Given the slow moving process of getting the economy back on track, the Federal Reserve has signaled that it plans to keep interest rates at historically low levels until 2014. For income seekers that continues to be a problem. Traditional sources of yield such as treasury bills, certificate of deposits and money market funds like the Guggenheim Enhanced Short Duration Bond (ARCA:GSY) pay next to nothing, and will do so for the next year or so. For those relying on their investments for their daily expenses, this means moving into some unfamiliar territory to gain yield. One unfamiliar and often ignored space could be exactly what income seekers need to play the low rate environment and ride any gains in equities.

Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

Big Yields in Hybrid Bonds
While preferred stock has been widely adopted by the general investing public, their bond/equity twins - convertible bonds have been largely ignored by portfolios. At their core, convertibles 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. Given that many factors affect the price of these investments, including the interest rate climate (which affects the bond side), supply and demand for the underlying stock (which affects the stock side), plus the conversion covenants and we can see why these types of bonds often do not make it to the average retail investor's portfolio. (For related reading, see Convertible Bonds: Pros And Cons For Companies And Investors.)

However, ordinary investors may want to give the bonds a go in their income portfolios. First, these bonds act like an insurance policy for equities. In falling markets, bond holders sit back and collect the securities juicy yields. While in rising markets, the bonds can be "converted" into shares of the underlying firm, benefiting from capital appreciation. According to Bloomberg, since 1995, the S&P 500 had negative performance for 51 out of 185 rolling 12-month periods. During that time, a broad measure of convertible bonds outperformed the S&P during 44 of those periods, by an average of 7.6%. In addition, converts participated on average in 83% of the upside during the rising phases. Secondly, during bankruptcy proceedings, converts rank higher than equities, given them a more favorable position on the ladder. Finally, yields for the average convertible bond tend to be higher than the company's stock dividend yield. This helps with outperformance during sideways or flat markets.

Adding Convert Income
For regular investors, adding convertible bonds has traditionally been quite difficult. After all, the entire size of the global convert market place is only around to $500 billion and $250 billion in the United States. This compares to the roughly $95 trillion in all bonds. Given the tightness of supply, a variety of traditional convertible mutual funds have closed over the recent months. However, for investors there are still ways to add the security type to a portfolio.

With nearly $800 million in assets, the SPDR Barclays Capital Convertible ETF (ARCA:CWB) is the largest exchange-traded fund (ETF) in the sector. The fund tracks 99 different converts from issuers such as Wells Fargo (NYSE:WFC) and EMC (NYSE:EMC) and yields a healthy 3.37%. The ETF has performed well, producing an annualized 14.75% return since its inception in 2009. Offering a lower maturity profile and cheaper expenses, the smaller PowerShares Convertible (ARCA:CVRT) makes an interesting choice as well.

Some the biggest and largest bargains in the space could be had in the various convertible closed-end funds. Asset manager Calamos (Nasdaq:CLMS) made their name specializing in the bond type. However, the firm has recently begun closing their funds to new investments. The Calamos Convertible & High Income Fund (NYSE:CHY) offers exposure to the asset manager at almost a 2.5% discount to its net asset value. Likewise, the Advent Claymore Global Convertible Securities & Income Fund (NYSE:AGC) offers global exposure to the convertibles market, with nearly 40% of its holdings outside of the U.S. The fund can be currently had for about an 8.96% discount and 8.28% yield. (For additional reading, see Open Your Eyes To Closed-End Funds.)

The Bottom Line
Given the low interest rate environment, income investors have continually sought new ways to find yields. One such ignored opportunity, is in the world of convertible bonds. These securities which offer both attributes of bonds and equities could be exactly what a portfolio needs. The previous funds, along with the Bancroft Fund (AMEX:BCV) make interesting choices within the sector. (To learn more, check out Convertible Bonds: An Introduction.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  2. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  3. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  4. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  5. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  6. Mutual Funds & ETFs

    American Funds' Top Funds for Retirement

    Planning for retirement in this economic and investment environment is far from easy. American Funds might offer an answer.
  7. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  8. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  9. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  10. Mutual Funds & ETFs

    The 8 Most Popular Vanguard Funds for a 401(k)

    Learn about some of the mutual funds in Vanguard's lineup that are popular among 401(k) investors, and find out why you should consider them.
  1. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  2. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  3. Does OptionsHouse have mutual funds?

    OptionsHouse has access to some mutual funds, but it depends on the fund in which the investor is looking to buy shares. ... Read Full Answer >>
  4. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  5. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  6. When are mutual fund orders executed?

    Whether buying or selling shares of a fund, mutual fund trades are executed once per day after the market close at 4 p.m. ... Read Full Answer >>

You May Also Like

Trading Center