Convertibles and Solvency II: Preaching to the unconverted
Joseph Mariathasan asks whether convertible bonds might offer Solvency II-regulated investors some equity upside with a limited capital charge
The Solvency II capital requirements (SCR) provide the critical framework that defines the attractiveness of asset classes for most EU insurance companies. Its aim is to match the capital requirements of insurance companies to the risks that they are undertaking.
On that basis, convertible bonds appear to come across very well. They can offer a significant portion of the upside of equities for capital charges that can be half those required for straight equity investment.
At AXA Investment Maanagers, portfolio manager Marc Basselier explains that there are three dimensions to the economic analysis of any potential investment in convertibles: “First, is the volatility, which we measure using the Sharpe ratio; second, is the maximum loss drawdown and; third, is the solvency capital charge.”
Dan Mannix, CEO of RWC Partners, which manages a range of convertible bond funds, points out that under Solvency II insurers may need to reduce equity holdings to reduce their capital charges.
“In that case, will there be a large shift of assets to the bond market?” he asks. “Will an increase in bond demand lead to lower bond yields, and will this reduce funds’ projected returns and increase liabilities? The key attraction to convertible bonds may therefore be to mitigate the immediate concerns of insurance and pension funds.”
SCRs for assets are based around the market risks they are exposed to, which comprise risks associated with interest rates, equity, property, spreads, currency and concentration. Convertibles are theoretically part fixed income and part equity, through their embedded equity options. But, as Amaury Boyenval, portfolio manager at AXA IM, points out, convertibles are more equity-like than bond-like.
“Convertible bonds do not currently give any income in this low-interest-rate environment, with companies issuing zero-coupon convertibles,” he says. “The fixed-income attributes of convertibles are important only for downside protection – so convertibles are products that give exposure to equity with less volatility and downside protection. They are not comparable to debt instruments.”
The fixed-income attribute of convertibles provides downside protection if the equity value falls, but investors are exposed to the credit risks inherent in a corporate bond. As a result, the more speculative the credit, the greater the SCR. Long-dated bonds also have higher SCRs than shorter-dated bonds. Convertible bonds have a shorter maturity profile than the high-yield bond market; nearly 50% of the market that is rated comes from investment grade issuers, but around 50% of the total market is unrated.
“Such securities have a better treatment than high-yield under Solvency II, as the shock applied to unrated credit spreads attributes a rating of between BBB and BB,” says Thomas Perez, head of convertibles at Aberdeen Asset Management.
However, the really critical aspect with regard to the CSR of convertibles is their ‘convexity’ – the ratio of upside to downside equity-risk exposure. If the convertible provides 64% of the upside participation with only 34% of the downside movement, then the convexity ratio is 1.88. In other words, the convertible provides 88% more upside participation than downside risk.
“You reduce the maximum drawdown by around 50% compared to equity, giving rise to a corresponding reduction in volatility, which means the Solvency II capital charge is reduced by around 50%,” explains Boyenval. “For pure equity, the capital charge is 39% while for a convertible it would be 20%.”
On a standalone basis, a convertible portfolio with the same expected returns as an equity portfolio could potentially have a lower capital charge but, as Perez explains, it is also true that mixing convertibles in with a straight equity-and-bond portfolio can also lower the overall capital charge.
“If you start with a balanced 50/50 portfolio and then introduce a certain allocation to convertibles, you could preserve the same risk-return profile and equity risk exposure, while reducing the SCR as a result of the convexity inherent within convertibles”
“If, for example, you start with a balanced 50/50 portfolio and then introduce a certain allocation to convertibles, you could preserve the same risk-return profile and equity risk exposure, while reducing the SCR as a result of the convexity inherent within convertibles.”
Most insurance companies contacted by IPE had little to say on the potential attractiveness of convertible bonds as an alternative to equity divestment, as it is an area they are still clearly getting to grips with. But with Solvency II due to be implemented on 1 January 2016, there is likely to be increased interest in the opportunities afforded by convertible securities.
Convertibles have always been popular in France where there has been large market issuance since the late 1990s.
“They have also been very popular in Switzerland, but less so in other markets such as Germany and Italy,” adds Boyenval. “However, since 2008 we have seen interest in Italy and Germany catching up rapidly with France and Switzerland. AXA IM sees this as a direct result of the Solvency II capital charge framework.”
Convertibles have not proved popular in Scandinavia, possibly because of a perception that they are issued only by distressed companies. This was the rationale offered for Finnish pension insurer Varma by its spokesperson Leena Rantasalo: “Varma does not invest in convertibles. In the domestic market convertibles have traditionally been used for funding distressed companies. As we are statutorily obliged to invest ‘securely’ we have abstained from investing in convertibles.” There is also little evidence that any of the Solvency II-regulated pension entities have any convertible investment.
Practitioners in the asset class feel that these are misperceptions. Rated or not, the universe splits about equally between high-yield and investment-grade in terms of fundamental credit risk; and Boyenval in particular says that he would not invest in anything lower than a BB-rated credit because of his clients’ risk constraints.
Although companies in growth sectors like technology tend to be more active issuers than those in defensive sectors, Perez argues that sector diversification is perfectly possible, and that issuance has been plentiful from property companies and utilities.
Moreover, managers like AXA IM report that clients that used to only invest in Europe – or even specific countries like France, have recently started switching to global convertible bond mandates, following the established trend in traditional equity and bond portfolios.
Insurers are still getting to grips with the full implications of Solvency II, particularly given the long lead time to its implementation and the changes that have arisen during this period.
“It may therefore follow that large allocations could be made, strengthening conviction and leading to an increase in AUM,” says Mannix. “More issuers will want to participate and the depth of both the investor base and the securities available could increase.”
But, as Perez points out, the size of the convertibles market relative to equity and bond markets is very small. As a result, even a small shift into convertibles could potentially create enormous demand. Perhaps more insurers should be taking a closer look sooner rather than later.