The Investment Opportunity in Convertible Bonds for Insurance Companies

The investment environment for insurance companies continues to be complex with many considerations weighing on investment allocation decisions. Heavily indebted municipalities have largely avoided credit events, but risks remain. Emerging Market credibility has eroded leading to increased market volatility. The risks of unprecedented Central Bank policies are not fully understood, but stimulus has bolstered global fixed income, equity, and real estate valuations. Since December 31, 2009, equity investors have been generously rewarded with the S&P 500 Index generating a total return of 107.5%[note]Zazove Associates, LLC, a Delaware limited liability company (“Advisor”) has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS). Advisor is a registered investment advisor and the successor to Zazove Associates, Inc., an Illinois corporation that transferred its investment advisory business on January 1, 1995 to Advisor. Zazove Associates, Inc. is the managing member of Advisor.[/note] through June 30, 2015. With many valuation measures suggesting caution, and underlying economic fundamentals sending mixed messages, investments that balance upside potential with downside risk management are optimal.

This paper will provide an overview of the Convertible Securities market, recent trends in the asset class, the role that Convertibles should have within an Insurance Company Portfolio, and the current risk / reward profile of the sector.


What is a Convertible?

As a hybrid investment, a convertible security combines the stability of an interest bearing debt instrument with the long-term total return potential of common stock ownership (Exhibit 1). Most convertible securities are issued as traditional debt instruments with an embedded call option to convert and receive the value of the underlying common stock. For investors, the sector offers participation in equity market appreciation with substantially lower downside risk relative to a direct equity investment. From an issuer’s perspective, the convertible market offers a lower cost of capital relative to traditional debt issuance with the potential for equity dilution at a reasonable premium to current market prices.

Exhibit 1:

Convertible Bonds 1

Asymmetric Risk Reward Profile of Convertibles

Convertible security valuation is dependent upon the intrinsic value of each piece of the investment (Exhibit 2). The value of the embedded call option is tied to the underlying equity share price, volatility, time, and interest rates. The value of the bond component is dictated by its fixed income attributes: term, interest rate, credit quality, and liquidity. When combined, these two values create a valuation curve with a simple, yet compelling return proposition: unlimited upside potential with
limited downside risk.

Exhibit 2: Convertible Values are Influenced by Stock and Bond Factors

Convertible Bonds 2

An Overview of the Convertible Market

According to Bank of America Merrill Lynch data, the Global Convertible market has a value of $375 billion, with approximately 60% of issues in North America and the remainder largely split between Europe and Asia (Exhibit 3). In the years following the credit crisis, convertible market growth failed to keep pace with traditional investment grade and high yield markets. For a period of time, the straight debt markets were too attractive for issuers and convertible new issue supply hit a trough in 2012. Subsequent years saw increasing new deal flow, but maturities, redemptions, and conversion activity exceeded primary market supply (Exhibit 4). With consistent supply and slowing redemption activity in 2015, organic growth in the convertible market is expected to continue.

Exhibit 3: Convertible Universe Metrics (As of 6/30/2015)

Convertible Bonds 3

Source: Zazove Associates, LLC

Exhibit 4: Convertible Issuance & Redemption History (2015 Annualized)

Convertible Bonds 4

Source: Zazove Associates, LLC

An example of a recent new issue convertible security is the $1.725 billion transaction from Microchip Technology (MCHP), a mid-cap provider of semiconductors. The 10-year deal priced at 1.625% with a 40% conversion premium and had unique, attractive features and metrics. The bonds featured full dividend protection (conversion ratio increases for all dividends paid on common stock) as well as incremental embedded warrants above a specific stock price level. The bond’s delta, or equity sensitivity, of 82% and premium to bond floor of 30% at pricing produced one of the most asymmetric risk / reward profiles we have seen this year. While the bonds received an unsolicited ‘BB-‘ rating from Standard & Poor’s (NAIC 3FE equivalent), we view the company’s credit metrics as consistent with Investment Grade quality.

