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The Upside Of A Stock With The Security Of A Bond?

David Goodboy

"The market can remain irrational longer than you can remain solvent."  

Attributed to the influential economist John Maynard Keynes, these are wise words indeed for today's roaring bull market.  

This year has truly been a blessing for stock investors. The major indexes have soared higher on the back of ultra-low interest rates and accommodative monetary policy. Every slight pullback in stock prices has been aggressively bought, sending the benchmarks to multiple record highs

But as you know, markets never move in one direction forever. 

The current extended uptrend has even stock market super-bulls like me wondering whether we've finally reached the top before a significant sell-off.  

No one knows what will happen next. The Fed may make a bearish statement or policy change that could throw cold water on the overheated stock market -- or stocks could just as easily continue higher for an indeterminate amount of time.  

That leaves investors in a quandary. Should you take profits now? Should you wait to sell? Should you try to short this market? Should you hold your position? These questions, unfortunately, have no definite answer.

Fortunately, there is a solution for investors who think the stock market will continue higher but want downside protection should things change quickly. Known as convertible bonds, these hybrid securities combine the advantages of stocks with the security of a bond

In addition to often providing greater yields than regular shares, convertibles allow you to participate in stock market upside with less risk than stock. However, it's important to note that they generally pay less than the company's bond offerings. 

Think of convertibles as a way to capture some of a company's upside while hedging the downside with a single instrument. This peace of mind comes at the cost of limiting the upside.  

How Do Convertible Bonds Work?

Convertible bonds give the owner the option to exchange the bond for a set number of shares in the issuing company. Initially, they act just like regular corporate bonds but with a lower interest rate. The rate is lower because convertibles can be changed into stock, therefore benefiting from an increase in the price of the underlying stock. 

The trade-off between risk and return lies in the condition that if the stock performs poorly, there is no conversion. That leaves the investor saddled with the bond's subpar return -- below what a nonconvertible corporate bond would get. However, this greatly lessens the downside risk of simply holding the stock itself.  

How Do I Use Convertible Bonds To Hedge My Portfolio?

My favorite way to hedge downside risk while remaining exposed to the upside is with the AllianzGI Convertible Fund (ANZDX). Available to the public for only the past three years, the fund's institutional shares have posted a nearly 11% annualized return over the past 10 years.  Ninety percent of the convertible fund's assets is dedicated to convertible bonds; the remainder is in high-yield bonds, cash and converted stocks.  

Converted stocks stay on the fund's books for a maximum of 90 days before being replaced by another convertible bond. The fund holds convertible bonds from big names like Gilead Sciences (GILD), Bank of America (BAC), Ryland (RYL), Equinix (EQIX), Avis (CAR), Hertz (HTZ) and Time Warner (TWX)

It's important to note that despite the fund's absence of a load (the fee charged to buy or sell the fund), it has a turnover ratio of 108% and an expense ratio of 1.06%. The turnover is due to convertibles being converted into stocks. With a return above 8% this year, the fund is lagging slightly behind the overall stock market's return of more than 10%, but the protection it offers against a potential stock market slump makes it well worth a place in your portfolio.

Still, every investment contains inherent risks. Always diversify your holdings to lessen the overall risk exposure of your portfolio. 

The Investing Answer: Starting to hedge your profits with tools like convertible bonds makes good sense. Although your upside will be limited, the downside protection offered by convertible bonds can provide you peace of mind for an uncertain future.

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