and a Convertible Ride

08/12/2005 12:00 am EST

Focus:

Carla Pasternak

Editor, The Income Investor

"How can you protect the downside while enjoying the upside?" asks Carla Pasternak. "With convertible bonds, you get paid while you wait for the stock to appreciate." Here, the income specialist looks at her three favorite convertible funds.

"Higher-yielding funds typically trade at a premium to (above) their net asset value (NAV) because investors are more interested in their yield than their portfolio risk. However, what's unusual about the super-high-yielding convertible funds I profile below is that many have recently been dumped by hedge funds. As a result, investors can now scoop them up at a discount to their NAV. T he three high-yielding closed-end convertible funds profiled below delivered double-digit returns last year.

"Calamos Convertible (CHI NYSE), yielding over 13%, is one of the more aggressive convertible bond funds, as more than half this fund's portfolio is invested in junk bonds and about 75% of its investments are below investment grade. Despite, or because of its high-risk profile, the fund has been a strong performer. Since its inception in mid-2002, the fund has posted an average annual return of 23%. Given that the fund has dished out $0.15 monthly dividend payments every month for the past two years, future payments at this level appear likely. Moreover, since the fund started paying dividends in August 2002, monthly payments have increased by 55% and the special year-end payment has climbed from $0.14 to $0.61 to last year's $1.04.

"Nicholas-Applegate Convertible (NCV NYSE) , yielding 14.5%, is managed by PIMCO, the world's largest bond fund managers. The portfolio's average credit rating is just below investment grade at BB- and is split between convertible preferred stock and bonds and high-yield corporates. The fund has been a top performer over its brief two-year history. Last year it generated a total return (share price gains plus dividends) of 16%, and since inception in March 2003 the fund has returned an average of 14% annually. Since May 2003, the fund has reliably dished out its regular $0.13 per share monthly dividend payment without fail. In addition, NCV also paid out a special $0.82 dividend last December for additional investment income earned during the year. This solid dividend history bodes well for the future.

"Advent Claymore Convertible (AVK NYSE), yielding 10.4%, has about two-thirds of its portfolio in convertible bonds, making it one of the more conservative of the group. Still, about a third of the portfolio consists of junk bonds, and about two-thirds of the holdings are rated below investment grade. With a total return of +11% last year, AVK ranks in the top half of similar closed-end funds. The dividend consists of regular $0.17 per share monthly dividend payments, which have been paid consistently since inception more than two years ago. The yield calculation also includes a special year-end distribution of $0.52, which has been paid every year since inception. Considering this solid track record, the dividend appears safe.

"Conservative investors will want to weigh the risk/reward trade-off of these investments carefully. These funds' bias toward high-yield bonds and sub-par credit quality is a mixed blessing, generating fabulous yields but also subjecting shareholders to above-average risk. Should any portfolio holding default on its interest obligations, then even a well-managed fund could be forced to cut distribution, an event that could also take a toll on share prices. Given their risk/reward profile, investors may want to use these convertible funds as a somewhat mild way to enter the hot high-yield market and spice up overall portfolio returns."

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