The Microchip transaction is indicative of a multi-year trend in the marketplace: a sizeable and growing portion of the U.S. convertible market is issued without credit ratings. According to Barclays Capital Research, as of June 30, 2015, 47% of the U.S. convertible market is non-rated versus 36% at December 31, 2012. Among new issues this year, 76% of deal flow has come to market without ratings. With more than half of 2013 and 2014 new supply also coming to market without credit ratings, this is a trend that is likely to continue. We attribute this pattern to a few factors: 1) an abundance of low cost financing available to investment grade rated industrial companies in traditional debt markets, 2) greater ‘growth capital’ needs in the mid-cap sector, and 3) domestic convertible buyers de-emphasizing rating agency ratings. Insurance companies may purchase non-rated securities, provided a request for credit review from the NAIC’s Securities Valuation Office is completed within 120 days of purchase. AAM completes these filings on behalf of clients, to ensure compliance with regulatory requirements.

AAM/Zazove Convertibles for Insurance Companies

AAM has partnered with Zazove Associates (“Zazove”) since 1991 to deliver expertise in convertible securities management to insurance companies. Zazove’s investment philosophy is distinguished by its statistical focus on convertible structures that optimize the asymmetrical risk/reward characteristics of a portfolio. The strategy seeks to build portfolios that capture approximately 70% of the upward movement in equity markets with less than 40% downside participation in periods of equity market declines.

The primary advantage of Zazove’s disciplined approach is the resulting consistency of downside risk control, regardless of market environment. Convertible investment premium, a measure of downside risk exposure, measures the excess value of a convertible security relative to the embedded bond value. In practice, a higher investment premium indicates greater convertible sensitivity to potential negative equity movements. Exhibit 5 displays the historical investment premium of Zazove’s convertible strategy relative to the convertible market. Recent divergence, highlighted below, further evidences the discipline of Zazove’s risk-controlled approach relative to the equity bull market driven convertible indices.

Exhibit 5: Historical Investment Premium Displays Downside Risk Control of AAM/Zazove Institutional Investment Grade (IIG) Convertibles

Source: Zazove Associates, LLC

The consistency in Zazove’s approach to risk/reward has resulted in superior performance for insurance companies with an allocation to this strategy. Zazove’s Institutional Investment Grade Convertible Composite[note]The composite was created on September 1, 1991 and includes all fee paying discretionary portfolios over $200,000 managed for Qualified Institutional Buyers under the Zazove Institutional Investment Grade Convertible Strategy, which mandates an investment grade average convertible securities portfolio with certain exposures allowed for BB rated securities and foreign securities and certain diversification requirements with regard to industry, issuer and security. Portfolios managed under this strategy are allowed to have certain exposures to convertible preferred stocks and foreign securities and provide for certain diversification requirements with regard to industry, issuer and security. [/note]has outperformed the S&P 500 with significantly less volatility[note]Portfolios that have significant additions of capital are excluded from the calculations for a month on the following basis: (i) if the cash balance at the beginning of the month is greater than 15% of the portfolio’s market value and is the result of an addition of capital by investor, (ii) if, as a result of an intra‐ month addition of capital by investor, average capital for a month is greater than 25% of the portfolio’s market value at the close of the prior month, or (iii) if, as a result of an intra‐month addition of capital by investor, average capital for a month is greater than 15% of the portfolio’s market value at the close of the prior month and the ending cash balance is greater than 15% of the portfolio’s market value. A portfolio is excluded from the calculations for a month in which the account is considered non‐discretionary as a result of specific instructions by investor (e.g., account liquidation, trading freeze, sell instructions). Additional information regarding policies for calculating and reporting returns is available upon request. [/note]. During quarterly periods with positive S&P 500 performance, the Convertible strategy captured nearly 70% of the upside movement. Importantly, outperformance was driven by the ability to manage downside risk with the strategy experiencing only 31.6% of the downward movement during negative equity market quarters.

Exhibit 6: AAM/Zazove IIG Convertible Performance History Demonstrates the Asymmetric Risk/Reward Opportunity (8/31/1991 to 6/30/2015)

Convertible Bonds 6
Source: Zazove Associates, LLC

The returns for the Zazove Institutional Investment Grade Composite are reflected both “Gross” before management fees and “Net” after management fees. Benchmark returns include reinvestment of interest/dividends. Past results are not a guarantee of future performance. See “Notes to Performance Summaries” for additional information that is an integral part of this paper.

