The stock market has been on a straight shot upwards since the depths of the Great Recession- with the broad SPDR S&P 500 (NYSE:SPY) up about 19.71% this year alone. And with the Fed not taking its foot of the gas with regards to its easing programs, analysts now predict that more gains can be in store for market.

That’s all well and good for investors. However, given how far we’ve surged in the last four years or so, some more conservative investors are getting a tab bit nervous. Trimming stock exposure could be prudent, but switching into most fixed-income investments does carry risks when the Fed does decide to taper.

Luckily, there is a way for these investors to have their cake and eat it too in an often ignored corner of the bond market. Namely, convertible bonds.

Flipping The Script In Hybrid Bonds

While preferred stock and funds like the iShares U.S. Preferred Stock ETF (NYSE: PFF) have been widely adopted by the general investing public, their bond/equity twins - convertible bonds have been largely ignored by portfolios. That’s a real shame as the asset class can offer plenty of benefits for investors willing to bet on the esoteric bonds.

Essentially, convertible bonds are basically a bond with a stock option hidden inside. Much like traditional bread-and-butter bonds, converts have face values, coupon payments and maturity dates, but can be exchanged for a specific number of shares of the issuer's common stock at a later date. This provides investors the potential to play both a company's debt and equity via a single security. That’s important as converts “bond” side helps create a floor during rocky markets, while the “stock” flank can help capture any upside if the markets surge.

Convertibles two-sided nature has been a powerful tool in the return department. According to Morningstar (NASDAQ:MORN) convertible bonds have produced a 7.6% annualized return over the past 20 years. That’s higher than the performance of the large cap stocks- which returned only 7.3% during the same time. What’s more impressive is that converts managed to do it with 22% less risk and volatility. At the same time, yields for convertible bonds also beat stocks. The average U.S. convertible bond offers a current yield of 3%, versus the S&P’s 2.02%. 

Then there’s rising rates to consider. Here again converts win out over stocks. Looking at the nine periods over the past 20 years when the ten-year Treasury yield rose one percentage point or more, convertible bonds only produced negative returns for just one of those periods. They actually posted double-digit gains in six. Meanwhile, the S&P 500 suffered losses in all nine periods. 

Adding Some Convertible Income

For regular investors, adding convertible bonds has traditionally been quite difficult. The total size of the U.S. convert bond market is only around $200 billion. However, with variety of firms like Tesla Motors (NASDAQ:TSLA) and NetSuite (NYSE:N) now issuing new convertible bonds, the sector has seen growth in the number of ways regular retail investors can access.

Perhaps, the easiest is the $1.8 billion SPDR Barclays Capital Convertible ETF (NYSE:CWB). The fund is the only ETF in the space and tracks 93 convertible bonds from issuers such as Priceline.com (NASDAQ:PCLN) and steel producer ArcelorMittal (NYSE:MT). The ETF has performed well since its inception in 2009, producing an annualized 14.49% return and yields a healthy 3.51%. 

Another option for convertible success could be found in the world of closed-ended funds (CEFs). Asset manager Calamos (NASDAQ:CLMS) made their name specializing in the bond type and Calamos Convertible Mutual Fund (CCVIX) is one of the first convert funds available to the general public. However, the asset manager does have a history of closing the fund when too much money flows into it. The Calamos Convertible & High Income Fund (NYSE:CHY) offers exposure to the asset manager without the closure risk at almost an 8.46% discount to its net asset value (NAV). Aside from the discount, CHY features an impressive 7.99% dividend yield.

The Bottom Line

Investors are certainly facing a quandary. The broad market has gone up by leaps and bounds since the end of the recession. That’s worrisome. Yet, more gains could be in store as the Fed isn’t ending its easing programs. Convertible bonds are a perfect way to potentially hedge the downside risk as well as play the upside from continued swooning markets.

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.

 

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