Are Convertible Bonds and Preferred Stocks Good Investments?

A reader sent me this question about convertible securities mutual funds.

I would love to read your opinions on convertible securities mutual funds. This is a subject that seems to be ignored completely by personal finance bloggers. What I would like to know is

1. How do these funds work and is there an interest rate risk with them?
2. For asset allocation purposes should they be placed under bond or stock allocation?
3. Pro and con arguments for their inclusion into one’s retirement account.
4. Which investors find this kind of a mutual fund attractive? Vanguard’s VCVSX has net assets of $2.2 billion, so somebody does find this fund worthy of investing in.

Good questions. I will take a stab at them.

Convertible securities include convertible bonds and preferred stocks that can convert to common stocks. They seem to be completely ignored because they are an odd ball: not straight stocks, nor straight bonds. They are somewhere in between, but not quite.

Convertible bonds are still bonds. They pay interest and they have a maturity date. Investors also have an option to convert them into the stock of the issuing company at a preset price, often far higher than the stock’s price at the time when the bonds were issued.

Investors win if that company’s stock jumps over the preset price. For giving that chance to win big, convertible bonds usually carry a lower interest rate than non-convertible bonds of similar quality and maturity.

Like other bonds, they have interest rate risk. They also have higher credit risk. Most convertible bond issuers don’t have as good a credit rating as other corporate bond issuers. They also have stock market risk because if the company’s stock does poorly and you never get a chance to convert, you just sacrificed interest for nothing.

Preferred stocks pay a higher dividend than common stocks. In that regard, they are like a perpetual bond, because preferred stocks don’t have a maturity date. The dividend can also be suspended if the company is short on cash. In terms of credit risk, they are worse than bonds from the same company. Like convertible bonds, some preferred stocks can also be converted to common stock of the same company at a preset price.

Think of convertible bonds and convertible preferred stocks as junk bonds plus a lottery ticket (a deep out-of-the-money call option). If you have to fit them into a portfolio, maybe count them as half bonds and half stocks.

Pros for investing in a convertible securities fund would be a lower risk bet on higher risk stocks. You think higher risk stocks will do well but you are not sure. So you buy the convertible bonds. If you are right and those stocks take off, the bonds convert and you win. If those stocks tank, you don’t lose as much as if you bought the stocks.

Cons would be that these bonds are of low quality. Take the Vanguard Convertible Securities Fund (VCVSX) as an example, of the 52% of the bonds that have a credit rating, only 7% are investment grade. The prospectus says the unrated bonds are similar to the rated bonds. That means about 85% of the bonds in the fund are junk.

Who finds them attractive? Not me. I don’t like junk bonds — too risky. Convertible bonds are junkier than junk bonds. I’d rather take risk on the equity side and have safer bonds.

The Vanguard Convertible Securities Fund did very well in the last 10 years though. It had a 10-year average annual return of 7.40% as of June 30, 2011. That performance is

• better than safer bonds in Vanguard intermediate term investment grade bond fund (6.26%)
• better than the Vanguard junk bond fund (6.70%)
• much better than the Vanguard total stock market fund (3.69%)
• almost as well as the Vanguard mid cap index fund (7.49%)
• better than the Vanguard small cap index fund (7.23%)
• better than the well respected balance funds Wellington (6.39%) and Wellesley Income (6.53%)

It also beat its benchmark by almost 2 percentage points per year over the last 10 years.

A good past performance. A supposedly stock-bond hybrid that ended up beating both stocks and bonds. That’s probably its biggest attraction.

This also shows how theory and reality collide. If someone asked me the same questions 10 years ago, I would’ve said the same thing: junk bonds plus a lottery ticket, not interested. Investment grade bonds plus stocks would be better, in theory, but theory does not always materialize in reality, even in 10 years, which seems to be a long time.

What about the next 10 years? I have no idea. I only know I will stick to safer bonds plus stocks. If the convertible securities fund does better again, I’m OK with missing that.