Cruising with convertibles
The hybrid securities are hot - especially for investors who are feeling a little stock-shy.
NEW YORK (Fortune) -- Tempted to get back into stocks, but still feeling the burn from last year's collapse?
One way to ease your way in is to buy convertible bonds, which can be exchanged for equities at a preordained price. Companies like them because they can issue them at lower interest rates; investors like their bond-like attributes and their potential to grow as stocks.
Say you buy a $1000 convertible bond with a 100 to one ratio. Then you'll get 100 shares of the stock at $10 each. If the stock - which was trading at $8 when you bought the bond - jumps to $15 before your issue expires, you can convert it into $1500 worth of stock.
And then if the market plummets, who would convert a perfectly good bond into a stock? That's why a convertible will generally only drop so far. "In a nervous market, convertibles offer defensive characteristics," says John Calamos, manager of the $1.4 billion Calamos Convertible Fund. "They're cushioned on the downside."
Nevertheless, convertibles did fall 26% in 2008 - further than bonds, but less so than stocks. Why so far? Until recently, hedge funds controlled about two-thirds of the convertible market (they used the bonds for arbitrage by short-selling the underlying stocks). When fund investors started to withdraw their money, managers began selling off convertibles in order to stay afloat.
As a result, says Marko Kolanovic, head of derivatives research at JP Morgan, convertibles were severely undervalued until March, when institutional investors recognized the opportunity and started scooping them up. Convertibles have risen 12% so far this year, compared with 1% for bonds and a 2% drop for stocks.
"This is the most interest that we've seen in years," says Calamos. His fund was closed to new investors last year, but he reopened it when prices dropped.
Despite the rally, Kolanovic says many convertibles are still undervalued. "They aren't across-the-board-cheap anymore, but there are opportunities," he says. "Our equities research team thinks the stock market will go up this year--so we're overweight on convertibles."
Both Kolanovic and Calamos prefer investment-grade issues. "I'm looking for bonds that come up on both our equities and credit buy lists," says Kolanovic. The market dried up last winter, but has rebounded this year, with several billion dollars worth of new issues.
It isn't easy to pick a convertible: You need to evaluate not just the issuer's credit rating, but also its stock and its ownership - if the bond is largely held by a hedge fund, then it's at risk for liquidation. In some cases, it may be more advantageous to purchase an investment-grade or high-yield bond from a company.
Because of the difficulty (and expense) of purchasing individual issues, a better option for the average investor is buying into funds instead. Calamos' Convertible fund is a top performer; others that have led the pack include Vanguard Convertible Securities and Van Kampen's Harbor Fund.
These funds are heavily invested in healthcare and tech companies, which bodes well for their bonds' creditworthiness - and their potential to grab upside on a conversion. All three funds have beaten 1-, 3-, and 5-year averages in their categories. 
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