Zazove’s focus on structure, and consequently its performance track record, is dependent upon the breadth of the market. The stability in new deal flow and net positive supply forecast described in Exhibit 4 are very healthy indicators for the convertible market and provides the opportunity to construct and maintain a diversified portfolio with optimal risk / reward characteristics.

AAM/Zazove Convertibles as a Complement to Insurance Companies’ Core Fixed Income Assets

Convertible bonds offer a compelling diversification benefit for insurance portfolios as they exhibit a low correlation to investment grade fixed income securities. As seen in Exhibit 7, Zazove Institutional Investment Grade Convertible portfolio performance has displayed far greater correlation to equity market returns than to high grade bonds[note]Composite dispersion for any period is calculated by the standard deviation of asset‐weighted portfolio returns represented in the composite for the entire period. Number of portfolios, composite assets and firm assets are determined at the close of the period. [/note]. From an interest rate risk perspective, convertible bonds have historically exhibited strong performance during periods of rising interest rates. As seen in Exhibit 8, since 1991 periods of poor performance for bond investors have coincided with positive returns for equity investors with average total returns of 12.5%. Over the same time period, Zazove Institutional Investment Grade convertible investors were rewarded with an average total return of 8.6% during periods of rising interest rates.

Exhibit 7: AAM/Zazove IIG Convertibles Have Exhibited a Low Correlation with High Quality Fixed Income (8/31/1991 to 6/30/2015)
Composite Zazove IIG Composite (Net)
Zazove IIG Composite 1.000
Barclay Aggregate Bonds 0.83
10-Year Treasury -0.051
S&P 500 0.823

Source: Zazove Associates, LLC

The returns for the Zazove Convertible Composites are reflected both “Gross” before management fees and “Net” after management fees. Benchmark returns include reinvestment of interest/dividends. Past results are not a guarantee of future performance. See “Notes to Performance Summaries” for additional information that is an integral part of this paper.

Exhibit 8: AAM/Zazove IIG Convertibles Average Historical Performance during Periods of Rising Rates (8/31/1991 to 6/30/2015)[note]Composite returns are presented both “Gross” before management fees (i.e., gross returns) and “Net” after management fees, but after trading expenses and non‐reclaimable withholding taxes. Both Gross and Net returns are before custody expenses, if any. Net returns are determined by applying Advisor’s basic fee schedule for a portfolio managed under the Zazove Institutional Investment Grade strategy (1% annual rate of assets under management). Management fees are described in Advisor’s Form ADV Part 2A. The impact of management fees on investment returns is illustrated in the above schedule. [/note]

Convertible Bonds 8
Source: Zazove Associates, LLC

The nine rising rate periods ≥ 100 bps are: 10/31/93-11/30/94, 1/31/96-5/31/96, 9/30/98-1/31/00, 10/31/01-3/31/02, 5/31/03-7/31/03, 6/30/05-6/30/06,12/31/08-12/31/09, 8/31/10-3/31/11, 4/30/13-8/31/13.

Historical average annualized total return for the strategy, illustrated in Exhibit 9, has outpaced the S&P 500 with volatility measures approximately in line with a 10-year Treasury note. Critically important for investment grade fixed income owners, current market yields suggest low future total returns for high grade bond investors. The addition of Zazove convertibles to an investment grade fixed income portfolio enhances potential total return with a small effect on overall risk.

Exhibit 9: Historical Return and Volatility Measures, Coupled with Correlation Statistics Make Convertibles a Compelling Component of Insurance Company Portfolios (8/31/1991 to 6/30/2015)

Convertible Bonds 9
Source: Zazove Associates, LLC

The returns for the Zazove Convertible Composites are reflected both “Gross” before management fees and “Net” after management fees. Benchmark returns include reinvestment of interest/dividends. Past results are not a guarantee of future performance. See “Notes to Performance Summaries” for additional information that is an integral part of this paper.

Statutory Accounting Rules and State Regulations Treat Convertibles as Bonds

In addition to compelling economic advantages, convertibles benefit from favorable regulatory, rating agency, and accounting treatments due to NAIC guidance. For Life Insurance companies, convertible securities have virtually no ‘mark-to-market’ risk as NAIC quality ‘1-5’ bonds are carried at amortized cost. Property & Casualty companies will carry non-investment grade rated convertibles at the lower of cost or market, but nonetheless produce balance sheet volatility that is materially lower when compared to a direct investment in common stocks.

