Convertible bonds and solvency capital constrained investments

Transcription

1 For Professional Use Only FocusPoint In-depth insights from NN Investment Partners A detailed look at the treatment of convertible bonds under the new Solvency II regulatory regime for European insurers. Convertible bonds and solvency capital constrained investments Solvency efficiency of NN Investment Partners convertible portfolio exceeds that of composite portfolios of similar exposure to equities and bond components. The forthcoming implementation of Solvency II for insurance companies in Europe is likely to increase the attention of insurers for convertibles as an efficient asset allocation tool. We expect an incremental increase in demand for convertible bonds investments from institutional investors.

2 FocusPoint Convertible bonds and solvency constrained investments Solvency Capital Requirements (s) relating to the new Solvency II regulatory regime for European insurers are due to be implemented in January Insurance companies are already making preparations and adjustments for the new framework. Most of them satisfy the s by a comfortable margin. The Spring 2013 survey by the European Insurance and Occupational Pensions Authority (EIOPA) shows that the median solvency ratio at the end of 2012 was 222%, a sharp improvement from the 186% observed in Declining yields and a rise in equities were the main contributors to this improvement. Still, we believe there is a high level of disparity among companies and the margin over solvency requirements is becoming a measure of companies financial strength. One principle of Solvency II is to assign capital requirements to risky assets and to encourage companies to look thoroughly at their investments in the light of the Solvency II risk assessment philosophy. The sharp decline in yields of government and highgrade bonds has mitigated the future expected returns of these supposedly safer investments. This decline in expected return carries a higher perception of their risk. Convertible bonds are bond investments and hold similar risk characteristics, but their expected returns are linked to underlying equity returns and are therefore comparable to equities in some respects. The purpose of this document is to analyse the Solvency II treatment of these instruments and to determine whether they can function as efficient investments in the Insurance Companies investment toolkit within the context. NN Investment Partners manages a convertible bond fund and faces growing demand from the insurance community to provide an estimate of linked to their investment in such vehicles. NN IP provides a look-through into individual securities held in the fund, a prerequisite for investors to be able to assess their aggregate. In addition, owing to the complex nature of the instruments, NN IP proposes a model to calculate the components at the security level and assess the aggregate market risk measure ( Market) of the fund. This model is consistent with the current research on the Solvency II principles. Details on the assumptions and methodology used to assess s are provided in the appendix of this document. Assessment of NN (L) Global Convertible Opportunities The NN (L) Global Convertible Opportunities has an aggregate Market of 18.3% for sensitivity to underlying equities of 44%. This provides a ratio of to equity sensitivity of 41%. The NN (L) Global Convertible Opportunities portfolio has not been designed to maximize solvency parameters, but seeks to deliver strong risk-adjusted returns with investment in pure convex global convertibles. The portfolio is actively managed and its characteristics and aggregate parameters change over time. Since its inception, the fund has delivered returns comparable to equities, with less than 50% of the equity market volatility. All investments in the fund are currency hedged so there is no Foreign Exchange component except for the so-called dual currency convertibles, where the main listing of the underlying equity is in a currency different from the bond currency. Table 1 shows calculation results for the portfolio. Figure 1: NN (L) Global Convertible Opportunities ( Market vs Equity Sensitivity) Market 35% 30% 25% 20% 15% 10% 5% 0% 0% 20% 40% 60% 80% 100% Equity Sensitivity Source: NN IP, December 2014 Convertible consideration in asset allocation process We believe