Finding the sweet spot between the yield of an asset and its capital charge has become a core consideration for EU insurers. Convertible bonds may represent a golden opportunity, as Benedicte Gravrand reports
Convertible bonds belong to a range of "smarter" equity-like investments; they have a versatility that usually goes with hybrids, and compared to equities they carry less risk and require less capital to be held against them.
Insurers tend to view convertibles in a positive light as they provide diversification to traditional bond holdings, Mathilde Sauve, insurance solution strategist at Axa IM, the investment management arm of Axa Group, told Insurance Asset Risk.
"The risk profile of convertibles is low – their expected return is between investment grade credit and equity – but with a Solvency II capital charge of only 15% versus equity investments at 39%. The risk-return profile is also compelling as the product behaviour and regional/sectorial exposures can bring diversification without adding excess volatility and drawdown."
There are no public disclosures as to which insurers invest in convertible bonds and how much, but she estimates that the average allocation to convertible bonds is less than 3% of a typical portfolio, compared with the allocation to equities which averages 10% in Europe.
According to Marc Basselier, manager of the Axa WF Framlington Global Convertibles fund, a downside of holding convertible bonds is that the universe is smaller (around $350bn globally) and less liquid than comparative bond and equity markets, and that limits their use in global asset allocation.
Also, convertibles can behave less efficiently than a mix of bonds and equities, "when the demand for convertible bonds overtakes the supply and high valuations lead to performance that is below expectations," he says.
How convertibles work
Instead of issuing stocks and risk being seen as overvalued, a company may opt to issue convertible bonds instead. These bonds have a fixed maturity but can also be converted into a fixed number of shares of common stock. Investors pay for that optionality by way of lower coupons than they would get with regular corporate bonds. The option to convert becomes desirable if the stock performs well. But if the option is not exercised, the investor is stuck with a low-yielding bond. From a risk management perspective, investors are protected from a downward move in the stock price because the value of the convertible bond will not fall below the value of the traditional bond component, known as the bond floor.
More drawdown risk mitigation
According to UK-based asset manager Schroders, convertible bonds offer a compelling solution for insurance company CIOs who are looking to access equity-like returns but with lower risk and capital requirements.
Insurers with investment products containing guarantees have been struggling to meet the minimum return requirements with investment-grade corporate bonds. The yield of the iBoxx Euro Corporates A 1-3 index has declined from more than 7% in 2009 to less than 50 basis points at the beginning of 2016, for example. Investing in growth assets to generate higher returns is an option, but the Solvency II capital charge on equities, for example, makes an allocation to this asset class prohibitive.
From a risk management point of view, Schroders claims that convertible bonds offer more drawdown risk mitigation than equities. This could be seen in 2008 and 2009, when the maximum drawdown experienced by equities was more than 50%, while an actively managed convertible bond fund analysed by the firm lost half as much.
"The convertible bond fund "captures more of the upside than it captures of the downside of the equity market. This is positive convexity, the holy grail of investing."
From an investment standpoint, Schroders compared the returns of a long-only convertible bond fund to the equity market and found that the fund on average participated in more than 80% of the upside in the MSCI World All Country Index over six years. The fund captured less than 50% of the negative return.
The convertible bond fund "captures more of the upside than it captures of the downside of the equity market. This is positive convexity, the holy grail of investing," Paul Forshaw, head of insurance asset management at Schroders, tells IAR.
From a capital treatment perspective, as convertible bonds are a hybrid equity/bond instrument, their overall charge is a combination of equity, credit spread and interest rate charges.
"The convertible bond's capital charge is lower for all values of underlying equity other than when the stock price falls so much that the equity exposure of the convertible bond is negligible," says Schroders. In some cases, the credit capital charge dominates, in others, the equity capital charge dominates. "This charge is far lower for convertible bonds than it is for equity because the convertible bond's floor acts to protect its value when the equity stress is applied."
"We are finding, particularly from the smaller insurance companies, that they are not necessarily able to invest in derivatives," notes Clara Yan, insurance asset liability management director at Schroders. "They require approval from the board to get access to downside protection. Convertible bonds are one area they can delve into more easily than your standard hedge strategy."
Investing in convertibles does present a few challenges. Their optionality needs to be considered from an ALM perspective, says Forshaw: "Because of their embedded equity exposure, convertible bonds are more difficult to use as liability matching assets from a duration management perspective, but an allocation to a fund within a broader portfolio to generate extra return can add a lot of value."
From a risk management perspective, the key issue would be around data and modelling, Yan explains. As it is a hybrid instrument, the data and the modelling need to cover both the bond and the equity elements for the embedded risk to be analysed.
SCR issue
Gareth Mee, executive director, EMEIA Insurance at Ernst & Young, a consultancy firm, thinks the main downsides of convertible bonds are found in the additional solvency capital requirement (SCR) compared to corporate bonds, as they contain equity risk. However, this is balanced against the upside that they carry less SCR compared to equity, he adds.
"It depends how you are painting the picture."
Convertible bonds also carry underlying uncertainty on future cash-flow profile, which makes them more complex for ALM than bonds. "Though again, they have some certain cash flows which compares favourably to equities," he adds.
"In general, it depends how you are painting the picture. You can paint a picture comparing to fixed income in which case the upsides are additional return potential and the downsides are the SCR and ALM. If you paint the picture comparing them to equities, you give up some additional return in favour of lower SCR and more certainty."
Mee also points out that convertible bonds are more complex than vanilla strategies and require a model to value them.
"And, because it's a more niche field, the fees associated with the strategies tend to be higher than vanilla strategies."
Addressing the asymmetry
Lombard Odier Investment Managers, the $49bn asset management business of Swiss bank Lombard Odier, sees the benefit of convertible bonds from the perspective of asymmetry in life insurers' business model i.e. dealing with shareholders and policyholders. Whereas the later have to be honoured regardless of the investment returns and profitability, which tend to fluctuate, the former only profit from the insurer's positive investment returns.
"Convertible bonds are often seen as a natural candidate to deal with the insurer's conundrum," Lombard Odier IM says in a paper, Long-only convertible bond investments for insurance companies.
There is a parallel between insurers' needs and the structure of the convertible bond: the fixed income component can be used to cover the claims and financial guarantees of policyholders, while the equity option can help grow the insurer's assets.
As for the balance sheet advantages, the charts below compare balanced convertible bonds with equities and high-yield corporate bonds over the past ten years.
From the regulatory balance sheet perspective, Lombard Odier IM considers the following metrics:
- Solvency-adjusted Sharpe ratio [a measure for calculating risk-adjusted return], measuring the return of the investment versus the level of solvency ratio volatility it generates.
- Return on regulatory capital under Solvency II, measuring the return of the investment versus the Solvency II capital charge it implies.
From the accounting balance sheet perspective, the asset manager looks at:
- Sharpe ratio, measuring the investment's return versus the level of net income volatility it generates.
Sourced from www.e-fundresearch.com
"Convertible bonds are a sensible solution for insurers as opposed to mainstream growth strategies which tend to be expensive in terms of balance sheet volatility and regulatory capital," Mehdi Guissi, head of insurance and pensions solutions at Lombard Odier Investment Managers, tells IAR.
"Since the implementation of Solvency II, we have found ourselves having more conversations with insurers about how they can use convertible bonds to mitigate all these factors. Insurers on the continent, particularly those in France, are well versed in the role convertibles can play. But UK insurers are only just starting to explore this investment avenue."
Convertibles are not a scalable solution, as the universe is still relatively small (the convertible bond market is around $350bn), so they are not a complete substitute for equities or fixed income. But they have obvious attractions in a diversified portfolio.