Hedge Your Bets With Discounted Convertible Bonds

| About: Ellsworth Fund (ECF)

The fixed income market isn't a popular place to be in today's environment, with interest rates and yields that remain near record lows. But, equity investors may be a little skittish given lofty valuations and a potential end to easy money from the U.S. Federal Reserve. So, where should investors put their money in these uncertain times? One option is convertible bonds.

Bridging the Gap with Convertible Bonds

Convertible bonds are hybrid fixed income securities that convert into equity if/when the issuer's share price rises above an agreed upon price per share. If the shares prices don't rise, the bonds are redeemed at par value of usually $1,000.00 at maturity. The yields on convertible bonds may be lower than conventional bonds, but unlike these conventional bonds, convertible bondholders can partake in any equity upside in an issuer's stock.

According to Forbes, the U.S.'s $200 billion in convertible bonds offer an average yield of 3% with an average rating of BB-, which is three notches below investment grade. These bonds have risen more than 13% so far this year, however, due to the rising stock market compared to the negative returns seen in many conventional non-convertible bonds. As a result, these securities may offer investors the perfect option as a bet in both worlds.

Playing Convertible Bonds with Ellsworth

Ellsworth Fund Limited (NYSEMKT:ECF) is a diversified, closed-end management investment company that specializes in these convertible bonds. With a broad portfolio that invests in everything from aerospace to pharmaceuticals, investors have access to significant diversification that has helped its stock remain stable with a beta coefficient of just 0.7. The fund also pays a healthy 3.1% dividend yield that's roughly on par with the 3% yield mentioned above.

The company's credit rating exposure as of year-end 2012 is:

And the company's industry exposure as of year-end 2012 is:

The 20% exposure to BBB, 18% exposure to BB and 18% exposure to B rated securities are characteristic of convertible bonds. Meanwhile, the oversized exposure to telecom and pharmaceuticals suggest a robust portfolio, given that these two sectors tend to generate very stable cash flows over time with few problems servicing their debt. Companies within this portfolio include well-known names ranging from Intel Corporation (NASDAQ:INTC) to U.S. Steel (NYSE:X).

Stable & Trading at a Discount to Net Assets

Aside from its usefulness as a hedged bet, Ellsworth Fund can be acquired at a roughly 9% discount to net asset value with no leverage clouding the pool. The figure above shows that the fund had total investments of around $110,434,231 and total net assets of $113,939,366, as of year-end 2012, which is about 9% less than the June 3, market capitalization of ~$105 million, which creates a unique buying opportunity/margin of safety for investors at these levels.

The margin of safety is further enhanced by its modest aforementioned beta coefficient of 0.7, which suggests that it's 30% less volatile than the S&P 500. Since 2008, the fund has also reduced its expense ratio from 1.3% to 1.1% and reduced its portfolio turnover from 61x to 39x, according to previous article written by Robert Lewis. Net asset value returns in FY 2012 totaled a healthy 17.75% with only a modest 2.82% loss in FY 2011.

Income investors can appreciate the company's stable 3.1% dividend yield that is significantly higher than the equity market's average ~2% dividend yield, while growth investors can appreciate its 13.5% gain over the past 52 weeks. While this is lower than the S&P 500's 22.4% return over the same time period, the fund outperformed many other fixed income investments, like the PIMPCO ETF Trust (NYSEARCA:BOND) that's up under 3% over the same period.

Risks & Other Considerations

Ellsworth Fund is a micro-cap stock with a market capitalization of $105 million and an average of just 24,000 shares traded per day. Those looking to invest in the stock should be aware of the limited liquidity and use limit orders when buying and selling the stock. Investors should also be sure to make the stock a part of a diversified portfolio, making sure that it replaces a portion of both equity and bond exposure given its convertible nature.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.