When most people think of investments, they want three things: significant appreciation potential, current income and safety of principal. Neither stocks nor traditional bonds offer all three. Convertible bonds do, and it's a hard combination to beat.
The term "convertible bonds" may or may not be self-explanatory. First of all, convertible bonds are, indeed, bonds. So, they promise interest and principal as long as the issuer remains solvent. But they also allow holders to convert into shares if the stock has appreciated meaningfully.
Most studies pitting convertible bonds against stocks find that over extended periods, they have delivered competitive returns with substantially less risk. Offering principal protection, they are also less susceptible to panic selling during down stock markets.
Convertibles have performed nearly as well as stocks, and far better than traditional bonds, this year. Roughly speaking, convertible bonds currently pay interest rates of 2 percent to 3 percent and should offer between one-half to two-thirds of the underlying stock's upside.
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Some of the most successful convertible investors follow a strategy akin to the bowling philosophy of "make the spares and the strikes will take care of themselves." In other words, when picking convertibles, these managers look for companies they expect will comfortably remain in business for the life of the bond. This is a lot less risky than picking stocks.
In a portfolio of companies built to survive, a moderate number will likely see their underlying stocks rise sharply. A larger number will probably chug along. As long as the portfolio manager is careful to avoid—or at least quickly dispose of—potential deadbeats, the strategy works remarkably well.
Frank Partnoy, a law professor and expert on securities law, wrote a book called "Wait" about the benefits of putting off decisions. Convertible bonds are a perfect example of these benefits. If you are deciding between putting your money into bonds or stocks, you're faced with these pros and cons:
No wonder investors are struggling to decide.
If you're like Partnoy, you will try to delay the choice. One way to do so: convertibles.
In general, when stocks win big, convertibles provide solid returns and trounce bonds. If stocks prove overextended, convertibles will experience some near-term losses. But their holders will feel a lot less pressure to sell, knowing that the companies that issued the convertibles are obligated to pay the money back.
Convertibles will sometimes give you a better outcome than either stocks or bonds in any given year. But they will almost never give you a worse result than both. When rates rise, it's probably because the economy is rising. Stocks likely are, too. Convertibles can go along for the ride. An asset blending stocks and bonds often turns out a better choice than either of its flawed components. Call it "hybrid vigor."
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Convertible bonds, though, are not for everyone. Before you invest, make sure you've considered several things.
While individuals can buy convertibles, most turn to professional managers. Convertibles have features, such as various embedded options, that inexperienced investors might overlook. Also, since convertible bonds are traded almost entirely over the counter, individuals don't face the level playing ground offered by online stock trading. Managers of significant pools of convertible assets—typically $500 million or more—possess negotiating clout that results in lower day-to-day trading costs and the opportunity to influence the pricing of new deals.
One benefit of the stock market is that it still offers plenty of choices, even though the number of publicly traded companies has been in steady decline. There are far fewer convertible bonds to choose from—somewhere around 500 in the U.S., or about one for every 10 stocks. So if you have a specific company you want to buy, it may not have a convertible.
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As you might guess from the relatively small number of issuers, the convertible market is tiny in comparison to the stock and bond markets. The total value of the domestic market is about $225 billion—somewhere around 1 percent of the value of the stock market. That is not a constraint for individual investors or small-to-midsize institutions. It does, however, pose a challenge for some of the really big fund managers.
Some managers fill their portfolios with "convertibles in name only" (CINOs). Not all convertible securities are bonds. The most insidious ones, mandatory convertible preferred shares, are dressed up to resemble bonds but don't offer principal protection. They're really just the underlying stock with a higher dividend—and you pay for the extra dividend up front. These securities are best avoided.
Other managers of convertible funds buy long-dated bonds that don't promise the return of capital for 10, 20 or even 30 years. Such bonds tend to be far more sensitive to changes in both interest rates and stock prices than shorter-dated convertibles. It's better to stay with shorter-dated bonds.
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Finally, some investors object to convertibles because they often lag stocks in bull markets, particularly in the near-term, even though over full market cycles convertibles have often outperformed stocks. Viewed in this light, convertibles become an increasingly attractive alternative. Convertible veterans have an expression reflecting how the bonds reward patient investors: "You get paid [in coupon income] to wait." Partnoy would probably approve.
—By Bill Feingold, special to CNBC.com. Feingold is a portfolio manager at Wellesley Investment Advisors with two decades of experience in convertible bonds. He has been a visiting lecturer at Yale University and has authored two books, including "Beating the Indexes: Investing in Convertible Bonds to Improve Performance and Reduce Risk."