 Fund Profile: Fidelity Convertible Securities Fund
by Ann C. Logue
Convertible securities are the stealth weapon of corporate finance. They're sort of like debt, sort of like equity and have the power to do good or evil. A convertible can be either preferred stock (paying a regular dividend) or a bond (paying interest). The yield is usually below market rates because the convert holder has the right to exchange it for common stock at a price or ratio agreed to in advance. Issuing companies tend to like them when interest rates are high and the stock market is weak because it lets them raise money at a lower price than with straight bonds or equity. Investors like getting the income along with performance kicker of the option to convert.
Convertibles are also common in venture capital, takeovers and lending to distressed companies. In those situations, the convertible is used to give the financier priority in the event of bankruptcy, as debt holders get paid before equity holders. A start-up company has a high likelihood of failure, so the venture capitalist wants some protection. But if the company succeeds, the equity holders can make big money, so the venture capitalist wants a cut. A convertible is a way to get the company the money it needs to grow while serving both of the investor's interests. Likewise, convertible securities and their cousins, payment-in-kind bonds (which pay investors more bonds instead of cash interest), are a cheap form of acquisition financing that give the lenders a nice payoff if the deal works out and steady interest if it does not.
The downside of convertible investing is that publicly traded convertibles aren't issued very often. (A mutual fund is only going to invest in publicly traded convertibles, of course, but sometimes converts issued in special situations are listed on the exchanges.) However, we may be entering the type of market that favors convertible investing. The stock market is certainly weak; interest rates are low, but it's unclear if they can stay that way for long. Hence, it's time to start watching the Fidelity Convertible Securities Fund. This $3.1 billion fund is 86.2% invested in convertible securities, pays a yield of 2.14%, and is beating the S&P 500.
Because there often aren't many convertible issues to buy, the fund prospectus commits to just an 80% allocation in them, with the remainder allocated between common stock, bonds and cash. The largest holding is natural-gas company El Paso Corporation's (NYSE: EP) 4.99% convertible preferred stock at 7.62% of assets, followed by chemical maker Celanese Corp. (NYSE: CE)'s 4.25% convertible preferred, which makes up 5.25% of assets, and oil and gas company Chesapeake Energy's (NYSE: CHK) 2.5% convertible bond at 4.40% of the portfolio. Energy companies make up 32.8% of the portfolio, which makes some sense: those companies often need to raise funds for exploration activities, they have good cash flow, and the existing shareholders don't want to dilute the profits that will come their way if the explorations pay off. The next-largest sector is information technology at 15.9% of funds.
The Fidelity Convertible Securities Fund has an initial investment of $2,500. It's sold with no load and no 12b-1 fee through Fidelity. The expenses are a low 0.79% of assets, especially when compared with the 1.42% average expense ratio for the category. Because convertible securities generate income, low expenses usually lead to better performance, and that's the case here. For the year ended April 30, the fund's total return was up 7.89% while the Merrill Lynch All-Convertible Securities Index was down 1.07%. For the past 10 years, the fund has posted an average annual return of 10.27% while the benchmark index had an annual return of 6.07%. With numbers like those, it's no surprise that the Fidelity Convertible Securities Fund ranks first in its Morningstar category for every time period but the latest 12 months, where it ranks second.
To be fair to the fund's competitors, it is a small category with just 75 funds in it. There simply aren't that many public convertible securities issued in ordinary market conditions to support more funds. But we might not be in an ordinary market right now. If interest rates spike up, takeovers become common, or the market continues to languish, convertibles could become hot, and the Fidelity Convertible Securities Fund might be a great way to play them.
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