August 4, 2005

Convertibles Are Starting to Look Attractive

Convertible securities and mutual funds that invest in them have had a tough time this year, but money managers say that's given them incentive to buy.

The 30 convertible securities funds tracked by Standard & Poor's were down an average 2.3% through June 30. By comparison, domestic stock funds slid 0.3% and high-quality corporate bond funds rose 1.5% on average during that span.

"It's been a difficult year," Stephen Boesel, the manager of the $6-billion T Rowe Price Capital Appreciation Fund (PRWCX), said of convertibles, which account for about 15% of its assets.

Convertibles are bonds or preferred stock that can be converted into a predetermined number of shares of common stock. The hybrid securities typically have lower dividend yields than regular bonds, but they can make money because of the underlying stock.

The asset class suffered in the first half of the year because the stock and bond markets were relatively weak for large chunks of the period, Boesel said.

Convertibles went through "something in between a sharp correction and a bear market" that started in mid-March and ran through the second quarter, said David King, lead manager of the $700-million Putnam Convertible Income Growth Trust/A (PCONX).

King attributed the problem partly to weakness in the broad stock market, as opposed to the segments represented in the Dow Jones industrial average and the Standard & Poor's 500 index.

In addition, King noted, convertibles were hurt when the bonds of giant auto manufacturers General Motors (GM) and Ford Motor (F) were downgraded to junk status in May. Both are heavy issuers of convertible securities, he said.

Hedge fund activity also pressured convertibles early this year, according to Boesel and King. Managers of these funds began to give up on convertibles when returns from so-called convertible arbitrage began to shrink, King said. (The strategy involves holding a long position in a convertible security and a short position in its underlying stock.)

Investors have also been pulling money out of convertibles funds lately. The funds, which took in $644 million in 2004 and about $3 billion in 2003, suffered outflows of $744 million through June this year, according to Financial Research Corp.

However, because the convertible market has taken a hit, valuations there have dropped to attractive levels, Boesel and King said.

Financial planner Steven Podnos also said he thinks convertibles are cheap. As a result, Podnos, a principal of WealthCare LLC in Merritt Island Fla., said he has been buying closed-end convertible bond funds for himself and and his clients.

The stock market's rally in recent weeks has added to the allure of convertibles, according to Boesel and King, who said they have been increasing their funds' stakes in the hybrids.

"I think if you get involved in convertibles now, you're not too late," King said. " I think between now and, say, the end of next year, you will have made a pretty good investment decision, in all probability."

Podnos recommend that investors limit their investments in convertible securities to about 5% of their portfolios because the securities can be more volatile than regular bonds. For the same reason, investors should cap their exposure to the sector at 5%-10% of their holdings, said Roseanne Pane, a mutual fund strategist with Standard & Poor's.

"You want to get your stock returns from stock funds, and your bond returns from bond funds," said Pane.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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