Convertibles can outperform equity funds over short term



When stock prices reach record levels and speculation abou a correction makes you want to defer investing in equity funds, consider a convertible securities fund as an alternative.

Say you had felt that stock prices had risen too fast last December following the Federal Reserve's discount rate cut, and you had invested in a good convertible securities fund in January 1992. You'd probably be happy with your decision.

The average convertible securities fund had a return of 11.6 percent for the year through Dec. 3, according to Lipper Analytical Services. Funds from Fidelity, Putnam and Vanguard earned around 6 to 7 percent more.

Compare these figures with the average general equity fund's 6.7 percent, or with the total return for the Standard & Poor's 500 Index of 6.3 percent through November. Even Salomon Brothers' High-Grade Bond Index had a return of 7 percent.

What are convertible securities funds, and why have several -- but not all -- done so well this year?

They're funds that seek income and capital appreciation by investing 65 percent or more of their assets in corporate bonds and shares of preferred stock that may be converted into shares of the issuers' common stocks at specified prices.

Convertible securities provide more income (interest in the case of bonds, dividends in the case of preferred) than the common into which they are convertible, but not as much as the same companies' nonconvertible bonds. They have potential for appreciation because of their linkage to the common shares, but not as much as the common.

When a convertible's price is close to the value of the shares into which it may be converted, it'll rise with the stock. It'll fall with the stock, too -- until it drops to a level at which the yield supports it. When its price goes to a large premium, it behaves like a bond: falling when interest rates rise, rising when rates fall.

Convertible securities funds tend to lag the S&P 500 over a long term but can lead it for a shorter period, as has occurred this year, when the coincidence of a few trends gave them a boost.

David L. King, co-manager of Putnam Convertible Income-Growth Trust, attributes his fund's performance to two of three major trends that its portfolio was positioned to exploit.

One was the strength expected in cyclical stocks with the economy's recovery from recession. Large positions in issues such as those of Ford and Chrysler have paid off handsomely, he says.

The other major play was in what he calls the high yield "busted" part of the market: companies whose common had fallen a lot and whose convertibles, therefore, offered double-digit yields to maturity. These included RJR Nabisco, Time Warner, and the Bank of Boston.

The $590 million Putnam portfolio also was invested to capitalize on expected strength in small company stocks, but it could not benefit from this trend as much as smaller funds. Because of the fund's size, King says, he could not buy enough of attractive small issues.

It's just the opposite for Desai Capital Management, investment adviser to the $87 million Vanguard Convertible Securities Fund, which is able to focus on small and medium-size firms.

Because a high portion of convertibles are issued by small and medium-size companies, co-manager Carlos Gonzalez says, it was not too difficult to find issues that would do well when such companies' stocks did. And, as the Russell 2000 Index's 14.4 percent total return through November indicates, this has been a good year for small company stocks.

Gonzalez seeks the convertibles of companies that have good managements with focused strategies and that are in "businesses that make sense."

The Vanguard fund's largest holding, for example, is a convertible issue of Comcast, a cable TV and cellular communications company, which accounts for 4.0 percent of its assets. Other major positions include Home Depot and Staples, both specialty retailers.

Although the world of convertibles is new to Andrew Offit, who took over Fidelity Convertible Securities Fund in March, his lack of familiarity apparently has not been a handicap.

Like several competitors, Offit does "bottom-up analysis" of the stocks underlying convertibles.

His largest holding is a Citicorp preferred. Other positions include CBS, Wendy's and Maxicare, a health maintenance organization.

Is it too late to get into a convertible fund?

"Convertibles just recently moved from being undervalued to being fairly valued," says Putnam's King. "They're still attractive."

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