Over the last five calendar years, the S&P 500 index has returned about 16 percent annualized while intermediate-term corporate bonds have returned about 3.5 percent. The disparity has been even more glaring recently.
Which brings up the question: Is there an investment that has less volatility than common stocks while receiving more return than traditional corporate bonds?
There is an investment that has returned an annualized 7 percent over the last three years and 6 percent over the last 10 years with lower volatility than the S&P 500.
That is the record of Vanguard’s Convertible Securities Fund (VCVSX), which also pays distributions higher than the S&P 500. There are other convertible securities funds, both mutual funds and exchange-traded funds, that have similar records. The website morningstar.com can provide more information.
Caveat: past performance is no guarantee of future results. This is especially true with interest rates on the rise as well as stocks. These two will both affect convertible securities returns. Traditional fixed-income securities’ prices fall as interest-rates rise, but rising stock prices may offset that for convertibles.
They come in two main types: convertible preferred stocks and convertible bonds.
In general, convertible preferred stocks look somewhat like common stocks because they pay dividends as opposed to interest and provide the holder with company ownership and sometimes limited voting rights. They look somewhat like bonds because the dividends of most convertible preferred stocks are fixed.
Convertible means that they can be changed into a specified amount of common stock.
A convertible bond is like a traditional bond in that it pays a fixed rate of interest. But it, too, can be converted into a specified number of shares of the company's stock.
The main differences between convertible preferreds and convertible bonds are:
• The original issue price of the bond is usually $1,000 and the preferred is $25.
• The preferred’s dividend can be suspended by a vote of the board of directors but the bond’s interest payment can’t be suspended short of bankruptcy.
• In the event of bankruptcy the bondholders will be paid before the preferred holders.
Convertible securities do have drawbacks:
• They are subordinate to the company’s non-convertible securities. If the company gets into financial difficulty, the convertible securities' holders won’t get paid until the non-convertible bondholders are paid.
• They pay lower interest or dividends than a company’s equivalent non-convertible bonds or preferred stock.
• They have less upside potential then the company’s common stock.
What characteristics should an investor look for who decides to buy individual securities rather than a fund?
The company should be financially sound, the underlying stock should be one the investor would be willing to own, the convertible security should be rated at least BB and the convertible security’s interest or dividend payment should be significantly higher than the common stock’s dividend
These securities have significant risk, since many are rated below investment grade (BBB-). They don’t belong in the portfolios of conservative investors.
Note to Readers: I will present a complementary seminar on “Investing Strategy” from 1:30 to 3:30 p.m. Tuesday at the Sarasota Yacht Club. Call 800-734-7171 for reservations.
Send comments and questions to Robert Stepleman, Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202, or firstname.lastname@example.org. Follow him on Twitter @logicalinvestor. Stepleman is associated with Dow Wealth Management LLC as a lecturer and chief portfolio strategist. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser. Past performance is not indicative of future results. The data and performance information is for informational purposes only and is not intended as a solicitation.