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The Value Line Convertibles objective group covers mutual funds that invest the majority of their assets in an unusual and relatively obscure asset class—convertible bonds and convertible preferred stocks. Indeed, convertibles are a mixture of a bond (or a preferred stock) and a warrant to purchase common stock in the issuing company. This creates a hybrid security with both bond-like and equity-like features.

At times, a convertible bond can trade like a regular bond, based on the underlying company’s ability to make interest payments, interest rates, and other bond-specific factors. At other times, however, convertibles can trade more like stocks—typically when the value of the conversion feature (the warrant) is greater than the value of the bond. The end result is that convertibles often provide downside protection because of the bond component of the securities, but also upside participation if the stock price of the issuing company rises (though this participation is usually muted relative to a direct equity purchase).

Mutual funds are one of the best ways for individual investors to participate in the convertible market because of the illiquid nature of many convertible securities. Also, small sales and purchases are often subject to large markups and trading costs, further reducing the benefit of direct purchase. Indeed, it would be difficult for an individual investor to cost effectively acquire a diversified portfolio at competitive prices.

The convertible market is small relative to the bond market and the stock market. Moreover, many issuing companies in this space are financially weak compared to the broader markets. Thus, managers here are generally selective in their portfolio construction. At the end of the day, the funds can be rather eclectic, and each needs to be reviewed carefully. Some managers tend toward more-aggressive, lower-quality holdings, while others prefer higher-quality investments. And these tendencies are subject to change based on market conditions.

Over the long term, the Convertible objective group has been a good performer relative to the broader market, as measured by the Barclays Aggregate Bond Index.  For the 10-year period ended November 30, 2012, the group had an annualized return of 6.3%, while the Barclays Aggregate Bond Index reported an annualized gain of 5.3%. Over the trailing five and three-year periods through November 30, 2012, the group had gains of 2.1% and 7.2%, respectively, while the Index reported annualized gains of 5.9% and 5.7% respectively. During the past year, the Convertible objective group reported a gain of 8.3%, compared with a gain of 5.5% for the Index. Year to date through November 30, 2012, the Convertible objective group outperformed the Barclays Aggregate Bond Index.It reported a return of 6.9% compared with a gain of 3.9% for the Index. The group has a better-than-average Risk Rank of 2, indicating that funds in this group might appeal to more conservative investors. 

One fund with a relatively strong year-to-date return through November 30, 2012 is Columbia Convertible Securities Fund A (PACIX). This fund seeks total return through a combination of capital appreciation and current income.

To achieve this objective, the fund will invest at least 80% of its assets in convertible securities. These include bonds, debentures, corporate notes, preferred stocks, and similar securities that are convertible or exchangeable for common stock. It may invest up to 15% of assets in Eurodollar convertible securities and up to an additional 20% of assets in foreign securities. The fund seeks opportunities to participate in the potential growth of underlying common stocks, while seeking to earn income that is generally higher than the income those stocks provide. The fund may sell common stocks short against positions in which the fund has directly invested in convertible securities. This short selling is limited to no more than 10% of assets. 

Another fund with better than average returns in 2012 is the Fidelity Convertible Securities Fund (FCVSX). This fund seeks high total return through a combination of current income and capital appreciation. The fund pursues this objective by investing at least 80% of assets in convertible securities. These securities can be from domestic and foreign companies. The fund can also invest in other securities, including common stocks and nonconvertible debt. In selecting securities, fundamental analysis is used, which involves a bottom-up assessment of a company’s potential, including balance sheet analysis, earnings outlook, industry position, management strategy, and economic conditions.

A third fund with a good relative year-to-date return for 2012 in comparison to the overall objective group is PIMCO Convertible Fund A (PACNX). The fund’s investment objective is maximum total return, consistent with prudent investment management.

Under normal market conditions, the fund pursues its investment objective by investing at least 80% of its net assets in a diversified portfolio of convertible securities, which may be represented by forwards, or derivatives such as options, futures contracts, or swap agreements. Convertible securities may include corporate bonds, debentures, notes, preferred stocks, and other securities that can be exchanged for common stock or other securities that provide an opportunity for equity participation. The fund also may invest in synthetic convertible securities and convertible structured notes created by other parties such as investment banks. Management may invest in both investment grade and high yield securities, subject to a maximum of 20% of its assets in securities rated below B. It may also invest up to 30% of its assets in securities denominated in foreign currencies, and up to15% of its assets in securities tied to emerging market countries. It may, without limitation, also invest in real estate investment trusts.

In the table below, we have listed 10 top-performing funds through November 30, 2012 that we follow in our Fund Advisor database.

  

10 Top Convertible Funds Performance

 

Fund Name

Ticker

% Year-to-date

Total Return

% 1 Month

Total

Return

% 3

Month

Total

Return

% 6 Month

Total

Return

% 5 Year

Total

Return

Annualized

Invesco Convertible Securities A

CNSAX

10.55

-1.11

2.97

2.77

4.10

Vanguard Convertible Securities

VCVSX

11.49

-0.54

3.20

2.74

3.11

Putnam Convertible Securities A

PCONX

11.94

-0.05

4.51

3.69

2.11

Columbia Convertible Securities A

PACIX

10.34

-0.27

3.34

1.42

1.00

Franklin Convertible Securities Fund A

FISCX

9.89

-0.40

4.24

1.88

2.48

Lord Abbett Convertible A

LACFX

9.07

-0.72

3.82

1.07

0.42

Fidelity Convertible Securities Fund  

FCVSX

10.43

-0.02

6.08

0.62

0.29

Allianz AGIC Convertible Fund A

ANZAX

7.83

-1.56

3.10

0.49

  

Victory Investment Grade Convertible A

SBFCX

7.95

-1.00

2.55

0.93

-0.77

PIMCO Convertible A

PACNX

6.99

-0.88

3.28

0.33

8.55

Convertible  Objective Group

  

7.82

-0.93

2.94

0.91

1.23

  

At the time of this article's writing, the author did not have positions in any of the funds mentioned.