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FEATURE-Convertible bonds an option when stocks look dicey

By Jonathan Stempel

NEW YORK, Aug 25 (Reuters) - Convertible bonds, often a refuge from stocks, are suffering a long, parched summer.

"The last two months have been among the most trying times for convertibles in a long while," said Venu Krishna, head of U.S. convertible research at Lehman Brothers Inc.

Convertibles combine some of bonds' perceived safety with some of stocks' upside potential. They usually pay interest, though less than a regular bond, and are convertible into stock at a premium to the stock price. They are often a safer way to invest with companies than buying stocks directly.

Yet the complex stock-bond hybrids suffered when capital markets seized up after the WorldCom Inc. accounting mess. Investors worried that other companies might have fudged their finances, and that many bonds would go into default.

Convertible bond mutual funds are down 10.66 percent so far in 2002, according to fund service Morningstar Inc. Morgan Stanley's U.S. 225 Convertible Index is down 12.4 percent, and the stocks underlying that index have sunk 33.19 percent.

Sales have dried up. Companies have sold $44 billion worth of convertibles this year, after a record $105.7 billion in 2001, according to Morgan Stanley's ConvertBond.com. But they have sold just $2.2 billion since June 30.

"Equity valuations and credit markets have been weak, the economy has softened, many companies fell to 'junk' status or defaulted, and there are macro concerns about corporate governance and geopolitical issues," Krishna said.

Investors see a turnaround, though.

"Factors placating equity markets -- executives certifying financials, indictments and Congressional action -- are helping convertibles," said Jason Voss, co-portfolio manager of the Davis Convertible Securities Fund. "Over the next six months, convertibles should outperform stocks because of their enhanced yields."

POPULAR, TO A POINT

Convertibles come as bonds, preferred stock or "mandatory" securities that convert automatically into stock. The latter two are more volatile, but credit rating agencies treat them as equity-like, which helps support companies' credit ratings.

Convertibles surged in popularity between 1999 and the first half of 2002. Ford Motor Co., Merrill Lynch & Co. and others sold them to raise cash cheaply, while Lucent Technologies Inc. and others sold them because it was too costly to raise needed cash elsewhere.

Even Warren Buffett liked them. His Berkshire Hathaway Inc. in May sold convertibles with the first "negative coupon." Investors are paying 0.75 percent annual interest for a chance to become part-owner of the billionaire's company.

The good vibe vanished as the weather turned hot. Voss said the market grew too unpredictable even for hedge funds, which do most convertible buying and favor stable credit markets.

Even now, he said, many convertibles still look too costly. And convertibles can fall apart just like stocks and bonds. Enron Corp., for example, sold convertibles. So did Adelphia Communications Corp.. Both are bankrupt.

Still, Lehman's Krishna said, "if equity and credit markets stabilize then convertibles will benefit quite substantially."

FEET WET

Nick Calamos, who oversees more than $11 billion as chief investment officer at Calamos Asset Management Inc. in Naperville, Illinois, sees pent-up investor demand for convertibles, especially mandatories. He said issuance could reach $20 billion for the rest of 2002.

"This is a good time to get your feet wet," he said. "The market is already pricing in a lot of fear, and you're getting paid to take the risks. If stocks cut their losses and finish down (this year) maybe 5 percent, convertibles are going to bounce back and with their income could finish the year flat."

Davis' Voss favors convertibles of International Rectifier Corp., which makes semiconductors that manage power in electronic devices, and School Specialty Inc., a large marketer of primary and secondary school education materials.

Most experts urge individual investors to buy convertibles, if at all, through diversified mutual funds.

Morningstar recommends Calamos Convertible A, with a 6.98 percent three-year annualized return; Davis Convertible Securities A, down 4.44 percent a year over that time. and Fidelity Convertible Securities, up 5.76 percent a year over three years. The funds in 2002 are down a respective 3.66 percent, 6.73 percent and 14.73 percent. The Calamos and Davis "A" shares have a 4.75 percent front-end sales charge.