Stock market volatility has caused many investors to question their commitment to buying individual stocks. This combined with a decade of flat to slightly negative stock market returns has stoked a debate over whether buy-and-hold investing makes any sense going forward.

Defensive-minded investors looking to lower equity volatility while still capturing the upside from bull-market returns should consider adding convertible bonds as an asset class. Convertibles combine some of the best features of bonds and stocks. The bond component offers income potential through a coupon payment and downside protection because a convertible trades more like a bond in a declining market and principal is returned if there is a standard maturity date.

The opportunity to convert the security into stock means investors can participate in a rising stock market as well as the sales and profit growth at the underlying company. The upside may not be as great as buying the company’s stock outright, however. Additionally, the yield will generally be below that of a standard company bond, but the combination can be very appealing and represents a unique opportunity to lower volatility but still leave upside potential.

One inconvenience is that it can be difficult to locate convertible bond offerings. Like bonds, they trade over the counter and require working with a broker to locate a particular bond or look over an inventory list at the brokerage house. This is opposed to centralized stock market exchanges where active quotes can be obtained and liquidity makes it easy to get in and out of positions.

One more wrinkle is that convertible securities can contain put and call features. The first is generally advantageous to investors in that it allows the holder to force the issuer to buy back the security at a pre-defined price and potentially lock in a gain. Similarly, the issuer can add a provision that would allow it to call the convertible back from investors. This generally puts the investor at a disadvantage compared to the issuing company.

Here is a more specific example as discussed in a recent interview with a fund manager. The manager mixes up his portfolio with stocks, bonds, and convertibles and holds one of each security in Time Warner (NYSE: TWX). Regarding the Time Warner convertible, the manager recently estimated a +13% to +14% return if the stock price increases +20%, but only -5% downside if the stock price falls -20% — in other words, the downside risk of a bond but a good deal of upside in the stock.

A current potential opportunity stems from a convertible bond offering from embattled offshore driller Transocean Ltd. (NYSE: RIG). The bond in question has a coupon of 1.625% and has a current yield to maturity in excess of 7% because negative sentiment and concerns over its liability from the Gulf oil spill have sent the bonds below par value. The bonds are put-able back to Transocean on December 15, 2010.

Action to Take —> For investors concerned about continued stock market volatility, adding convertible bonds to your investment repertoire is a great idea. The Transocean convertible bond represents a short-term profit opportunity for more enterprising investors. Otherwise, there are countless other convertibles to consider for investors looking for downside protection from traditional stocks.

A final option is to invest in an exchange-traded fund (ETF) that invests in convertible bonds. For example, Barclays has the SPDR Barclays Capital Convertible Securities (NYSE: CWB) fund, which is an ETF that seeks to match an index of convertible bonds traded in the United States. The fund currently yields 3.3% and has returned +27.05% since its inception in April 2009. As you would expect, its returns have lagged the market since that timeframe, as the market has been up overall, but volatility has been less and it should provide downside protection during the next difficult market environment.