the outcome of this calculation is worth considering for anybody investing under solvency constraints. We have been considering and assessing the s of investments in other asset classes and hypothetical alternate portfolios displaying similar exposure to equities. The portfolios we considered are composite portfolios with an equity component (44% to match the equity sensitivity of NN (L) Global Convertible Opportunities) and bond components with different maturities and ratings. The outcome of this analysis is displayed on Table 2. The outcome of the calculation is that our convertible portfolio displays a Market measure of 18.3%, lower than the would-be contribution of 44% equities in a portfolio. As a result, no composite portfolio could match the solvency efficiency of the observed convertible portfolio. Our considerations regarding such a composite portfolio are as follows: This portfolio would not display the asymmetrical features one could expect from a convertible portfolio. The volatility of this portfolio is expected to be 44% of the volatility of equities contained in the portfolio. This is the median observation of the volatility observed on mixed convertible portfolios. The expected return ( E ) of such a portfolio in the context of low interest rates would be relatively easy to assess: E (portfolio) = 44% * E (equities) + 56% * E (bond element) 2

3 Table 1: calculation details for NN Global Convertible Opportunities Portfolio (December 2014) Short Name Wgt Maturity Last Equity Sensitivity DBF Pct Rate Credit Equity Fx Market / Eq. Sensi. Grand City Properties 1.5% 2019 EUR 8.70% 24/02/ , % 18.50% 0.40% 3.90% 19.10% 0.00% 22.20% 37.50% Jarden 1.5% 2019 USD 6.10% 15/06/ , % 29.80% 0.90% 3.70% 26.40% 0.00% 29.30% 38.50% Marine Harvest 0.875% 2019 EUR 6.00% 6/5/ , % 25.00% 0.40% 4.60% 20.60% 12.90% 30.30% 51.70% FXCM Inc 2.25% 2018 USD 5.60% 15/06/ , % 10.00% 1.40% 5.30% 15.00% 0.00% 19.30% 38.40% Priceline Group 0.35% 2020 USD 5.20% 15/06/ , % 20.60% 2.70% 6.60% 17.10% 0.00% 22.60% 47.10% Glencore Finance (Europe) 5% 2014 USD 4.80% 31/12/ , % 0.00% 0.00% 0.10% 0.00% 0.00% 0.10% % Huron Consulting Group 1.25% 2019 USD 4.60% 1/10/ , % 17.20% 2.00% 6.20% 16.80% 0.00% 21.90% 42.40% Qiagen 0.375% 2019 USD 4.60% 19/03/ , % 15.40% 2.10% 6.60% 13.50% 0.00% 19.10% 44.90% Sandisk 0.5% 2020 USD 3.90% 15/10/ , % 29.00% 1.90% 7.00% 23.70% 0.00% 29.40% 45.60% UNITE JERSEY ISSUER LTD 2.5% 2018 GBP 3.70% 10/10/ , % 12.40% 1.70% 5.50% 12.90% 0.00% 17.50% 38.00% Salesforce.com 0.25% 2018 USD 3.60% 1/4/ , % 18.40% 1.40% 5.20% 15.30% 0.00% 19.50% 41.80% Illumina 0% 2019 USD 3.50% 15/06/ , % 19.60% 2.50% 6.90% 14.20% 0.00% 20.00% 53.70% LINTA/HSN 1% 2016 USD 3.50% 5/10/ , % 11.20% 0.40% 6.10% 10.40% 0.00% 15.50% 30.50% Starwood Property Trust 4% 2019 USD 3.50% 15/01/ , % 10.60% 0.80% 3.50% 12.50% 0.00% 15.30% 16.60% Fresenius 0% 2019 EUR 3.50% 24/09/ % 16.30% 0.70% 13.80% 13.90% 0.00% 25.90% 64.70% Fresenius Medical 1.125% 2020 EUR 3.40% 31/01/ , % 12.10% 0.80% 10.30% 11.30% 0.00% 20.30% 56.70% Prospect Capital Corp 5.375% 2017 USD 3.10% 15/10/ % 0.10% 1.60% 5.60% 2.40% 0.00% 7.70% 65.30% Premier Oil Finance 2.5% 2018 (Exch) USD 2.90% 27/07/ , % -0.10% 2.50% 9.10% 2.90% 2.00% 12.50% % Nihon Unisys 0% 2016 JPY 2.80% 20/06/ , % 8.30% 0.10% 2.70% 9.30% 0.00% 11.40% 28.00% Asics 0% 2019 JPY 2.60% 1/3/ , % 21.30% 0.30% 5.20% 19.20% 0.00% 23.30% 40.10% DWNI 0.5% 2020 EUR 2.30% 22/11/ , % 18.70% 0.40% 5.20% 16.70% 0.00% 20.90% 39.60% Orpea SA 1.75%2020 EUR 1.80% 1/1/ , % 25.30% 0.50% 4.90% 22.30% 0.00% 26.20% 43.90% Indra Sistemas SA 1.75% 2018 EUR 1.70% 17/10/ , % -0.40% 0.60% 9.00% 4.40% 0.00% 12.60% 67.90% Citrix Systems 0.5% 2019 USD 1.60% 15/04/ , % 11.80% 2.60% 7.30% 10.50% 0.00% 16.90% 51.40% Aggregate Parameters 93.20% 44.30% 14.60% 1.10% 5.30% 13.70% 0.80% 18.30% 41% Source: NN IP Table 2: calculation estimates alternative portfolios (December 2014) Portfolio Equity Sensitivity Annualized Expected Return (3 Year Horizon) Market 100% ING IM Convertible Portfolio 44% Convex Equity Returns 18,30% 1,10% 5,30% 13,70% 0,80% (60-70% Upside, 30-40% Downside) Asset Class Portfolios 100% OECD Equities 100% 100% Equities 46.50% 0.00% 0.00% 46.50% 0.00% 100% BBG Sovereign* 0% 0.92% 3.30% 3.30% 0.00% 0.00% 0.00% 100% BBG Global IG* 0% 2.22% 9.90% 4.20% 9.00% 0.00% 0.00% 100% BBG Global High Yield* 0% 6.42% 25.40% 4.50% 25.00% 0.00% 0.00% CB Equity Exposure Portfolios 44% Equities + 56% BBG Global Sovereign 44% 44% Equities + 0.5% 20.50% 1.90% 0.00% 20.50% 0.00% 44% Equities + 56% BBG IG 44% 44% Equities + 1.2% 24.60% 2.40% 5.00% 20.50% 0.00% 44% Equities+ 56% BBG Global HY 44% 44% Equities + 3.6% 32.40% 2.50% 14.00% 20.50% 0.00% * ING IM Estimates, December 2014, Indices : BCOR Index, BGSV Index, BHYC Index Source: NN IP Rate Credit Equity FX 3

