From the April 2006 issue of Wealth Manager Web • Subscribe!

Soft Landing

Convertibles hit potholes last year. During the first five months of 2005, the average convertible fund lost 4.5 percent, lagging the Standard & Poor's 500-stock index by a wide margin. Part of the problem stemmed from heavy selling by hedge funds. That was a sudden turnaround from earlier years when hedge traders had grabbed convertibles eagerly. Many of the hedge funds specialize in convertible arbitrage, buying a convertible and shorting the issuer's common stock. But with too much hot money chasing returns, the arbitrage strategy began producing meager results.

Once the hedge funds had moved on in search of richer fields, the convertible markets returned to a more normal environment. During the last half of 2005, the average convertible fund returned 5.8 percent. Now the convertibles seem reasonably priced, poised to deliver the steady growth that many investors seek.

Convertibles are hybrids, bond-like instruments that can be converted to stocks. Because of their rich yields, convertibles often prove relatively resilient in stock downturns. Their stability makes the securities attractive diversifiers, and convertibles can produce healthy gains when stocks rise. During the decade that ended in December 2005, the average convertible fund returned 8.7 percent annually, less than half a percentage point behind the S&P 500.

Which convertible fund provides the best ride? To select a winner, Wealth Manager again turned to screens developed by Donald Trone, chief executive officer at Fiduciary360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that are at least three years old and have more than $75 million in assets. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also surpass category medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

Trone's screens whittled the field from 75 down to seven finalists. Top contenders included Davis Appreciation & Income A and Calamos Growth & Income A. SB Convertible A had the highest five-year returns, but we awarded the title to Franklin Convertible Securities A because it combined strong returns with moderate risk, posting the highest alpha results of any finalist.

Franklin has outpaced the S&P 500 for the past seven consecutive years. The fund has achieved its steady record by taking a cautious approach. In the convertible universe, many securities have either primarily bond-like characteristics or stock-like traits. Franklin portfolio manager Alan Muschott limits risk by avoiding the extremes. Instead, he holds securities that have a balanced mix of bond and stock qualities.

In a typical convertible, an investor might pay $12,000 for the right to buy a security that can be converted to a quantity of stock currently worth $10,000. The investor is said to pay a 20 percent premium. The premium may be worthwhile because the convertible security pays a higher yield than the common stock. In addition, the investor gets some appealing flexibility. If the stock rises substantially, the convertible owner can swap his security for equity and realize a nice profit. If the stock falls, the convertible investor can simply sit with his bond-like security and collect interest payments.

In cases where the stock price climbs, the convertible may also soar. The premium could drop to 5 percent or less as the yield declines and the likelihood of conversion improves. Such convertibles act much like common stock. If the common rises by $1, the convertible price climbs nearly that much.

At the bond end of the spectrum are so-called busted convertibles. These occur when the common shares of the convertible issuer drop sharply. The price of the convertible collapses as investors see little chance that the security will ever rise enough to be swapped for stock. Instead, investors often view the convertible as a junk bond that is attractive solely for its yield. The convertible may sell for a premium of 100 percent or more. If the common climbs a bit, the convertible price may barely budge.

Franklin manager Muschott favors securities that have premiums of about 30 percent. Such middle-of-the-road convertibles provide downside protection and a chance to benefit from stock rises. "When the market drops, we only want to suffer 50 percent of the downside," says Muschott. "When stocks rise, we want convertibles that will achieve 70 percent of the market rise. That balanced kind of security is in the sweet spot of the convertible market where you get the best combination of risk and return."

Muschott starts by looking for convertible issuers that have attractive common stocks. Then he focuses on convertibles with the middle-of-the road characteristics that he likes. A favorite holding is a convertible for Chesapeake Energy, a natural gas producer with onshore production in Oklahoma and Texas. "They are a low-cost producer with good margins," says Muschott.

The Franklin manager thinks that the common stock seems poised to rise, and he likes the convertible because it has a rich yield of 4.78 percent and a middle-of-the-road conversion premium of 29 percent.

Another holding is the convertible for Lifepoint Hospitals, a chain of rural facilities. Muschott says that the company often buys inefficient hospitals and improves their management and information systems. That strengthens margins. The yield on the security is a rich 5.4 percent. The premium is about 60 percent, near the top end of the range that Muschott prefers.

Besides sticking to attractive companies, Muschott aims to limit risk by staying broadly diversified, holding securities from a mix of industries. The aim is to protect shareholders from any sizable losses and deliver steady returns nearly every year.

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