Aug. 25, 2004 — Convertible bond funds provide returns between those of the stock and bond markets. Not surprisingly, they perform best in equity bull markets, although most convertible bond funds trail the Merrill Lynch All US Convertibles index. Nonetheless, a well-managed convertible fund can provide a cushion against equity market weakness and offer upside when stocks are rising. However, these funds usually lag the bond market during equity bear markets.

High oil prices, the strength of the economic recovery, and the Iraqi situation have investors wondering where to turn. Stocks could do well if these situations improve, yet equities remain vulnerable to a sudden worsening in any of them. Bonds offer more safety, though with rising interest rates, the fixed-income landscape looks tricky. In theory, convertible bond funds offer some of the safety of bonds while potentially benefiting from stock appreciation.

We reviewed 80 convertible bond funds, including multiple share classes, over various periods. As expected, convertible bond results reflect a blend of stock and bond market performance. The Merrill Lynch All US Convertibles index posted results between the Lehman Brothers Aggregate Bond index and the S&P 500 for the one-, three- five- and ten-year periods through lastmonth. This pattern held for the recent equity bear market, from March 24, 2000 through October 11, 2002, and for the year-to-date period in 2004. The results are in Tables 1 and 2 below.

The average convertible bond fund duplicated this result for every period, except the year-to-date in 2004. However, these funds were less successful at beating the Merrill convertible index, as seen in Tables 1 and 2. Of the seven periods, the average fund beat the Merrill index only twice: the bear market and the five-year period. It should be noted that the five-year period included the bear market.

Interestingly, over the past two years, convertibles have outperformed the stock and bond markets by a wide margin. While the S&P 500 has fallen so far in 2004, over the longer term, the index has been in a bull market. Since bottoming on October 11, 2002, the S&P 500 has gained 36.2% through last month. During that period, the Lehman Brothers Aggregate Bond index climbed 7.7%, while the Merrill Lynch All US Convertibles index surged 41.9%.

Once again, however, as convertible bonds surged in the equity bull market, the average convertible bond fund trailed the Merrill index. While these funds provided stellar returns of 36.1%, that trailed the Merrill benchmark’s 41.9% gain. Only 24.6% of these funds beat the Merrill index in this bull market. The average fund also fell just shy of the S&P 500′s 36.2% jump, though it solidly outpaced the 7.7% gain in the Lehman bond index.

Based on these results, convertible bonds appear to be more useful in beating the stock market than in outperforming bonds. The Merrill index outpaced the S&P 500 in five of the seven time frames, however it beat the Lehman bond index only three times. Meanwhile, convertible bond funds are less successful at beating equity or fixed income benchmarks. However, these funds are more consistent relative to the two asset classes. The average convertible bond fund beat the S&P 500 three times and also topped the Lehman index three times.

While the equity exposure of a convertible fund can boost returns in an equity bull market, weakness in stocks usually causes these funds to trail the Lehman benchmark. The choice of a convertible bond fund should consider future equity market performance and whether the objective is to beat an equity or a fixed-income benchmark.

We screened for funds which beat the Merrill Lynch All US Convertibles index in the one-, three- and five-year periods through last month. The results are in Table 3 below, with the funds ranked on their one-year returns. In terms of expenses, four of these five funds have expense ratios of 1.00% or less. The highest expense ratio of these five funds, 1.42% for the SB Convertible/Smith Barney A (SCRAX), is still below the 1.58% average for all 80 funds.

Table 1 — Returns for convertible bond funds and related indexes

Bear Market (%)

3/24/00-10/11/02

Bull Market (%)

10/11/02-7/30/04

Lehman Aggregate Bond Index

+28.42%

+7.73%

Merrill Lynch All US Convertibles Index

-36.99%

+41.88%

S&P 500-Stock Index

-43.38%

+36.19%

Convertible Bond Funds

-28.47%

+36.10%

Table 2 — Returns for convertible bond funds and related indexes (continued)

Returns through July 30, 2004 (%)

Year-to-Date 2004

One-Year Annualized

Three-Year Annualized

Five-Year Annualized

Ten-Year Annualized

Lehman Aggregate Bond Index

+1.14%

+4.84%

+5.92%

+7.25%

+7.28%

Merrill Lynch US Convertibles Index

+0.85%

+12.13%

+5.03%

+4.57%

+10.02%

S&P 500-Stock Index

+0.02%

+13.16%

-1.48%

-2.24%

+11.09%

Convertible Bond Funds

-0.31%

+11.09%

+4.60%

+5.29%

+9.27%

Table 3 — Funds beating the Merrill Lynch All US Convertible Index in the one-, three-, and five-year periods

Returns through July 30, 2004

One-Year

Three-Year

Annualized

Five-Year

Annualized

S&P Star

Rankings

Franklin Inv Sec: Convertible Securities/A (FISCX)

+17.90%

+6.24%

+9.63%

3

SB Convertible/Smith Barney A (SCRAX)

+14.35%

+7.25%

+6.80%

3

PIMCO Convertible/Ist (PFCIX)

+14.30%

+6.80%

+5.42%

4

Vanguard Convertible Securities (VCVSX)

+14.18%

+5.96%

+7.52%

3

Northern Income Equity Fund (NOIEX)

+12.38%

+5.20%

+4.94%

3

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