Though it’s still too early to tell how 2009 will play out, convertible bonds have outpaced common stocks thus far in January. That’s a bullish development considering the massacre stocks witnessed last week following more news affecting the distressed financial sector.

To be sure, convertibles did pull back last week as stocks declined. But they’re still winning the race in early 2009.

For the first half of January convertibles have rallied about 0.5% versus a loss of 5.7% for the S&P 500 Index. Some of the better-managed funds in this sector like Vanguard Convertible Securities Fund have gained 1.7%.

In 2008, the worst year for the markets since 1931, stocks tanked more than 37% while convertible bonds fell almost 38%.

Starting in August, the convertible bond market literally shutdown following massive hedge fund liquidations and forced selling of securities. Last year was the worst calendar year loss on record for convertibles.

Hedge funds have  dominated this market over the last ten years employing a popular strategy called convertible bond arbitrage, which involves buying or selling a company’s convertible and shorting or going long a competitor’s common stock. That strategy came to a halt in late August as liquidity evaporated and has only started to heal again since November.

Convertible bonds are a hybrid asset class with about $500 billion in market capitalization. Banks have historically dominated the universe with about 40% of all outstanding convertibles issued by the financial sector. The asset class remains a popular and cost-effective avenue for companies to raise funds.

Convertibles offer equity-linked returns tied to a company’s growth prospects while allowing the holder of the security to convert to common stock at a future date. At the same time, they also pay income – and yield almost three times more than the S&P 500 Index or about 9%.

The only caveat for convertible investors now is the ongoing collapse of the financial sector and how this event will affect convertibles.

For the most part, the largest issuers of convertibles are large-cap banks and these issuers won’t fail since the U.S. government now guarantees most bank IOUs. Still, investors should largely avoid most convertibles in the bank sector or at the very least buy a diversified convertibles portfolio harbored by an experienced asset manager with a solid track record. Many convertibles are still trading at historically cheap conversion premiums to their underlying equity component and offer great values.

For investors looking to bottom-fish in a bear market, convertible bonds probably offer the safest way to play a future bull market or a rally. Risk-adjusted returns should improve going forward though I would still expect volatility until the banking sector finally stabilizes.

The important variable to remember about convertibles is that these securities pay high income – something that’s absolutely vital in today’s low interest rate world. They’re also a much safer option than stocks.