BARRON’S
Convertible Bonds: Nice Yield, Lower Risk
Convertible bonds offer much of the upside during bull markets while limiting losses in bad times.
By Mark Hulbert
June 5, 2014
As hybrid securities that don't fit neatly into either the stock or the bond categories, convertible bonds rarely get the
attention they deserve. They lose out to common stocks during bull markets and to straight bonds during bear
markets.
Yet convertible bonds can play a valuable role in your portfolio, especially right now if you—like many investors—
have the dual goals of wanting to participate in any remaining upside of this incredible bull market but also wanting
to protect yourself if stocks turn south.
Convertible bonds hold out this dual potential because they are part bond and part stock. They pay a regular interest
rate like an ordinary bond, but can be converted into a preset number of shares of the issuing company's common
stock.
The performance of a convertible bond depends on many factors, including the value of the shares into which the
convertible can be converted, as well as the prices of nonconvertible bonds with similar maturities, interest rates, and
credit qualities. In some circumstances a convertible bond will act a lot more like a stock than a bond, and in other
situations just the opposite.
In other words, it's possible that a portfolio of convertible bonds can be a good all-weather portfolio.
Sounds good in theory. But how do convertible bonds perform in the real world?
The Hulbert Financial Digest for more than 20 years has been tracking an investment newsletter that invests solely in
convertible securities: The Value Line Convertibles Survey. Even during a rough period for investors, the
newsletter's recommendations have fared well. Since the bull market top in October 2007, just as the Great
Recession and associated bear market was beginning, the newsletter's model portfolio has produced a 9.6%
annualized return, according to the Hulbert Financial Digest, versus 5.9% for buying and holding the stock market as
a whole.
Better yet, this outperformance was turned in with 41% less risk, as measured by volatility of returns. That's a
winning combination. The newsletter is in second place for risk-adjusted performance since October 2007 among the
129 advisory services the HFD has followed over this period.
To be sure, over the entire 20-year period since May 1994, Value Line's convertibles service has lagged the broad
stock market—producing a 7.5% annualized return, versus a total return of 9.5% for the Wilshire 5000. But it's
hardly surprising that a portfolio of convertibles will have lagged during a period which, on balance, has experienced
such strong gains for the broad stock market.
In any case, the performance of the Value Line service has matched that of the average convertibles mutual fund
tracked by Lipper. Compared to Value Line's 7.5% annualized return over the past 20 years, for example, the Lipper
index of convertibles mutual funds gained 8.3%. However, because Value Line's model portfolio was more than
10% less volatile, or risky, than the Lipper index, their two performances are almost identical on a risk-adjusted
basis.
All in all, it appears that convertibles have potential both in the real world as well as in theory.
The accompanying table drills down into the data further and shows how convertibles performed during the last two
major bear markets and bull markets, and how traditional portfolios performed over the same time period.
Value Line Convertibles Survey Lipper Convertibles funds index Wilshire 5000 index Diversified portfolio (60% stock index fund/40% bond index fund) 3/2000 to 10/2002
10/2007 to 3/2009
BULL MARKETS 10/2002 to 10/2007
-­‐15.0%
-­‐20.2%
90.9%
-­‐14.8%
-­‐40.1%
86.7%
-­‐27.3%
-­‐50.0%
114.6%
-­‐15.0%
-­‐31.4%
71.6%
3/2009 to date
128.5%
140.9%
191.2%
113.7%
BEAR MARKETS Sources: Lipper, Hulbert Financial Digest
Two themes emerge.
First, in bear markets in particular, convertibles provide substantial downside protection. For example, the Value
Line Convertibles Survey lost less than half of what the overall stock market suffered during the 2007-2009 bear
market, and only two-thirds the loss of a diversified 60% stock/40% bond portfolio. Its record relative to the overall
stock market was almost as good in the 2000-2002 bear market, though in this case notice that it didn't do any better
than the diversified stock/bond portfolio.
A second theme: A price is paid for this downside protection. Convertibles' bull-market returns are not as great as
those of an all-stock portfolio. Still, it's worth emphasizing that their bull-market returns are nothing to sneeze at,
either. And notice that the Value Line Convertibles Survey in bull markets does outperform the diversified
stock/bond portfolio.
Even more than the usual care needs to be exercised right now when picking a convertible, however, since many of
them trade well above the value of the shares into which they can be converted and, therefore, have elevated risk.
Their hefty premiums are the result of investors' willingness to pay a big price for the downside protection that
convertibles offer. For these and other reasons, you may want to follow the lead of an advisor, such as the Value
Line Convertibles Survey.
Or, rather than buying individual securities, you may want to go with a mutual fund that holds convertible securities.
For example, you'd need at least a six-figure portfolio to purchase even the smallest-possible lots of each of the
positions recommended in the Value Line Convertibles Survey portfolio. And commissions and bid/ask spreads can
impose a particularly large cost when buying small lots.
The convertibles funds with the best 10-year returns, according to Lipper, and which are both no-load funds and
have relatively small minimum investment levels, are Fidelity Convertible Securities Fund (ticker: FCVSX ), with a
0.72% expense ratio; and Vanguard Convertible Securities Fund ( VCVSX ), with a 0.63% expense ratio.
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