Convertible bonds - a Solvency II silver bullet?
Insurance companies are looking to access equity-like returns with lower risk and capital requirements. In the first of our 'Insurance Strategy’ articles, we explain why convertible bonds offer a compelling solution.
The investment problem
Investors are looking for risk-efficient and capital-efficient ways to access the return potential of equities. The yield on the iBoxx Euro Corporates A 1-3 index has declined from over 7% in 2009 to below 50bps at the beginning of 2016, illustrating the magnitude of the challenge faced by insurers looking for fixed rate cash flows with which to meet liabilities.
No one wants to be exposed to 2008-style losses, but the price of option protection is penal. Some have increased their allocation to equity and other risk assets with higher potential returns, but these expose one to more risk and of course higher Solvency II market risk capital charges.
Convertible Bonds as a solution
A potential solution to the risk and capital challenge of investing in equities is offered by convertible bonds i.e. bonds that have a fixed maturity like a bond, but which also have an investor-option to convert the holding into the equity of the issuer at a fixed price.
A convertible bond’s trading behaviour can be split into three different regimes. At either extreme we see bond-like behaviour and equity-like behaviour. In between these two regimes the convertible bond’s price is ‘floored’ by the market valuation of the fixed income payments of the bond but, at the same time, able to rise if the issuer’s equity price rises. This gives the convertible bond the ability to capture more equity price upside than downside.
Positive convexity and the price behaviour of convertible bonds
Source: Schroders, for illustrative purposes only
We believe convertible bonds are a compelling proposition for three reasons:
- They allow investors to gain equity exposure with a far lower Solvency II capital requirement than an equivalent direct equity position in stocks.
- They provide a useful element of downside protection, more cheaply than buying option protection
- They have a favourably asymmetric risk profile (positive convexity) offering the ability to capture more equity market upside than downside.
For a deeper discussion, please get in touch with your Schroders Insurance Asset Management representative here.