Equity and fixed income investing overlap in an asset class called convertible bonds. This unique asset class, which offers an attractive risk/return combination and thus, provides investors with more controlled risk, is often misunderstood and underutilized. That’s unfortunate. When uncertain which way the stock and bond markets might head, one can lower risks and hedge investment bets by buying convertibles. One popular use: hedge funds and other speculators have long used convertible bonds to hedge short positions in common stock.

Convertibles are a hybrid breed of security that combines a non-convertible (“straight”) bond or preferred stock with a warrant, the right to acquire the underlying company stock at a fixed predetermined price.

Because of their dual nature, convertible bonds present a way to earn some yield while keeping some leverage to a stock’s upside potential. If a security trades well below the conversion price, a convert acts more like a bond; when the underlying stock appreciates, so does the convert. The closer the price of underlying stock gets to the predetermined conversion price, the more the convertible exhibits its stock-like qualities.

But because there is no free lunch, the lower risk of a convertible security goes hand in hand with its smaller (than an equity position) exposure to the upside. In other words, the potential to capture the stock’s upside is limited. Also, the current yield on convertible bonds is usually lower than that available  on comparable straight bonds issued by the same company.

These two sides of the convertible security determine its price, and they also define how these securities react to factors such as the level of interest rates (“fixed income part”) and the changes in the price of the underlying stock (“equity” or warrant, price).

Meanwhile, just as with stocks or straight bonds, plenty of factors can make a convertible security more or less risky. In the case of these hybrids, risk factors include, for example, the current price and the current price of the underlying stock; the securities’ protection level against a call (whether for refinancing or otherwise); the time until it is scheduled to mature; its yield to maturity; its quality as an investment; and given its maturity date, its sensitivity to changes in interest rates, up or down. Just as with bonds, long time horizons in a rising rate environment would depresses value more.

These securities tend to perform best in times of rising equity markets and falling interest rates, such as that witnessed for the last several years. At such times, the direction of both stock and bond markets would tend to increase the value of convertibles.

We are entering, most economists agree, a period of rising rates. Does this mean that investors should abandon convertible securities in favor of other asset classes? We don’t believe so. And this is why.

The prospect of a market with rising interest rates and falling equities is the worst kind for convertible securities. It would tend to depress prices on both bond and warrant portions of the hybrid. Still, the solutions is for investors to focus on issues from companies with high-quality credit ratings.

In a falling equity market with flat interest rates, the bond-like characteristics of convertibles provide better downside price support. If investors anticipate such an environment, they would want to buy or own issues with high premiums above the conversion value and low premiums over the investment value. These “busted” convertibles offer the most protection, as the “busted” feature means the convert trades more like a bond, which immunizes the holdings somewhat against declines in stocks.