A panel of insurance portfolio management experts examines the potential risk-adjusted return benefits of pairing fixed income securities with equity options within insurance portfolios.
- John Weber
- August 2019
INVESTMENT DISCUSSION: Invesco executives (from left) Chris Marx, managing director and head of institutional insurance; Pete Miller, an insurance research strategist and part of Invesco Global Solutions and Rob Young, portfolio manager and head of institutional convertibles, participated in the AM Best webinar “How Insurance Portfolio Managers Are Leveraging Equity Enhanced Fixed Income.”
Portfolio managers are leveraging equity enhanced fixed income. It's a new way to look at convertible bonds. A panel of experts examined the potential risk-adjusted return benefits of pairing fixed income securities with equity options within insurance portfolios, during the AM Best webinar, “How Insurance Portfolio Managers Are Leveraging Equity Enhanced Fixed Income,” sponsored by Invesco.
Participating in the webinar from Invesco were Chris Marx, managing director and head of institutional insurance; Pete Miller, an insurance research strategist and part of Invesco Global Solutions and Rob Young, portfolio manager and head of institutional convertibles.
Following is an excerpt from the webinar.
How has the convertible bond market changed over the past several years?
Young: The convertible market has changed dramatically over the past decade. First, the size of the market is only $190 billion, which is very small for an actual asset class, and it's down about 50% in size since 2008.
In addition, the credit quality profile of the asset class has changed. Fifteen years ago, investment grade securities were 40% to 45% of the market, and nonrated securities were only 15% of the market. Now, that's completely changed. It's reversed.
Investment grade is only 15% of the market, and nonrated securities have surged to over 60% of the market, and because of that, it's been very difficult for insurance companies and other institutional investors to invest in the asset class.
Why has this market become smaller?
Young: The main reason is the low interest rate environment that we've been in for the past decade. Convertibles are a submarket rate coupon instrument by design, by nature and so they already have a very low coupon, a low yield.
Companies don't need to use them, because they can use the traditional bond markets to raise capital, and don't have to give up an equity option like they would in a traditional convertible.
As bonds have been maturing and are being called or put, or bought back from the market, there hasn't been a lot to replace them.
How have the insurance companies approached the convertible market?
Marx: If you look back over an extended period of time—let's say 20 years—you'll find that insurance companies have been active in the convert space.
Post a global financial crisis, the converts market has shrunk dramatically, particularly in the investment grade convert space.
Along with that, you saw allocations to converts within insurance general account portfolios shrink as well. They rolled off, and for the most part, over the last three to five years, converts have generally been an overlooked asset class.
However, that's changing, and there's an emerging interest in the convert space, particularly with a little bit of an uptick in converts allocation.
One of the drivers of the interest in converts is where we are in the economic cycle, where we are relative to a long-in-the-tooth bull market, with investment decision-makers thinking about, how should their equity allocation or equity-like allocation look? Should there be a downside protection component, or a derisking profile put into in an allocation?
Can you address the topic of interest rates? What's a new way to look at convertibles, and how might insurers assess this asset class?
Young: We have a very interesting strategy called equity enhanced fixed income. When you think about a traditional convertible bond, it's essentially just a bond and an equity option stapled together as one security.
We view that as very rigid and inefficient, because you can't separate the components and make a different investment decision on each one. You might like the credit, or you might like the equity of the issuer of the convertible, but you might not like the bond exposure or the equity exposure that's in the convertible.
We take a totally different approach, and we source our convertible exposures from the broader equity and fixed income markets, and we put them together in a way that replicates a traditional convertible profile. In this way, we can customize the individual components.
For the fixed income component, we can buy fixed rate versus floating rate bonds. We can buy short-dated versus long-dated bonds, or senior versus subordinated. And we can attach to that, equity options that are either in the money, at the money, or out of the money, depending on our views.
Is there a benefit to this bond structure?
