We spoke with Conning to discuss the potential role of convertibles within insurer portfolios. Highlights from the discussion include trends in the global convertible market, maturities that are currently available in the market, and how convertibles have behaved in market downturns.
To learn more about convertibles, see the recent Conning ViewPoint here.
SAA: What is Conning seeing in terms of trends in the global convertible market?
Conning: Recently, we have seen the number of higher quality non-U.S. dollar pay issuers expanding in the market. Both the number and the dollar value of the issuers has increased, including a wider variety of industries which helps improve portfolio diversification.
Non-U.S. dollar pay issuance has increased since 2017 from 27% at the end of 2017 to 42% at the end of the second quarter of 2019. However, the market value of non-U.S. dollar pay convertibles still remains relatively small, as it comprised only 12% of total global dollar pay convertibles through the second quarter of 20191.
Conning believes that international exposure within a convertibles portfolio can help enhance both sector and quality diversification. The addition of non-U.S. issuers helps the portfolio achieve a roughly equal exposure across delta categories (<30%, 30-70%, >70%), improve the overall credit quality of the portfolio through the increase of allocations to investment grade convertibles (AAA-A and BBB), and enhance sector diversification.
SAA: How is current convertible issuance compared to its history?
Conning: There are two primary sources of convertible issues – newer companies that typically issue convertibles before they enter the traditional corporate bond market and more mature companies that issue convertibles when they need to raise equity-like financing.
A recent example of a new company that recently raised financing capital was Tesla. First, the company issued convertibles and then, subsequently, issued high yield bonds at a point when the company was viewed to be more established. Other established companies whose first bond issues were convertibles included LinkedIn (before being acquired by Microsoft) and Twitter.
The other primary source of convertible issues are mature companies that issue convertibles as a form of equity financing, which is often used to fund an acquisition. It has also been used to adjust balance sheets to appease investor or rating agency pressure. Recent examples include Anthem, which issued convertibles to help fund the firm’s purchase of Amerigroup, and Fortive, which issued convertibles to facilitate the acquisition of Advanced Sterilization Products. Examples of companies utilizing convertible issuance to protect a credit rating include Johnson Controls in 2009. Just prior to the Global Credit Crisis, a number of financial institutions issued convertibles in late 2007 through early 2008.
Convertibles issuance often picks up later in the economic cycle, reflecting increased demands by companies raising equity capital to strengthen their balance sheets. As the economic recovery from the global credit crisis has gotten older, 2018 issuance was at the highest level since 2009. Thus far in 2019, issuance has been tracking slightly lower than what the market saw in 2018 but is still on pace to be higher than every other year since 20092.
The Tax Cuts and Jobs Act of 2017 reduced the benefit and appeal of debt financing which should shift the mix over the long term. In 2018, we began to see a shift back to equity issuance as a result of the cap on tax deductibility of interest as a percentage of income phases in3. There has also been a lot of discussion in the market about the increase in the number of BBB issues as well as a number of (often BBB rated) acquirers whose financial metrics are worse than their ratings based on expectations of merger benefits promising deleveraging in the future. These are the types of companies that would typically issue in the convertible market if they need to strengthen their balance sheets when the economy weakens late in the cycle.
SAA: Convertibles issuance typically had 30-year maturities (pre 1990s). What kinds of maturities are available in the market today?
Conning: Convertibles have been present in the market since 1874. For the first 100 years, issuance was typically for longer maturities and investors often discussed convertibles using rules of thumb analysis like the payback period (premium paid over the equity price divided by the convertible’s yield advantage over the common stock). However, as computing capability expanded through the years, more sophisticated options modeling capabilities were developed. This has led to an extensive increase in the diversity of convertible structures issued.
41% of the convertibles issued in today’s market have maturities or first puts at issuance of 6 years or less, and 62% have maturities of less than 9 years4. The first 5-year issue was a Home Depot convertible in the early 1990s. Treasury rates were above 7% but Home Depot was able to issue at a 4.5% coupon which was viewed in the media as a very low rate. However, the advantage of the 5-year structure was that it enabled them to lower their coupons because their bond floor was higher due to the shorter maturity. This feature was then enhanced in future issues by adding shorter maturity puts that also served to raise bond floors. The varying terms that were introduced back then, continues today.
SAA: How have convertibles behaved in market downturns?
Conning: The fixed income value of a convertible is designed to provide support to convertible pricing in down equity markets. Looking at the historical returns of both the ICE BofAML Investment-Grade Convertible Index (ex Mandatories) Index and the S&P 500 Index, the data shows that to be the case on both a quarterly and annual basis. The best examples of the bond floors holding up well were in 2000-2002 after the dot-com bubble burst when the S&P 500 Index declined by 37.6% while the ICE BofAML Investment-Grade Convertible Index (ex Mandatories) Index returned -1.6%.
The only quarter where the convertibles index underperformed was during the third quarter of 20085. In early 2008, several of the large banks (Bank of America, Citigroup, FNMA, Lehman Brothers, and Wachovia) had improved their capital position in the convertible market, but ended up either declaring bankruptcy or having large credit concerns that caused their fixed income floors to decline sharply in the third and fourth quarters of 2008.
Bond market selloffs generally do not cause havoc for convertibles as they historically have a higher correlation with stocks than they do with bonds (80-90% vs. 20-25%)6. Since 1990, during periods when 5-year Treasury rates have risen more than 75 basis points, convertibles have typically responded with positive returns6. The ability of convertibles to provide capital gains in a rising interest rate environment is especially important for insurance companies, that naturally maintain a concentration in fixed income assets.
Source: Strategic Asset Alliance, Conning
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About Conning: Conning (www.conning.com) is a leading investment management firm with approximately $145 billion in global assets under management as of June 30, 2019.* With a long history of serving the insurance industry, Conning supports institutional investors, including pension plans, with investment solutions and asset management offerings, risk modeling software, and industry research. Founded in 1912, Conning has investment centers in Asia, Europe and North America.
*As of June 30, 2019, represents the combined global assets under management for the affiliated firms under Conning Holdings Limited, Cathay Securities Investment Trust Co., Ltd. (“SITE”) and Global Evolution Fondsmæglerselskab A/S and its group of companies (the “Global Evolution Companies”). The Global Evolution Companies are affiliates of Conning. SITE reports internally into Conning Asia Pacific Limited, but is a separate legal entity under Cathay Financial Holding Co., Ltd. which is the ultimate controlling parent of all Conning controlled entities.
©2019 Conning, Inc. All rights reserved. The information herein is proprietary to Conning, and represents the opinion of Conning. No part of the information above may be distributed, reproduced, transcribed, transmitted, stored in an electronic retrieval system or translated into any language in any form by any means without the prior written permission of Conning. This publication is intended only to inform readers about general developments of interest and does not constitute investment advice. The information contained herein is not guaranteed to be complete or accurate and Conning cannot be held liable for any errors in or any reliance upon this information. Any opinions contained herein are subject to change without notice. Conning, Inc., Conning Asset Management Limited, Conning Asia Pacific Limited, Goodwin Capital Advisers, Inc., Conning Investment Products, Inc. and Octagon Credit Advisors, LLC are all direct or indirect subsidiaries of Conning Holdings Limited (collectively “Conning”) which is one of the families of companies owned by Cathay Financial Holding Co., Ltd. a Taiwan-based company.