4 FocusPoint With current yields and spreads, an optimistic estimate of the expected annualized return of this portfolio is: 44% * E (Equities) + 50 to 360 basis points (bps), depending on which bond index is selected (assuming no default). On the other hand, owing to the asymmetrical features of convertibles and based on a combination of theoretical and empirical evidence of the returns of this asset class, we believe the expected return of the convertible investments depends on whether underlying equities rise or decline. Rising equity markets : E (convertibles ) = 60% to 70% of equity returns Declining equity markets : E (convertibles) = 30% to 40% of equity returns Long term observed returns match equity returns. We can conclude that the convertible portfolio is likely to have stronger expected returns and a better return profile than the composite portfolios consuming more solvency capital. Therefore, under constraints, allocation to convertibles may be an efficient way to minimize capital requirement and maximize expected returns. The composite portfolios contain an intrinsic duration risk, whereas the convertible portfolio historically displayed no or negative correlation to interest rates. The use of equity options and derivatives may lead to other solvency efficient portfolios with comparable exposure to equities and asymmetrical return features. The assessment of the expected returns of such portfolios lacks empirical evidence and would probably be more difficult. Solvency efficient portfolios of convertibles We analysed the benefit of a non-solvency-optimized portfolio of convertibles such as NN (L) Global Convertible Opportunities. We believe that the efficiency of convertible investments with regard to may be greatly improved by applying a few considerations to convertible selection and portfolio construction: Discarding cross-currency convertibles, which would likely improve the ratios without statistically harming the expected returns; Avoiding severely penalized high-yield rated bonds; Focusing the portfolio on optimal 30%-50% equity sensitive convertible with optimal convexity. By applying these simple rules, we believe it is possible to bring the Market of an efficient convertible portfolio to 15% or less, with a similar 40% equity exposure. Adding constraints may alter the expected return of the portfolio, but we do not expect the alteration would be material. Such a portfolio is likely to perform attractively versus a composite portfolio of equity and bonds with regard to the solvency efficiency. Drivers of efficiency in convertibles rules applied to convertibles are quite stringent: the of the convertible portfolio as displayed in Table 1 (18.3%) is higher than the aggregate distance to the bond floor of the convertible portfolio (i.e. the equity risk). This means that under extreme scenarios considered under Solvency II, convertibles lose their equity component and suffer from a declining bond floor. But some elements specific to the convertible market play in its favour: The duration of the convertible universe is low, minimizing both the impact of the Rate and Credit components; The rating profile of the global convertible market is such that a large portion (60% 1 ) of it is non-rated. The non-rated bonds are favorably treated under Solvency II as compared to high yield; The convertible market is strongly biased towards OECD countries (85% 1 ) of the universe and 100% of ACSG investments. These OECD equity investments are penalized less than other markets under Solvency II (currently 46.5% vs. 56.5% with the systemic risk element at +7.5%). The most obvious element that protects convertibles under solvency calculation is the convexity arising from the optionality inherent to convertibles. The current effect of the equity shock (-46.5%) applied in the case of OECD convertible underlying is reduced by the bond floor protection in the context of balanced convertibles. This high level of