Since the global financial crisis, persistently strong equity markets and muted volatility have led to a prolonged period of market complacency. Recent movements in equity volatility, combined with the prospect of rising interest rates may prompt investors to search for investment strategies that can help capture potential equity upside while also mitigating risk. Meanwhile, interest rates and credit spreads have remained low by historical standards, making it increasingly difficult to find attractive risk-adjusted returns in traditional fixed income markets. Many insurers have been moving further out the risk spectrum, allocating more to equity and alternatives – yet this naturally increases concern about downside risk.
Previously, insurers have used convertible bonds in their portfolios. The public convertible securities market has contracted meaningfully in size over the past decade (particularly the investment grade segment), often trades rich to theoretical value, and as a result, offers less opportunity to identify attractive investments. Traditional convertibles are also rigid in design and provide limited flexibility to adequately reflect a manager’s investment views.
We believe a unique way to manage this challenge is by pairing fixed income securities with equity options that seek to attain the stability of fixed income securities with equity upside. This approach – what we call equity enhanced fixed income (EEFI) – can offer investors an attractive return profile while providing equity risk management capabilities. And importantly, it can be done in a capital- efficient way.
An EEFI strategy can be a complement or an alternative to traditional convertibles, providing the same attractive profile but through larger, more liquid investment universes with opportunities for greater portfolio customization. A critical advantage of EEFI is that the fixed income and equity components can be tailored independently to reflect compelling investment views, and the embedded equity exposure can be customized to introduce various degrees of equity sensitivity to a portfolio.
In this paper, we provide a brief refresher on the fundamental characteristics of convertible securities and then explore three compelling reasons why we believe an EEFI strategy can and should be part of a well-balanced portfolio.
TRADITIONAL CONVERTIBLES AS A PROXY FOR EEFI
Despite the current headwinds in the public convertibles market, in our view, the asset class offers an effective proxy to illustrate the attractive risk/return profile of a broader EEFI strategy.
Combines performance characteristics of stocks and fixed income securities
As illustrated in Figure 1, convertibles have captured a large portion of equity market returns over both short and longer time periods, across a wide variety of market conditions.
Figure 1: Convertibles have consistently participated in equity upside and have also outperformed corporate bonds
Dark Blue: BAML U.S. Convertibles | Medium Blue: S&P 500 index | Aqua Blue: Barclays aggregate index
Source: Bloomberg L.P., as of June 30, 2018. Past performance is not a guide for future returns.
Additionally, over these same periods, convertibles have outperformed the Barclays US Aggregate Bond Index.
A) Strong defensive characteristics may help mitigate downside equity risk
Although convertibles offer equity- like returns, they have historically provided attractive defensive characteristics relative to equities. Convertibles have a coupon and a fixed maturity date at which time principal is repaid to the investor if the conversion feature is out of the money. This can help absorb equity drawdown risk.
Figure 2 illustrates the rolling five- year drawdown capture ratio of the Bank of America Merrill Lynch US Convertible Index relative to the S&P 500 Index. Over the 15-year period ending 6/30/18, the downside capture relative to S&P500 most often falls with the 60-80% range. Annualized volatility was also markedly lower compared to equities across these time periods.
Figure 2: Convertibles may offer lower drawdown and lower absolute risk than equities
Lower drawdown and lower absolute risk than equities
Source: Bloomberg, as of June 30, 2018. Past performance is not a guide to future returns.
B) Strong performance in rising rate environments
Convertibles have historically performed well during rising rate environments due to their lower interest rate duration and embedded equity exposure. Figure 3 highlights the attractive total return of convertibles during periods when the 10-year Treasury yield rose by more than 100 basis points over the past 25 years. The time periods when this occurred are of varying lengths; however, in all periods, convertibles significantly outperformed traditional fixed income.
Figure 3: Convertibles have performed well in rising rate environments
Strong performance in rising interest rate environments
Dark Blue: BofA Merrill Lynch® All U.S. Convertibles Index | Medium Blue: S&P 500 Index | Aqua Blue: Barclays U.S. Government Credit Index
Source: Bloomberg, as of June 30, 2018. Rate changes measured by the US 10 Year Treasury Note. All returns annualized for periods over 1 year. Past performance is not a guide to future returns.
Clearly, convertibles have offered benefits across various equity market conditions and were well positioned in rising rate environments. An EEFI strategy builds on these features. We believe it provides a more efficient way to replicate public convertibles and an expanded investment universe which, in turn, can offer greater ability to tailor solutions with specific risk/ return characteristics.
