OCEAN CITY – Recent rough markets have allowed convertible securities to prove their worth: While Standard & Poor’s 500-stock index dropped 4.8% during the 12 months that ended in April 2008, the performance of the average convertible fund tracked by Morningstar was flat.
“Convertibles can help to diversify a portfolio and provide downside protection,” says Brian Zinser, a fixed income strategist for Merrill Lynch.
Convertibles are hybrid securities, fixed income instruments that can be converted to common stock. Because of their structure, they offer equity-like returns while providing greater downside price protection than stocks. During the period from 1989 through 2006, convertibles’ returns matched those of the S&P 500. Convertibles returned 10.5% annually, compared with 10.8% for the S&P 500 for the same period. But in downturns, convertibles often suffered smaller losses than stocks. Because of their relative stability, they can cushion portfolios and help investors weather difficult markets.
Owners of convertibles may profit in several ways. If the price of a $10 common stock doubles, the investor may choose to exchange the convertible security for 100 shares of common stock and sell the lot for $2,000. What happens if the stock price dips? Because many convertibles deliver bondlike yields, the investor receives interest as holder of the convertible security. What’s more, the yields are generally predictable: While companies might not declare stock dividends during a given period, companies are obligated to make the interest payments on most convertible securities, except in the case of a default.
The hybrid characteristic of convertibles also means that the market price of a convertible security typically will not rise as sharply as the underlying stock in a favorable market environment. However, convertibles provide downside protection in a declining stock environment.
Convertibles are issued by a wide array of companies and range from solid, high-quality shares to riskier and more speculative investments. Zinser expects the markets to continue favoring higher-quality convertibles; he suggests that investors focus on companies in consumer staples and other sectors that perform well during economic slowdowns.
Even a small stake in convertibles may be an important defensive addition to a diversified portfolio that includes a mix of stocks and bonds.
(A Merrill Lynch senior financial advisor. She can be reached at 410-213-8520.)