equity shock of 46.5% reflects the Solvency Systemic risk component resulting from the appreciation of equity markets over the past three years. A less obvious element is the fact that the convexity also plays a role in reducing the impact of credit (and to some extent rate) shocks as the convertible value is held by the equity parity. Figure 3 shows the declining credit sensitivity as credit widens for a given convertible. On this chart, the effect of the credit convexity can be measured as the convertible feature reduces the impact of the +440bps credit shock suggested by Solvency II rules for this 2-year BB rated convertible. The so-called systemic risk adjustment of the standard Solvency formula favours convertibles. Solvency II rules provide a provision in cases where equity markets have risen which increases the amount of Equity. Owing again to the convex feature of convertibles, the marginal impact of this increase favours convertibles when compared to a non-convex equity holding as in a composite portfolio. Composite portfolios of equities and credit that in theory could provide equivalent returns to convertibles a theory we do not support cannot benefit from this convexity and therefore are structurally less efficient. Impact on future convertible bond demand We expect that the forthcoming implementation of Solvency II for insurance companies in Europe will increase the attention of these investors for convertibles as an efficient asset allocation tool. So far, the convertibles investor market has been dominated by private banks. We expect incremental demand for convertible bonds investments from institutional investors. 1 Source: UBS October

5 Figure 2: LINTA/HSN 1% 2016 Equity Calculation CB Price Eq Shock, Initial CB Price, CB Price Shock Linear, Underlying Price CB Price Shock CB Price (Linear, no convexity) Equity Shock: (-46,5%) Source: NN IP/Bloomberg, December 2014 IORP and pension fund use of convertibles Although not subject to the full Solvency II framework, pension funds across Europe will see the implementation of some form of harmonised capital adequacy principles in order to assess their asset/liability matching. Currently, each country uses its own principles to assess the capital requirements of investments. These vary greatly across countries. As an example, the Netherlands accounts convertibles as equity investments, leading to the rare use of the asset class by Dutch pension funds. We believe that a more unified set of rules with drawdown risk consideration will favour their use of asymmetrical return investments such as convertibles in the future and contribute to a greater demand for the asset class as well. Figure 3: LINTA/HSN 1% 2016 Credit Calculation Initial CB Price, CB Price Credit Shock, CB Price Shock Linear, Credit Spread CB Price Shock CB Price (Linear, no convexity) Credit Shock: (+450.0Bps) Source: NN IP/Bloomberg, December

6 FocusPoint Appendix NN IP Convertible Calculation Methodology (Table Source: Technical Specifications for the Solvency II valuation and Solvency Capital Requirements calculations, EIOPA-DOC-12/362, 18 October 2012) Solvency II is a major conceptual shift in insurance accounting for risk. A direct link is created between portfolio structure and capital requirement. The capital requirement (cost) is largely determined by the nature of assets held in the portfolio. A key measure is the Market and results from the ex-ante calculation of the risk of loss in value of the investment portfolio for extreme variations of key market parameters. The directive implies that the amount of equity corresponds to the Value-at- Risk, for a probability of 99.5 and a time horizon of one year. In other words, the is the capital required to ensure that the insurance company will be able to sustain market loss 199 times in 200 cases. The equity amount required could be calculated by the standard formula, given by the directive, or by an internal model-based approach. In this document, we focus on the standard formula, and still adapt the calculations to the context of convertible bonds. Indeed, the treatment of convertible bonds has not been fully clarified so far under Solvency II. Yet, given the precise elements provided at this stage for accounting of individual risks, academics and consultants have provided insights into the likely acceptable treatment of Solvency II when