Stock tremors worry you? Try convertibles

You're uneasy about the possibility of a near-term drop in stock prices from today's high levels but want to participate in the stock market's expected long-term rise while earning above-average income.

This may be the time, therefore, for you to consider a convertible securities fund -- one primarily invested in bonds and preferred stocks that are convertible into common stocks at specified prices, or conversion rates.


Convertibles, which some growth and income and other funds also invest in, are hybrid securities that combine features of both common stocks and non-convertible bonds. As fixed-income securities, they pay interest at fixed rates (convertible bonds) or dividends (preferreds). But like the corporate common stock into which the securities may be converted, they have the potential for appreciation. Of course, their prices also can fall when their issuers' stocks do.

Convertibles can be attractive to some long-term investors at times such as these because their yields usually exceed those of underlying stocks and tend to cushion convertibles against large price declines.


But because their selection requires weighing more factors than picking stocks involves -- such as the relationship between convertibles' prices and the total values of the shares into which they can be converted -- they also are more difficult to analyze. For most individuals, it makes sense to acquire interests in convertibles via mutual funds and let professional managers make the decisions.

If you wish to find a suitable convertible securities fund among the nearly 30 such funds in existence, you need to become familiar with their investment policies by studying their prospectuses and shareholder reports. You want to be reasonably sure of spotting one that's compatible with both your risk tolerance level and your investment goals.

Investment policies differ significantly, as indicated by the total returns for the funds, listed in the table, that have been in operation for at least five years.

To understand the practices that produced these results, you need to bear in mind a few basics:

* Selection of convertible securities typically depends on the perceived attractiveness of the stocks into which they can be converted as well as on the valuation of the convertibles.

* Convertibles are more commonly issued by medium-sized and small companies than by large ones and tend to perform more in line with stocks of the broader group. Thus, the Standard & Poor's 500 Index, reflecting prices of large companies' stocks, may be a less meaningful benchmark than the Russell 2000 Small Stock Index.

(Performance significantly lagging the S&P; 500 apparently led many convertible fund shareholders to redeem their shares in recent years. Since the October 1987 crash, the group's total net assets have fallen from $5.3 billion to $2.2 billion.)

* Total returns depend partly on yields. In the case of convertible securities funds, these depend on the grades of the convertibles in their portfolios -- investment grade or speculative -- and on the types of non-convertible securities they own. Higher-grade securities yield less than lower-rated ones. Ordinary bonds usually yield more than convertibles of comparable quality. Common stocks or cash equivalents usually yield less.


Against this background, consider the strategies of some of the leading funds in the group:

John G. Martin, who has managed Phoenix Convertible Fund for 10 years, attributes its top long-run performance to his reliance on reasonably priced, high-grade convertibles of large, seasoned companies with good earnings prospects. He also has felt free to raise cash levels to 20 percent or 25 percent when market conditions warranted. When small-company stocks and low-quality bonds suffered large losses in 1990, his strategy helped the fund earn a positive 4.2 percent total return. This year, the fund has lagged its peers. "Not being in younger companies hurt us," Mr. Martin says.

James H. Behrmann, portfolio manager of American Capital Harbor Fund, also is substantially committed to investment-grade issues. While the fund's policy permits it to invest as much as 45 percent of its assets in common stocks, it holds about 15 percent to 20 percent. Convertibles make up 60 percent to 65 percent of the portfolio.

Vanguard Convertible Securities Fund is concentrated in the small and medium-sized companies that make up the bulk of the convertibles market. This hurt performance in 1990 but has been rewarding in 1991.

The fund's policy requires it to be at least 80 percent invested in convertibles, most of which can be high-quality "junk." In practice, however, investment-grade securities usually run about 50 percent; lower-quality bonds, no more than 30 percent.