Published: August 24, 2009

The Dow Jones Industrial Average has rallied more than 2,500 points, climbing from a March low near 6,500 to retake the 9,000 level. That's a +40% advance in less time than it takes to grow a tomato.

So is the market set to roar past 10,000? Or is it about to roll over and retreat?

Investors could jump back in now and watch their money disappear in a violent reversal. Or stocks could break out to new highs and leave investors behind. I don't find either option appealing.

Fortunately, there's a middle ground, one that allows investors to participate in a rising market without getting whipsawed if the bottom drops out. Convertible bonds were made for this kind of volatile environment. Regardless of which path the market takes, these unique securities will put profits in investors pockets.

Convertibles are hybrid securities that pair the reliable income of a bond with the potential capital appreciation of a stock.

Convertible bonds work like traditional corporate bonds. They offer fixed, semi-annual interest payments. The difference is these securities come with the opportunity to convert into a pre-determined number of regular common shares at some point in the future.

That's a nice bonus.

A new bond with a $1,000 par value, for example, might be convertible into common shares at a price of $40. In that case, each convertible would represent 25 common shares ($1,000/$40).

Should the common shares rise above the conversion price, let's say to $50, then investors can opt to forgo any future interest payments and exchange the convertible for 25 common shares for a profit.

Generally speaking, stocks must rise about +25-30% before the conversion feature kicks in.

That's exactly what happened with Alcoa (NYSE: AA). The aluminum producer issued new convertibles on March 19. During the next month, the common shares increased from $6.40 to more than $9.00. That increased the conversion value of the convertible bonds, and they spiked about +60% in response.

But here's the beauty: You don't have to convert if the common stock fails to budge or even loses ground. Just sit on the bond until maturity and your principal will be repaid in full while you collect regular interest checks along the way.

This versatility is what makes convertibles the perfect all-weather asset class. These securities typically capture two-thirds of the market's upside potential, with only one-third of its downside exposure according to convertible bond experts.

As you might expect, the equity conversion feature isn't a freebie. Owners usually accept lower interest rates than they could get with similar corporate bonds -- three to four percentage points. Many investors are more than happy to make that tradeoff.

Companies find convertibles to be a creative way to raise cash in a rough market. Not surprisingly, the convertible bond market has tripled in size from $65 billion in 1990 to $180 billion today.

If the market tumbles, and convertibles appear unlikely to be exchanged, they will lose their equity characteristics and trade on their fixed income value. That's what happened last year when forced selling by hedge funds decimated the market. During the height of the panic last fall, the pool of buyers dried up and the market fell more than -30% in a matter of months -- its worst setback on record.

Convertible bonds have recuperated this year. More than 90 new issues have come to market since January, raising $33 billion. Convertibles gained +21% through the first half of the year -- trouncing the +11% return of the S&P 500.

That's a risk to reward imbalance that anyone can appreciate.

Here's an example of how convertible bond funds have fared this year.
 

The market is still sharply underpriced and dozens of issues are "busted," meaning they trade as pure bonds with zero value attached to their equity options.

It's easy to see why some are now referring to convertibles as free lottery tickets -- if the underlying stocks rise in value, investors can convert their hybrid security for a nice profit without any additional costs than a typical bond.

Good Investing!

-- Nathan Slaughter
Editor
StreetAuthority Market Advisor