Convertibles may rebound

NEW YORK – They haven’t drawn any envious stares lately, but some experts are convinced convertibles are poised for a comeback.

It’s been a difficult year for these hybrid securities and the mutual funds that invest in them. Other than specialty financial and technology offerings, convertibles are the worst-performing fund category of 2005. But where many see good reason to unload the group, some Wall Street pros spot a buying opportunity.

“Most investors, they’re going to look at the last few years and say, forget it. But the opportunity is ahead of us, not behind us,” said Nick Calamos, co-chief investment officer of Calamos Mutual Funds, a convertible specialist. “This is definitely a time you can buy into the convertible market, capture a very decent risk-reward advantage and some undervaluation to boot. I think it’s a very attractive marketplace.”

Convertibles are essentially bonds that can be converted into a preset number of shares of stock. They pay interest, but their yield is lower than non-convertible bonds because they offer the upside potential of making money through the underlying stock.

The theory behind convertibles is that you get most of the upside of the equity market, but with less volatility and some protection on the downside. These attributes might appeal to more conservative investors, but convertibles can be a very quirky market in reality. Their performance so far this year offers a vivid illustration of their potential pitfalls.

Convertibles, and the strategy of convertible arbitrage, became quite popular among hedge fund investors in recent years. The trade involved buying the convertible and selling short the underlying stock; the payoff came in the form of income from the short sale and because convertibles throw off a yield. But returns from this strategy have dried up over the past year, leading many hedge fund investors to dump convertibles during the first four months of 2005.

All this selling has put an unusual pinch on the convertible market, even leading to cases where a stock is flat but the convertible is down substantially, which is definitely not how they’re supposed to perform. For long-term investors, this has presented an opportunity to pick up convertibles on the cheap – a welcome change, considering many fund managers had found the market richly valued over the last three years.

“Lately the convertible market has come under considerable pressure, and as a result it’s as cheap as we’ve ever seen it,” Calamos said. “We’re increasing our exposure.”

Given the recent underperformance and attractive valuations of convertibles, now may be a good time for small investors to increase their exposure, too, said Kerry O’Boyle, an analyst with fund tracker Morningstar Inc. But because convertibles have so many moving parts, this is not an area most investors would want to delve into on their own.

“Experience is critical with convertible funds,” O’Boyle said. “You need to know how to value stocks, you need to understand the fixed income aspect and balance sheets … there’s a lot of complexity in the market. I think an experienced manager can really help.”

When judging convertible funds, O’Boyle considers style consistency, the experience of management and how well they execute their strategy. Other factors are the overall credit quality of the portfolio and how much is devoted to straight equities as opposed to actual convertibles. Funds with lower overall credit quality and higher equity stakes tend to be more aggressive.