Young: There's basically three main benefits to the structure. One is a broader investment universe, the second is liquidity and the third is customization. From an expansion of the universe, most S&P 500 companies don't issue convertibles because they don't have a reason to do so.
We can create custom convertible profiles for them as if they did. We can use those in our portfolio, and that really broadens our universe.
From a liquidity standpoint, we're buying and selling our exposures from the natural buyers and sellers of those exposures, and so we don't have to package them up like a convertible and transact as a package. That really improves our liquidity profile.
Lastly, customization. We can customize individual securities. We can also customize how we use those securities in a portfolio. Some clients have a higher level of equity sensitivity need, and some have a lower equity sensitivity need, and we can customize and build portfolios for them without effecting our portfolio construction process.
How's this strategy treated for accounting purposes?
Miller: It is important to recognize that historically, a lot of companies may have shied away from convertibles for a couple of reasons on the accounting front.
One is a bit of concern around income statement volatility coming from the equity component, and the other is the complexity that's inherent in accounting for the bond and the equity components separately.
We think that with this strategy that we're discussing today, you'd still have a similar accounting treatment where, for GAAP accounting, you'd look at the bond piece and the equity option piece separately.
You have to recognize that the income statement volatility is lower than if you were just investing in equities directly. You get that participation, but the income statement volatility would be less than if you were just buying stocks directly.
The other thing to keep in mind with this strategy is the transparency. We're putting bonds and equity options together, and by virtue of that structure, we can easily point to the components distinctly and work with insurers to account for those. It's a very straightforward exercise to do that.
How would you use such a structure in a portfolio context?
Young: Convertibles have a very interesting risk return profile. They tend to act like stocks when the stocks are rising, and they tend to act like bonds when stocks are falling, so they fit very naturally and attractively into a larger portfolio between traditional fixed income allocation and a traditional equity allocation.
Miller: The work that our group has done, and the solutions team, a lot of times we're looking at multiasset portfolios that might have a fair amount of equity exposure as well.
We've seen this dynamic, where when you look at a convertible strategy or a convertible replication strategy alongside equities and fixed income, you do see that the strategy will give you that equity upside performance in rising markets. On the downside, when stocks are doing poorly, you do see that the left tail, if you will, the downside risk, is diminished, because it really does behave a lot more like fixed income in that environment.
That's something that really resonates and is attractive with a lot of institutional investors, and particularly insurance companies.
How do you think different types of insurance companies view this strategy?
Miller: Insurance companies of all types could find this compelling, but actually, perhaps, for different reasons.
Life companies tend to be significantly oriented toward fixed income. It's largely a function of their liability structure, the nature of their business.
For those types of companies that are starting from a very high fixed income allocation to begin with, this type of strategy could be a nice, modest step, if you will, in the direction of higher return risk asset allocation, rather than going all the way to a full on equity allocation. This is kind of a bridge to that destination.
On the other side, think about P/C and reinsurance companies, those companies that tend to have a bit of a higher equity allocation to begin with. They may look at it from a different perspective, and say, “I don't want to necessarily completely get out of equities or undo that allocation.”
This expansion has been a little bit long in the tooth. We're now 10 years on in the bull market. Folks are starting to think about when the next recession might hit, when risk assets might take a bit of a turn.
I think for those insurance companies that do have that equity allocation to begin with, this type of strategy could be a nice complement, where they get that downside buffer if we do get a risk-off type of market.
What do you see as the implications to risk- based capital?
Miller: We think that's probably, if not the biggest, one of the biggest strengths of this type of strategy. It's very similar to what we've seen in the traditional convertible market, where by virtue of looking at a package of fixed income investment with equity option investment, for RBC purposes, it's really getting a fixed income capital charge. It's a great way to get some equity upside participation via that option piece, but the RBC treatment looks like any other bond. Since we tend to look at investment grade as the basis of a lot of this strategy, that could be a really compelling reason for companies to look at this, where they can get that upside performance with a very modest RBC charge.