By Lewis Braham

As the manager of the Franklin Convertible Securities fund, Eric Webster has a mission: Capture 75% of the upside of stocks, while facing only 50% of the downside in more challenging markets.

Seeking such an asymmetric performance trade-off -- less upside for more downside protection -- is typical for investors in the hybrid securities known as convertible bonds, which have qualities of both stocks and bonds. Yet the ICE BofA U.S. Convertible Index returned 19.0% in 2025, beating the S&P 500 index's 17.9%. Convertibles are also winning this year, up 5.9% versus the S&P 500's 0.1%.

That isn't supposed to happen. "Convertibles have actually been out of favor since the end of 2021, and that's because they didn't provide the downside protection in 2022 and then they didn't capture the upside participation in the market in 2023 and 2024," Webster says.

He blames it on the market dominance of artificial-intelligence stocks. That started to change in 2025, "when we saw broadening out of the market," he says. "Convertibles are an asset class that is going to benefit from that."

Convertible bonds pay interest and have principal protection and maturities, but when the stocks of their issuers climb above a certain target price, they can be converted to stock shares. The bonds' principle protection is defensive, while the conversion feature provides much of the upside. For the bond to convert, the stock must typically rise 20% to 30% above its price at the convertible's issuance.

Can the good times continue? Convertible bond fund managers think so. The indexed iShares Convertible Bond exchange-traded fund has a low 0.20% expense ratio, but some active managers have beaten it. During the slow period that the sector experienced in the past five years, the Franklin fund produced a 3.9% annualized return versus the ETF's 2.1%, although it underperformed more recently, as it tends to be more defensively positioned.

The Fidelity Convertible Securities fund has proved adept at both offense and defense, outperforming in 2022's downturn and matching the benchmark more recently. "A lot of the convertibles that were issued in 2020 and 2021 ended up losing their equity sensitivity when their stocks traded down" in 2022, says Rick Gandhi, the fund's co-manager. The further away a falling stock is from the bond's conversion price at issuance, the less sensitive to the stock's moves the convertible becomes.

If a stock falls 50% below the bond's conversion target price of $10, it must recover from $5 to $10 -- or 100% -- before the bond has 100% equity sensitivity to the stock's price moves.

But all of that has now changed for the better. "Generally speaking, convertibles have a five-year maturity, so a lot of those bonds that were issued in 2021 need to be refinanced in 2026, and issuers don't want to wait until the last minute," Gandhi says. "So, we've had a lot of very good issuance, where companies have taken out very low equity sensitivity bonds and issued [new convertibles] with better risk profiles. When that happens, as the equity starts to do well, you participate in that."

The fund has notably benefited from a surge in certain tech stocks rising above their bonds' conversion prices -- such as hard-drive makers Western Digital and Seagate Technology, both up more than 300% in the past year.

But this isn't just a Big Tech stock story. "It's going to be a continuation of what we saw in the back half of 2025," says manager Ethan Turner of Virtus Convertible, another top fund. "A lot of these smaller companies have been in an earnings downturn since 2022. As they get more comfortable with the economic outlook and their earnings recovery, they're coming to the convertible market to fund their growth."

Bonds of smaller companies such as infrastructure construction company Granite Construction sit beside blue-chip tech stocks like Western Digital in Turner's portfolio. Both could do well in this environment.

Write to editors@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

February 18, 2026 02:00 ET (07:00 GMT)

Copyright (c) 2026 Dow Jones & Company, Inc.