In the latest issue of his industry leading No-Load Fund Investor, mutual fund expert Mark Salzinger reviews convertible bond funds, highlighting his two favorites.

Here, he looks at Fidelity Convertible Securities (FCVSX) and the “more conservative” favorite, Vanguard Convertible Securities (VCVSX).

“Convertibles are hybrid securities, often slight below investment grade, which can be redeemed for stock at a predetermined price and quantity.

“Because their values are often closely correlated to the value of the underlying equities, convertible bonds have more capital appreciation potential also more volatility than plan vanilla corporate bonds. However, because the value of their interest payments creates a floor of value, they tend to be less volatile than stocks.

“Our top convertibles pick is Fidelity Convertible Securities. The fund has been managed by Tom Soviero since 2005, since when it has generated an annualized return of 11.7% vs. 5.7% for Merrill Lynch All Convertible Index.

“Soviero is one of Fidelity’s best portfolio managers. He favors convertibles that trade in line with the movements of the underlying equity’s price and he wants the underlying equity to have an inexpensive valuation.

“He is not hesitant to load up in sectors where he finds numerous appealing ideas: energy makes up nearly of third of the portfolio and has for most of Soviero’s tenure. Information technology and materials (about 17% and 12%, respectively) are also prominent.

“He can also invest in common stocks (recently about 15% of the portfolio), which is welcome in a fund whose manager is a proven stock picker. Fidelity Convertible Securities is a bit more volatile than the S&P 500 Index, but returns have been higher than those of the stock market.

“Vanguard Convertible Securities has a solid record in manager Larry Keele’s nearly 12-year tenure. Keele works exclusively on convertible securities for the fund’s sub-advisor, Oaktree Capital Management. His fund is less aggressive than Soviero’s but has delivered strong returns.

“The biggest difference between Fidelity and Vanguard’s convertible funds is their risk profiles. The Vanguard offering holds only convertibles; Keele does not purchase common stock for his fund. Also, Keel is more risk-conscious in choosing individual securities.

“He wants to find convertibles with an ‘imbalance’ between potential returns, those with far more upside than downside. He looks first at the characteristics of the individual convertible bond, its covenants and terms, then at the company’s finances.

“Only then does he consider the outlook for a company’s stock. Keele’s record, though is one of limited volatility and returns comparable or superior to broad equity benchmarks (three year annualized return of 9.7% vs. 5.7% for the S&P 500).

“Vanguard Convertible Securities holds about the same number of issues as its Fidelity peer but is less concentrated in the top positions.

“The biggest single sector weighting here is in healthcare, which makes up about 27% of the portfolio, mainly from biotechnology companies. Other major sectors include technology, with 17% of the funds assets, and energy, with 14%.”