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With stocks soaring and interest rates rising, income-focused investors should look for ways to tap into equity performance while taking less risk. Convertible securities could be just the ticket.

As their name implies, convertibles are corporate bonds that convert to company stock at a set price, usually about 25% higher than the price at issuance. When a company’s stock goes up, so does its convertible—by almost as much. But if the stock falls, these bonds typically fall only by about half. That’s because, as with other corporate bonds, convertible investors collect the coupon and get their principal back at maturity—as long as the company doesn’t default, which happens only rarely.

“With convertibles, you get equity-like returns with downside protection, plus current income,” says Tracy Maitland, president of Advent Capital Management. “Right now, the stock market is priced for perfection,” adds Maitland, who sees market risk in geopolitics, rising rates, and trade protectionism. But convertibles usually perform well when interest rates rise, he notes, unlike regular bonds or high-yielding equities, like utilities.

Funds that invest in these securities are up an average of 18% in the past year, according to Morningstar, while the convertibles index is up about 20% in that time. Many convertibles are issued by emerging growth companies in industries like biotech, semiconductors, and communications, which have done well in the recent bull run. Morningstar gives high marks to convertible funds run by Allianz Global Investors, Franklin Templeton, and Vanguard.

Dave King, who manages the Columbia Convertible Securities fund (ticker: PACIX)—up 24% in the past year—says they are still attractively priced. He has sold some of his highfliers, like Tesaro (TSRO). A newer favorite is Chesapeake Energy (CHK), which issued a convertible when it was starved for capital last year.

“Convertibles are a great way to invest in a riskier equity without taking on all the volatility or the risk of loss of capital,” King says. One example: His fund owned Dendreon, which went bankrupt in 2014 after its cancer treatment disappointed. His fund got about 85 cents on the dollar in the restructuring, while stockholders got wiped out.

THERE ARE OTHER TAIL WINDS for convertibles, in addition to higher stock prices. Maitland is cheered that new issues have structural improvements, such as shorter maturities and better call provisions. Some of his favorites now are those issued by Dish Network (DISH), which yields 2.8%, Dycom Industries (DY), which yields 0.6%, and Cemex (CX), which yields 3%.

Another plus: Issuance is up. Three business-development companies, Ares Capital (ARCC), Hercules Capital (HTGC), and TPG Specialty Lending (TSLX), issued convertibles last week with fixed rates between 3.75% and 4.5%.

“New paper creates a healthy and stable market,” says Eli Pars, co-head of convertible strategies at Calamos Investments. If tax reform leads to limits on companies’ ability to deduct interest, that could lead to even more convertible issuance, some analysts have postulated.

Investors who want to buy individual convertibles should be forewarned: Many new issues are available only to institutional investors, and it’s a tough market for nonprofessionals to trade in.

The largest convertible exchange-traded fund is SPDR Bloomberg Barclays Convertible Securities (CWB), which yields 3.1%. Some active managers have outperformed the index, but growth-oriented convertible funds usually generate less income. For a yield boost, explore closed-end funds, which use leverage and can sell at big discounts. Maitland’s Advent Claymore Convertible Securities & Income (AVK) yields 7.4% and trades at an 11% discount to net asset value.

Email: amey.stone@barrons.com

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