After getting beaten to a pulp last year, convertible bonds are making a comeback.
The convertible-bond-fund category as tracked by Morningstar Inc. of Chicago was up 7.66% year-to-date as of last Monday, making it the top-performing bond fund category.
"Converts are a way to play the markets with less risk," said Lewis J. Altfest, president of New York-based L.J. Altfest & Co. Inc., which manages about $400 million in assets.
The holder of a convertible bond can opt to exchange the bond for a predetermined number of a company's common shares.
Convertible bonds thus offer some of the downside protection of fixed-income securities and some of the upside potential of equities.
But that isn't the way convertible bonds behaved last year.
Convertible bonds underperformed stocks at the end of 2008 for "technical" reasons, said Edward Silverstein, portfolio manager of the $376 million MainStay Convertible Fund (MCOAX). The fund is advised by New York Life Investment Management LLC.
For example, large hedge funds sold convertible bonds to cover redemptions toward the end of the year, forcing convertible-bond prices to fall regardless of the direction of the corresponding stock, Mr. Silverstein said. He also is the director and head of the convertibles division at New York Life's MacKay Shields LLC, the fund's subadviser.
That selling, however, has stopped, Mr. Silverstein said. As a result, convertible bonds "are off to a very good start this year," he said.
It is a big turnaround for convertible bonds, considering that some industry observers were questioning whether the market would ever come back, Mr. Silverstein said.
This year, there has been a trickle of new convertible-bond issues, he said. And some say the bull market for them will last.
Given how beaten up convertible bonds were, it seems likely that they will continue to generate good returns for a while longer, said Richard Howard, portfolio manager of the $20 million Prospector Capital Appreciation Fund (PCAFX). The fund is advised by Prospector Partners Asset Management LLC of Guilford, Conn.
Mr. Howard, who from 1989 to 2001 managed the $6.4 billion T. Rowe Price Capital Appreciation Fund (PRWCX) from T. Rowe Price Group Inc. of Baltimore, has about 30% of his portfolio in convertible bonds.
DOWNSIDE PROTECTION
Because of the downside protection, convertible bonds are a great way to invest in companies that are appealing but that you don't have strong expertise in, he said.
Except for such situations, however, Mr. Howard doesn't see himself adding to his convertible-bond position because he thinks that equities — particularly mid-cap value stocks — have more potential.
That may eventually prove to be true, because in a rising stock environment, convertible bonds will likely underperform stocks.
But for now, markets continue to be volatile and that favors convertible bonds, Mr. Silverstein said.
He said he views the biggest threat to convertible bonds as coming not from stocks, but from predictions among some in the bond-rating business that defaults in the junk-bond arena will reach levels not seen since the Great Depression.
If those predictions come to pass, it would hurt convertible bonds, Mr. Silverstein said.
But he doesn't view the prospect of defaults as likely. "I think that's overdone," Mr. Silverstein said.
Advisers agree, though they still don't see themselves allocating any more of their clients' assets to convertible bonds than is typical.
Rather than view convertible bonds as a relatively safe way to wade into equities, Stephen Gorman sees them as an aggressive fixed-income play. "I'd rather take the risk in the equity area," said the president of Gorman Financial Management of Hingham, Mass., which has $150 million in assets.
Mr. Altfest agrees. He prefers municipal bonds and mortgage-backed securities to convertible bonds for the fixed-income portion of his clients' portfolios and prefers to get equity exposure from stocks.
E-mail David Hoffman at [email protected].
