Investing in a hybrid asset class: Why insurers should consider allocating to convertible bonds
- More insurers are considering adding convertible bonds to their balance sheet, as a way to gain exposure to equities in a capital efficient manner.
- The recent volatility in markets led to a dramatic cheapening of the asset class, typically only witnessed during periods of market dislocation.
- However, our analysis shows that an investment in convertible bonds can offer a significant return pick-up without adding risk to the balance sheet.
The benefits of convertible bonds
In simple terms, convertible bonds may be considered as a hybrid of corporate bonds and equities – benefiting from the features of both asset classes. As such, convertibles offer a return pick-up compared to corporate bonds through their sensitivity to equities, while they have a low capital requirement compared to traditional equity investments.
Although insurers are increasingly looking to gain exposure to convertible bonds, the asset class does not yet represent a large share of the typical insurance balance sheet. However, from an asset liability management (ALM) point of view, convertibles can help provide insurers with exposure to equities in a capital efficient manner.
Adding convertible bonds to a strategic asset allocation
I. Risk/return trade-off
To highlight the benefit of investing in the asset class, Exhibit 1 plots the incremental changes in expected return, surplus volatility and the market risk capital requirement arising from reallocating 0.5% to 2.5% of an existing investment into one of the broad asset classes in the investment universe. The intersection of the y axis and x axis represents a typical life insurance portfolio.
From a surplus volatility point of view, assets in the top left quadrant would help diversify the portfolio (reducing surplus volatility) and increase expected return. We can see that convertible bonds would offer a significant pick-up in return without adding risk to the insurance balance sheet.
From a market risk solvency capital requirement (SCR) perspective, most asset classes sit on the right hand side of the chart and therefore cause an increase in SCR. However, the allocation to convertible bonds is more efficient than allocating to developed and emerging market equities.
Exhibit 1: Adding convertibles to an insurance portfolio
II. Strategic asset allocation results
To support our analysis, we conducted an asset allocation optimisation exercise that seeks to minimise surplus volatility for varying levels of expected return. We considered two scenarios – one with and one without convertible bonds – and plotted the two efficient frontiers in Exhibit 2. For an equivalent level of surplus volatility, adding convertible bonds to the asset allocation generates an additional 20 basis points of expected return. The allocation to convertible bonds is funded mainly from European government guaranteed bonds, developed market equities and infrastructure equity.
Exhibit 2: Asset allocation scenarios
Efficient frontier – CBs increases the expected return by 20bps
Strategic asset allocation and expected returns
Convertible bonds and the SCR spectrum
Convertible bonds offer a spectrum of market risk SCR characteristics for investors. We have created our in-house market risk SCR calculation methodology, which in our view adequately reflects the capital requirements for a range of convertible bond strategies. We offer three open-ended convertible bond strategies and manage additional segregated portfolios for insurance clients across the spectrum.
Exhibit 3: SCR calculation methodology
Why invest in convertible bonds now?
The volatility in markets since the COVID-19 outbreak led to a cheapening of the asset class, marking an attractive entry level. We believe this valuation opportunity and a resurgence in primary market issuance has created opportunities for both balanced and income-focused opportunistic strategies. While markets rebounded strongly since the initial correction in the first quarter of 2020, volatility and implied credit spreads remain high.
Exhibit 4: Convertible bond implied spread versus high yield option-adjusted spreads
We believe the market currently provides attractive valuations and still offers a good entry point into the asset class, especially in comparison to straight bonds where credit spreads have already largely retracted to pre-crisis levels. There are three factors that explain why convertible bond spreads have stayed at elevated levels:
- Central banks are targeting government bonds and credit with their quantitative easing programmes, not convertible bonds;
- Investors have fewer opportunities to exploit market dislocations via tactical asset allocation in the convertible market given the limited offering of passive investment vehicles (exchange-traded funds);
- Record new issuance has suppressed prices in the convertible bond secondary market.
Opportunities provided by new issuance
2020 convertible bond new issuance is the strongest since the global financial crisis. This strong supply provides the opportunity to build exposure to quality companies trading at a significant discount to their intrinsic value that need to strengthen their balance sheet through new issuance.
New convertible bond issues can represent an attractive opportunity for investors, since convertible issuance simultaneously strengthens the issuer’s balance sheet while creating a catalyst for its share price to re-rate. Issuers will also find convertibles an attractive financing tool since convertibles can provide lower coupon costs than straight debt by selling the right to convert the bond into shares, effectively offering investors access to potential equity upside.
Exhibit 5: Total convertible issuance (USD)