it comes to accounting for for Convertible Bond investment. The following parameters are relevant in the context of convertible bond investments: Interest Rate, Credit Spreads, Equity and FX. NN IP approach to module calculation for Convertible bond investments In most cases, insurance companies allocate investments to convertible bonds through investment in funds. calculation looks through to the individual fund investments. Our approach to assessment is to apply sequentially the Solvency II one-year horizon proposed market shocks to all parameters driving the value of a convertible bond. Then, these risks are aggregated using the Solvency II extreme correlation matrixes in order to estimate the aggregate of the portfolio. The Solvency II risk modules pertaining to convertible bond investments are the following: Rate (Interest Rate Risk): Owing to the bond nature of the convertible bonds, this upward shift risk is relevant. Solvency II suggests applying predefined interest rate shocks along the yield curve to measure this risk (see Table 3). Table 3: Interest Rate shock to prevailing yield curve 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 70% 70% 64% 59% 55% 52% 49% 47% 44% 42% 11Y 12Y 13Y 14Y 15Y 16Y 17Y 18Y 19Y 20Y 39% 37% 35% 34% 33% 31% 30% 29% 27% 26% 21Y 22Y 23Y 24Y 25Y 26Y 27Y 28Y 29Y 30Y 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% Credit (Credit Risk): Convertible bonds form an asset class spreading across the full range of the credit spectrum: investment grade, high yield and non-rated. The credit module of Solvency II CSR calculation suggests the application predefined credit spread shocks along the yield curve to measure this risk For each individual convertible bond, a valuation is to be performed assuming a credit shock on the convertible bond issuer. The magnitude of the credit shock will be dependent on the credit rating of the issuer, as shown in Table 4. Table 4: Credit Spread shock to prevailing credit spread Years AAA AA A BBB BB B CCC NR % 1.10% 1.40% 2.50% 4.50% 7.50% 7.50% 3.00% % 1.09% 1.39% 2.47% 4.40% 7.24% 7.24% 2.96% % 1.09% 1.38% 2.44% 4.31% 7.00% 7.00% 2.91% % 1.08% 1.37% 2.41% 4.22% 6.78% 6.78% 2.87% % 1.08% 1.36% 2.38% 4.14% 6.58% 6.58% 2.83% % 0.99% 1.24% 2.21% 3.79% 5.98% 5.98% 2.60% % 0.93% 1.16% 2.08% 3.53% 5.54% 5.54% 2.44% % 0.88% 1.09% 1.98% 3.34% 5.21% 5.21% 2.31% % 0.84% 1.04% 1.90% 3.18% 4.94% 4.94% 2.21% % 0.81% 1.00% 1.84% 3.05% 4.71% 4.71% 2.12% % 0.78% 0.95% 1.75% 2.89% 4.31% 4.31% 2.02% % 0.75% 0.91% 1.67% 2.76% 3.97% 3.97% 1.93% % 0.73% 0.88% 1.61% 2.65% 3.68% 3.68% 1.85% % 0.71% 0.84% 1.55% 2.55% 3.44% 3.44% 1.78% % 0.69% 0.82% 1.50% 2.46% 3.23% 3.23% 1.72% % 0.68% 0.79% 1.45% 2.33% 3.04% 3.04% 1.67% % 0.66% 0.77% 1.42% 2.21% 2.88% 2.88% 1.62% % 0.65% 0.76% 1.38% 2.11% 2.73% 2.73% 1.58% % 0.64% 0.74% 1.35% 2.01% 2.60% 2.60% 1.55% % 0.63% 0.72% 1.32% 1.93% 2.49% 2.49% 1.51% % 0.62% 0.71% 1.28% 1.85% 2.38% 2.38% 1.46% % 0.61% 0.70% 1.23% 1.78% 2.29% 2.29% 1.41% % 0.61% 0.68% 1.20% 1.72% 2.20% 2.20% 1.36% % 0.60% 0.67% 1.16% 1.66% 2.12% 2.12% 1.32% % 0.59% 0.66% 1.13% 1.61% 2.05% 2.05% 1.28% 6

7 Equity (Equity Risk): Convertible bonds are sensitive to their underlying equities. Therefore, we must estimate the equity component of the CSR for each convertible bond. Solvency II defines two types of risky equities. Type 1 relates to equities whose main listing is in a OECD country. Type 2 refers to non-listed equities (usually not applicable for convertible bond underlyings) and equities whose main listing is in a non-oecd country. Standard equity shocks to be applied to the underlying equity are listed in Table 5. Table 6: Covariance Matrix for Risk aggregation Rate Credit Equity FX Rate Credit Equity FX Once the vector of independent risk modules is calculated ( Rate, Credit, Equity, FX), we can apply the matrix calculation. Table 5: Equity Shocks in Solvency II Systemic Risk Level* 7,5% Equity Type Basic Shock% Current Shock Type I (OECD) 39,0% 46,5% Type II (non OECD) 49,0% 56,5% * Systematic Risk adjustment as of Q Solvency II directives provide for an adjustment to the shock level to take into account the relative value of the equity market during the past three years. The shock levels will be adjusted for the relative historic market level. Currently, we assume the adjustment level to be at +7.5%. This leads to current applicable shocks of 46.5% and 