Bond values are expected to fall as interest rise. Stocks may be overvalued and could plunge in a weak economy and volatile environment. So what's an investor supposed to do?

Convertible securities can offer a good option for investors seeking diversification to protect themselves against risk.

Convertible bonds are hybrids, with characteristics of both bonds and stocks. They offer yields like bonds, and their owners have the option of exchanging them for the issuing company's stock at a predetermined price.

Editor’s Note: 5 Reasons Stocks Will Collapse . . .

"Many investors think of convertible bonds as a straight bond with an embedded call option," explains Morningstar senior fund analyst Timothy Strauts in a column on his firm's website. "Because this embedded call option has some value to the end investor, the interest rate on a convertible will tend to be lower than that for a standard fixed-rate bond."

It's surprising investors are not more interested in them, he says. Morningstar's convertible-bond category has returned 7.6 percent annualized the past 20 years, beating the 7.3 percent return for large-blend stocks. Plus, their risk level, as measured by standard deviation, is 22 percent lower than the large-blend category's is.

"Based on their track record, it would seem as though convertibles offer a compelling risk-adjusted return and could be a relatively less risky alternative to traditional equity investments."

If the stock value falls, the convertible behaves more like a bond and trades based on its yield, he explains. If the stock rises, the convertible acts more like the company's common stock.

"Owning a diversified basket of both of these 'types' of convertibles in a fund blends the beneficial aspects of stocks and bonds together," Strauts writes. "The 'equity-like' securities provide downside protection and income if the market performs poorly."

Money managers expect convertibles to offer about two-thirds of stock market returns, but just half as much in a downturn, says MarketWatch columnist Chuck Jaffe, noting that convertibles historically perform better than fixed-income securities when interest rates are rising.

"The equity portion of the convertible market pulls it along with the equity market, so that's been positive for convertibles in a rising interest rate environment," said John Calamos, CEO of Calamos Convertible Securities, whose fund recently reopened to new investors, according to MarketWatch. "So you have many investors looking at convertibles as part of their fixed-income asset allocation."

The average convertible fund had an annualized return of 8.75 percent over the last five years, compared with almost 10 percent for the average high-yield bond fund, Jaffe notes. Over the past 12 months, however, convertibles gained 6.1 percent, while junk bond funds gained 1.1 percent.

Editor’s Note: 5 Reasons Stocks Will Collapse . . .

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