Convertible bonds also receive favorable treatment over equities in companies’ risk-based capital (RBC) and rating agency capital calculations. As displayed in Exhibit 10, AAM/Zazove Convertibles have approximately 83% lower C-1 RBC when compared to a direct investment in common stocks[note]The benchmark: Merrill Lynch All U.S. Convertibles‐Investment Grade Ex Mandatory (V0A1).[/note].

Exhibit 10: C-1 Asset Risk of Convertibles & Common Equities
Zazove Convertibles 1.9% 3.9%
Unaffiliated Equity 15.0% 22.5%‐45.0%

Source: AAM Investment Analytics, NAIC

Insurance companies that made, or held, equity investments in the aftermath of the financial crisis have been rewarded as the current bull market approaches its seventh year. Equity market exposure has grown organically as a result, particularly in the P&C space, with unaffiliated equities as a percentage of surplus growing from 26.4% to 36.6% since December 31, 2009[note]A complete list and description of firm composites is available upon request.[/note], which can be seen in Exhibit 11. Current market valuations have risen above long-term historical averages and suggest that further stock market appreciation will necessitate earnings growth, rather than through multiple expansion.

Exhibit 11: Property & Casualty Industry Unaffiliated Equity Exposure (% of Surplus)

Convertible Bonds 11
See “Notes to Performance Summaries” for additional information that is an integral part of this paper.

Insurers looking to lock in gains achieved in recent years should consider an allocation to convertibles for the reinvestment of proceeds. The unique attributes of the asset class offer investors continued capital appreciation, should markets rally further, with meaningfully less downside risk exposure. The regulatory and accounting treatment of the asset class add to the value proposition the sector offers to insurance companies.

An investment in convertibles is not without risk, which should be carefully considered by investors. As indicated by historical total return, volatility, and correlation measures, convertible performance is largely driven by equity market movements. As such, individual security and diversified portfolio returns would be expected to be negative during periodic equity market declines. Zazove’s strategy seeks to limit the downside participation to less than 40% of the negative performance of the equity market.

Historical financial market performance[note]Historical performance data reflects actual past performance and is not a guarantee of future performance.[/note] has demonstrated that equity investments outperform bond investments through market cycles. In return for the potential of superior returns, equity investors assume the risks of the periodic downward movements in risk assets. On the heels of a sustained market rally, we believe that insurance company investors looking to manage downside risk should take a close look at AAM/Zazove Convertible strategies as a means to achieve these goals.

Written by:


Timothy J. Senechalle, CFA
Senior Portfolio Manager


Allison A. Weisnacht, CFA
Portfolio Manager

End Notes:

  1. Bloomberg L.P. Total return including reinvestment of dividends into Index from 12/31/2009 to 6/30/2015.
  2. Equivalent credit quality assessment and cost of debt capital provided by Zazove Associates, LLC.
  3. Note: Portfolio returns are reflected before management fees. See “Notes to Performance Summaries” for additional information that is an integral part of this paper.
  4. Source: Zazove Associates, LLC. Correlation of monthly total return from 8/31/1991 to 6/30/2015
  5. Rising interest rate performance statistics capture periods with monthly 10-year Treasury increase accumulating to 100 basis points or greater.Source: Zazove Associates, LLC
  6. Source: AAM investment accounting and analytics
  7. Source: SNL Financial, Inc. Unaffiliated common stock exposure measures as of 12/31/2009 and 12/31/2014

Notes to Performance Summaries – AAM/Zazove Institutional Investment Grade Composite

Convertible Bonds Notes 1

Impact of Management Fees on Investment Return

The following Schedule illustrates the effect of management fees on a portfolio that obtains consistent returns at the specified annual rate, while incurring management fees at the beginning of each quarter equal to one- fourth of the annual fee.

Convertible Bonds Notes 2

For more information, contact:
Colin T. Dowdall, CFA
Director of Marketing and Business Development

Neelm Hameer
Vice President of Business Development

John Olvany
Vice President of Business Development

30 West Monroe Street 3rd Floor
Chicago, IL 60603-2405

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

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