Convertible bonds play part of defensive strategy

— -- Superinvestor Warren Buffett is fond of comparing the stock market to a manic-depressive shopkeeper. Sometimes Mr. Market sells apples for $10. Other times, he lets them go for 10 cents. It all depends on his mood.

These days, however, Mr. Market is simply sadistic. He puts out apples for 10 cents, then whacks you upside the head at the checkout stand.

Not surprisingly, many investors are wary of the apparent bargains Mr. Market has recently put up for sale. Traditionally, convertible bonds have been a good way to invest cautiously in a nasty market. Converts are long-term, interest-bearing IOUs that convert to stock when the stock's price hits a certain level.

Convertible bond funds are still a decent idea for the bruised investor. But these days, you can get almost as much value by investing in high-quality, high-dividend stocks.

You can see why a convertible bond holds a certain charm for cowards. Let's visit Exampleland, where BamStick, a company that makes hand-crafted cudgels, sells for $10 a share. In this economy, people are increasingly turning to cudgel alternatives, such as bricks. Not surprisingly, the stock has been clobbered, but you think it could be a hit again someday.

As it happens, BamStick also has a convertible bond, which yields about 5%. Should BamStick stock hit $15, you have the opportunity to convert the bond to stock at that price. If BamStick falls to $8, you'll still have your convertible bond, which will continue to pay interest at the same pace.

"It's a bit of a defensive strategy," says John Calamos Sr., manager of Calamos Convertible fund. "You get the interest payment from the bond, which is typically above the dividend yield of the stock." Put simply, you get paid to wait for the stock price to rise to a higher level.

Convertible bonds will still pay interest if the company cuts its dividend. If you hold the bond to maturity, the company will pay you the bond's full face value. And many convertibles mature in about five years, so you don't have to wait too long to get your money back.