NEW YORK (CNN/Money) - There's a theory that when you cross two breeds of animal, the offspring can be more robust than either parent. Biologists call that hybrid vigor -- and what holds true for dogs and horses also applies to investments.
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Convertibles combine the traits of both stocks and bonds, and under the right conditions, they can outperform each of their parents.
Convertibles are bonds or preferred shares that can be exchanged for a specified amount of common stock at the owner's option. Like bonds, convertibles typically yield more than the common shares. But they also benefit from any substantial rise in the stock price.
It's easy to see why convertibles often outperform straight bonds. Capital gains on bonds are limited, but the stock market usually rises substantially over a long stretch of time -- and those gains help boost the market price of converts.
Convertibles have a tough time keeping up with stocks in booming markets, but their yields can put them out in front in sideways markets. And in a falling market, convertibles' yields offer downside protection.
That yield support explains the most characteristic feature of convertibles. They share in stock gains to a greater degree than they do in losses. A convert might move up 70 percent as much as the common when it's rising, but fall only 30 percent as much on the downside. The exact ratios depend on the security's price and yield.
Convertibles almost always trade at a premium over the value of the common stock for which they can be exchanged. The rule of thumb is that the convertible is a better buy if it offers a yield advantage that would pay off that premium in four years. For example, if a convertible offers a 4 percent yield and the common pays 1 percent, the three-point difference over four years would cover a premium of up to 12 percent.
Sometimes companies have the right to "call" a convertible, or redeem it early. When that happens, you are essentially forced to convert it or sell it back to the company -- in either case, the value may be less than what you paid. Companies don't always call these issues at the first opportunity, but it's important to know the call terms.
Obviously, investing in individual convertibles requires a lot of research. And although some information is available sporadically in newspapers, magazines, and on the Web, you'll probably need more details. That could mean subscribing to an expensive investment research service or sifting through original documents filed with the Securities and Exchange Commission.
The easier alternative is to use a broker who specializes in convertible issues and works at a major firm that does proprietary research. Or better yet, find a mutual fund with a good track record and below-average expenses. This is one case where it's worthwhile to pay for professional management.