Convertible bonds provide investors with the option to convert the bonds into stock of the issuing company. They offer high yields, upside stock potential in bull markets, and downside bond protection in bear markets.
Convertibles and convertible funds may be appealing now. Vanguard Convertibles Securities Fund is an "excellent choice," according to Morningstar.
However, most convertible bonds are also "junk" bonds: they provide high yields but have poor credit ratings. Right now, the difference in yield between junk bonds and Treasury bond is almost 7 percent.
Historically, investing in junk bonds when spreads reach 7 percent and selling when spreads drop to 5 percent has led to annualized returns of nearly 20 percent.
The bottom line is that aggressive investors may get better long-term returns in convertibles. Investors with less tolerance for risk may do better to wait until the spread between junk-bond yields and Treasury-bond yields reaches 7 percent, and then invest in junk bonds. Northeast Investors, T. Rowe Price High-Yield, and PIMCO High Yield funds are well-regarded.