56.5% respectively for Type 1 and Type 2 shocks. Foreign Exchange ( FX): We assume that the convertible bonds are managed in a fund, and hedged for currency risk into euros for the investment. Therefore, we can discard the FX CSR component for all single currency convertible bonds. Some convertible bonds are so-called dual-currency bonds. The currency of the investment (bond) is different from the currency of the underlying stock. In such cases the value of the convertible bond may suffer a drawdown resulting from a drop in the exchange property of the convertible bond due to a drop in the value of the underlying stock currency. For such convertibles, we apply a shock on the FX rate for the 25% required in the Solvency Standard formula. This leads to the calculation of the FX Component. Concentration ( Concentration): Convertibles are a small asset class compared to other investments, and we therefore consider that investors subject to Solvency II (namely insurers) will only hold a small portion of their assets in convertibles. We then consider that investors will reach the concentration thresholds owing to their convertible holdings. We therefore do not consider the CSR Concentration module as relevant. Aggregate Calculation ( Market): We aggregate independent modules in order to assess the aggregate of the instrument. Solvency II proposes extreme correlation levels as defined in Table 6 in order to estimate the total. 7

8 FocusPoint Disclaimer The elements contained in this document have been prepared solely for the purpose of information and do not constitute an offer, in particular a prospectus or any invitation to treat, buy or sell any security or to participate in any trading strategy. This document is intended only for MiFID professional investors. While particular attention has been paid to the contents of this document, no guarantee, warranty or representation, express or implied, is given to the accuracy, correctness or completeness thereof. Any information given in this document may be subject to change or update without notice. Neither NN Investment Partners B.V., NN Investment Partners Holdings N.V. nor any other company or unit belonging to the NN Group, nor any of its officers, directors or employees can be held directly or indirectly liable or responsible with respect to the information and/or recommendations of any kind expressed herein. The information contained in this document cannot be understood as provision of investment services. If you wish to obtain investment services please contact our office for advice. Use of the information contained in this document is solely at your risk. Investment sustains risk. Please note that the value of your investment may rise or fall and also that past performance is not indicative of future results and shall in no event be deemed as such. This document and information contained herein must not be copied, reproduced, distributed or passed to any person at any time without our prior written consent. Any claims arising out of or in connection with the terms and conditions of this disclaimer are governed by Dutch law. NN (L) Global Convertible Opportunities is a subfund of NN (L), established in Luxembourg. NN (L) is duly authorised by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. Both funds are registered with the CSSF. For more detailed information about the investment fund we refer to the prospectus and the corresponding supplements. In relation to the investment fund mentioned in this document a Key Investor Information Document (KIID) has been published containing all necessary information about the product, the costs and the risks which may occur. Do not take unnecessary risk. Read the prospectus and the KIID before investing. Investments are accompanied by risks. The value of your investments depends in part upon developments on the financial markets. In addition, each fund has its own specific risks. See the prospectus for fund-specific costs and risks. The prospectus, supplement and the Key Investor Information Document are available on the following website: This document is not directed at, and must not be acted upon by citizens of the United States (US) and is otherwise only directed at persons residing in jurisdictions where the relevant share classes/(sub) funds are authorised for distribution or where no such authorisation is required. 8