Commentary

It feels like we're at a crossroads. Markets have come a long way off their lows since March, but there are serious doubts about where we go from here. Many keen market observers say the rally is on shaky ground because they see tough times ahead for the economy and corporate profits. Bulls counter by predicting a sustained and surprisingly strong recovery.

Fund investors can't be blamed for being circumspect in these dubious times. The market surge in recent months may suggest otherwise, but Morningstar's year-to-date fund flow data suggests the bulk of new money has gone to bond funds. Indeed, nine out of the top 10 funds this year in terms of inflows are bond funds.

Just as staying out of trouble is a key concern for investors, it must be equally nerve wracking to be missing out on a big equity rally. One way to resolve the dilemma could well be to literally take the middle ground offered by preferred stocks and convertible bonds. These are hybrid securities that have both bond- and stocklike characteristics, so you get some shelter from a stock market sell-off without giving up all the upside in a rally. Essentially, preferred stocks pay a fixed and higher dividend than common stocks, and they are higher in the capital structure as well, so you get paid before common stockholders if a firm hits serious financial trouble. The fixed dividend rate and higher picking order mean preferreds offer a more predictable cash flow and much lower volatility than common stocks. Also, some preferreds can be converted to common stock at a pre-determined ratio--you get, say, five common shares for every preferred share you own--so investors get to participate if the common stock rallies. Convertible bonds work the same way as well.

There are a couple of caveats, though. While hybrid owners are paid off before common shareholders in case of bankruptcy (bondholders get paid first of all), the income streams from preferreds and convertibles have default risk just like any corporate bond. Thus, it's vital to assess the company's ability to remain a going concern. This is especially important now because the rally has boosted these securities as well, so most hybrids issued by companies with relatively strong credit are not offering rich yields. This means you have to take chances on high-yield issuers that have a reasonable shot at credit upgrades. It's also important to keep an eye on inflation. Unlike common stocks, hybrids represent fixed claims on a company's cash flow. Thus, hybrids won't generally preserve purchasing power in a high-inflation environment. This also calls for a rich enough yield cushion.

Following are some examples of fund managers who have made hybrids an important part of their strategy and who we think can strike a delicate balance between the trade-offs described above. Also, check out the exchange-traded options iShares S&P U.S. Preferred Stock Index and PowerShares Preferred if you want to go whole hog.

Calamos Growth & IncomeCombined Preferred Stock and Convertible Weight: 45%
This offering from hybrid investing specialist Calamos is close to being a poster child for the ideas above. The portfolio is roughly an even split most times between common stocks and hybrids and is designed to provide an optimal balance between upside potential and protection from sudden market downswings. Lack of pure fixed-income exposure still led to large losses in 2008 relative to its moderate-allocation peers, but the fund has participated heartily in this year's rally. We still believe the fund's promise because of Calamos' demonstrated skill in picking the spot in a company's capital structure with the best risk/reward trade-off. For example, the portfolio's large current exposure to the energy and mining companies features many convertible bonds that management believes will benefit from sustained high yields and growth prospects in those sectors, while offering some protection from the sudden price swings typical in that area.

Fidelity Strategic Dividend & IncomeCombined Preferred Stock and Convertible Weight: 21%
This fund has had some partial manager changes in recent years but has maintained continuity in its diversified strategy. Lead managers Joanna Bewick and Chris Sharpe allocate assets into stocks, real estate investment trusts, convertibles, and preferred stocks according to their bottom-up assessment of where they see the best value or capacity to grow income. The approach wasn't effective in last year's market meltdown, but the fund has come back strong in 2009, partly on the back of resurgent hybrids. Bewick and Sharpe continue to highlight the benefits of picking good values among preferreds and convertibles as they pay a high yield while you wait for the upside in their equity.

Franklin Equity IncomeCombined Preferred Stock and Convertible Weight: 22%
This fund's focus on hybrid securities is fairly recent, timely, and makes a lot of sense based on management's competitive advantage. In a move that owes to their expertise in the area, comanagers Alan Muschott and Ed Perks gave the portfolio a makeover last year, incorporating a heavy role for preferreds and convertibles in the strategy. (They have a successful record at Franklin Convertible Securities). The tweak occurred just in time for management to take advantage of the many bargains available among hybrid securities over the past year. Here, too, management stresses the upside potential of the portfolio's hybrid stake even as the fund boasts one of the highest yields in the category in the meanwhile.

Thornburg Global OpportunitiesCombined Preferred Stock and Convertible Weight: 10%
You can't accuse management of being gun-shy here. The concentrated portfolio, large deviations in sector weights from the benchmark, and sizable exposure to small caps and emerging markets all suggest this is one of the most aggressive world-stock funds. So it's particularly interesting that managers Brian McMahon and Vinson Walden have found compelling opportunities in corporate bonds and preferreds. But keep in mind that despite the fund's hybrid stake, the portfolio packs enough risk overall to be rocked in any sudden market panic attack.

Nuveen Tradewinds Value OpportunitiesCombined Preferred Stock and Convertible Weight: 11%
This is another example of a fund that goes its own way. Veteran skipper Dave Iben will place massive bets against the benchmark if he sees great long-term prospects elsewhere. For example, this mid-blend fund currently has a huge stake in energy and industrial materials and an especially heavy emphasis on gold stocks. Hybrid securities are also a permanent feature of Iben's strategy. His keen eye for value and company fundamentals has allowed the fund to drub rivals in both 2008 and thus far in 2009, which is a rare feat. We would like the fund even more were expenses to come down.

Arijit Dutta does not own shares in any of the securities mentioned above.