up 5 percent to 10 percent of an overall portfolio in this asset class."

Chuck Jaffe is a senior columnist

at MarketWatch.

He can be reached

at cjaffe@marketwatch.com.

or Box 70, Cohasset, MA 02025-0070.