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.

As a defensive strategy, buying convertibles has had its merits. The average convertible bond fund has gained 1.7% this year vs. a 7.4% loss for the Standard & Poor's 500-stock index with dividends reinvested.

Naturally, converts have drawbacks. In return for the ability to convert your bond, you typically get a lower interest rate than you would on a garden-variety, non-convertible corporate bond. "That's the trade-off," Calamos says. Another problem: The market for convertible bonds can be illiquid, meaning that you can't always find a buyer for your bond when you need one the most. For that reason, you probably should invest in a convertible fund rather than in individual bonds.

In the last bull market, hedge funds were big buyers of convertible bonds, pushing their prices up and their yields down.

This bears a bit of explanation. Bonds pay a fixed rate of interest, and you can't go back to a bond issuer and ask for a higher rate. A deal's a deal. You can, however, drive down a bond's price, which increases its yield. A $1,000 bond that pays $50 in interest has a 5% yield. Smack the bond's price down to $800, however, and its yield rises to 6.25%. Push the price up to $1,200, and the yield falls to 4.17%.

But many hedge funds, beset by redemptions, dumped their convertible bonds in the last three months of 2008, Calamos says, making converts more attractive now than they have been for a long time.

Ted Southworth, manager of Northern Income Equity fund, agrees that some convertibles are good deals now. But they're not screaming bargains, either. "I can find many top-quality companies whose dividend yields are higher than their convertible bonds' yields," he says.

So if you think the stock market is cheap, consider tiptoeing in by investing in a convertible bond fund. You'll have some downside protection if Mr. Market takes out his cudgel again. The top-performing convertible bond funds are in the chart.

If you're a bit braver, consider a fund that invests in high-quality companies with a long record of paying dividends. Two suggestions: Vanguard Dividend Appreciation fund vig or the S&P Dividend ETF sdy, which invest in stocks of companies that have consistently raised their dividends, and whose dividend yields are relatively high.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com.