WHY WE BELIEVE THERE ARE THREE COMPELLING REASONS TO CONSIDER AN EEFI STRATEGY:
1. Attractive risk/return profile
Unlike traditional fixed income and equity return profiles which are linear in nature, EEFI return profiles are convex (i.e., non-linear), as illustrated in Figure 4., EEFI combines a bond (e.g., corporate bond or Treasury bond) with an equity option that together possess performance characteristics similar to a convertible security. This allows a manager to replicate a convertible security’s return profile for a company that may not have any convertible debt outstanding.
Figure 4: Convex nature of EEFI return profile provides a risk/return dynamic not found in traditional equity and fixed income products
Dark Blue: Convertible price | Medium Blue: Equity value of convertible | Aqua Blue: Bond value of convertible
For illustrative purposes only. Sources: Invesco and Bank of America Merrill Lynch.
EEFI and the embedded equity convexity feature can provide a number of advantages such as opportunities for customization, diversification, and yield potential, creating a very powerful risk/ return dynamic typically not found in other strategies. By carefully combining fixed income and equity features, this strategy may offer greater risk control of the overall portfolio and allows for more efficient positioning at various points across the risk/return spectrum.
More importantly, the equity convexity feature is most powerful and influential within the balanced portion of the return profile. Equity sensitivity in this region is dynamic (i.e., not static) because it changes as underlying stock prices change – as stocks rise, equity sensitivity increases by a greater degree, and as stocks fall, equity sensitivity falls. In other words, EEFI is designed to offer an asymmetric return: more upside participation than downside as equity markets move higher or lower. For investors who want to participate with rallying equity markets, but simultaneously want some level of downside risk mitigation should equity markets decline, the structural features of EEFI can potentially offer an attractive investment alternative. It is this feature that makes EEFI most unique.
2. Broader investment universe and greater liquidity
The universe of public convertible securities has become smaller and more concentrated over the last decade due to the large number of securities called, put or matured relative to the number of new issues brought to the market. Rather than being constrained by a small market size, an EEFI approach offers access to a broader set of liquid market securities. As illustrated below, these broader markets are significantly larger than the global public convertibles market. However, an EEFI strategy still has the ability to invest in the public convertibles market if there are compelling investment opportunities there, as the public convertibles asset class is simply a subset of the larger strategy.
Invesco Equity Enhanced Fixed Income
Access to Broader Capital Markets
Source: Bloomberg L.P. As of June 30, 2018
The larger universe also provides important liquidity features. The equity and fixed income components of the strategy can be bought and sold independently within their respective markets, rather than being sold as a combined, single security. This provides a significant liquidity advantage, especially during challenging market environments. In short, a manager can tactically pair securities in terms of the companies and individual security characteristics. This customization can help enhance alpha generation in more discretionary mandates.
3. Customizable to provide solutions for insurers
An EEFI strategy also has the flexibility to accommodate an insurer’s unique requirements, such as duration, credit rating, country, or currency limitations.
We believe EEFI can achieve this due to the bifurcation of the risk and return elements, which allows for the maximization of research input. That is, a fixed income security can be chosen from a broad, liquid universe based on its overall attractiveness, considering macroeconomic views, sector calls, individual credit determinations, and specific investor requirements. The strategy pairs this with a separate equity option on a favorable equity, where there are also multiple opportunities to express views on optimal strike price, option structure, etc. This dynamic is illustrated below.
Fixed income and equity components can be customized independently
For illustrative purposes only.
This does not constitute a recommendation of any investment strategy for a particular investor.
Insurers who are looking to increase returns without adding incremental credit risk should consider an allocation to EEFI. Given the flexible aspects of this type of strategy, a customized portfolio can be constructed for a broad array of investor needs, introducing various levels of risk/return and asymmetric upside potential. In our view, the case for EEFI includes:
- Access to entire capital markets – source exposures from both the traditional convertibles market as well as the broad, liquid traditional debt and equity markets
- Greater potential for alpha – a larger investment universe creates more opportunity to diversify credit risk and potential to generate outperformance
- Customized solutions – portfolios can be customized for specific investor equity and fixed income risk tolerances without changing the investment process or security selection, and can be done in a capital-efficient way
- No capacity constraints – an EEFI strategy has theoretically no capacity constraints
We believe that these factors could provide insurers a way to help strengthen their overall asset allocation and navigate today’s complex markets.
Robert Young, Head of Institutional Convertibles
Peter Miller, Insurance Research Strategist, Invesco Investment Solutions
Steve Thompson, Senior Client Portfolio Manager, Invesco Fixed Income