The case for convertible bonds: understanding their role in an insurance portfolio

Traditional fixed-income securities, which have historically made up the lion’s share of insurance portfolios, often fall short in delivering the returns necessary to keep pace with evolving market dynamics. This is where convertible bonds—financial instruments that combine the stability of bonds with the growth potential of stocks—become particularly relevant. These instruments provide a unique blend of benefits that can substantially enhance the performance of an insurance portfolio. 

What are convertible bonds?

Convertible bonds are a type of debt security that can be converted into a fixed number of shares of the issuer's common stock at a predetermined price. They combine the benefits of both bonds and stocks, offering regular interest income along with the potential for capital appreciation if the underlying stock price rises.

This dual characteristic provides convertible bonds with a distinctive characteristic: upside participation with downside protection. This payoff profile arises from the bond’s intrinsic value combined with the equity option embedded within it. This combination yields an asymmetric return profile, enabling convertible bonds to provide greater upside potential compared with downside risk.

Key benefits

• Diversification—Convertible bonds exhibit lower correlation with other fixed-income securities, as they’re influenced by both bond and stock markets. This reduces overall portfolio volatility and risk, as convertibles tend to perform well when other bonds don’t, and vice versa.
• Upside potential—Convertibles offer the option to convert into shares of the issuer’s common stock, allowing participation in the company’s growth and stock appreciation, thereby enhancing portfolio returns, especially in bullish markets.
• Downside protection—Convertibles have a bond-like floor, ensuring a minimum value based on future interest and principal payments. This protects investors from significant losses even if the issuer’s stock price declines, limiting portfolio losses in bearish markets.
• Capital efficiency—Convertible bonds receive favourable treatment under Solvency II capital guidelines, enabling insurers to achieve equity-like returns with lower capital requirements. This makes them a compelling investment for optimizing capital allocation.

At this point, it might be reasonable to question why convertibles aren’t part of every investor’s portfolio, but these assets aren’t for the casual investor. Different convertible structures offer different return profiles, and careful security selection and fundamental research are vital to ensure that the investment performs in the way its structure allows, most notably that the downside bond floor is expected to hold in the event of equity price weakness. Convertible bonds also come with potential risks that investors should be aware of, including:

• Credit risk—caused by the issuer being unable to make their scheduled principal or interest payments.
• Interest rate risk—as with traditional fixed income, convertible bond prices can be negatively affected by rising interest rates.
• Equity risk—If the equity price fails to reach the conversion price, the option to convert becomes less appealing.
• Liquidity risk—Depending on market conditions, convertibles can be less liquid than corporate bonds.

The appeal of convertibles is growing

Convertible bond issuance nearly doubled year over year in 2023, and that pace has accelerated in 2024, presenting abundant opportunities in primary markets and expanding the investment universe. Issuance is well distributed across various sectors and regions, enhancing the diversification of the investment landscape and facilitating effective portfolio construction. The increased issuance has also led to more attractive convertible valuations, presenting an excellent entry point into the asset class.

Why are convertible bonds particularly suitable for insurance portfolios?

Insurance portfolios are typically composed of fixed-income securities such as government bonds, corporate bonds, and mortgage-backed securities, which provide stable and predictable cash flows to meet liabilities. However, these securities also have some limitations, such as low returns, interest-rate risk, and credit risk. Convertible bonds help mitigate these challenges by adding diversification, upside potential, and downside protection to the portfolio.

Comparing convertible bonds with other asset classes

Having outlined the range of benefits that convertible bonds can offer, we next want to consider how they perform when compared with other asset classes. Using data from our Multi-Asset Solutions Team’s quarterly capital market assumptions, our analysis shows how convertibles perform across several metrics important for insurance portfolios.

When we look at the relationship between economic risk and return for several different asset classes plotted over a five-year period, we found that convertible bonds offered a strong balance between risk and return, providing a lower risk compared with equities such as U.S. small-cap stocks, while offering higher returns than traditional fixed-income securities, including investment-grade and government bonds.

Balancing capital requirements with returns is crucial for insurers and, thanks to their dual nature, it’s at this intersection where convertible bonds can truly shine. Convertible bonds receive favourable treatment under Solvency II capital guidelines, allowing insurance portfolios to achieve equity-like returns with considerably lower capital requirements.

When we looked at the relationship between solvency capital requirements and return for several different asset classes plotted over a five-year period, it became clear that convertible bonds offered a good balance between the two, sitting close to the centre of our chart. This is in comparison with high yield, investment grade, and government debt, which all require lower capital requirements but typically generate lower returns. Conversely, equity strategies—including Europe, Asia, and the Far East (EAFE) and U.S. small cap—can both generate higher returns but at almost twice the capital requirement levels of convertible bonds, while EAFE equity and U.S. large cap are both more costly and typically generate lower returns.

Finally, we wanted to compare asset classes for return adjusted for capital requirements and economic risk, in much the same way as a typical insurance portfolio would do. Convertible bonds once again made a compelling case by offering a favourable trade-off between return, capital efficiency, and economic risk. They offered stronger returns than other fixed-income asset classes but lower economic risk than any of the equity classes. Once again, they outperformed EAFE equity and U.S. large cap in both metrics. 

Implementation strategies for convertible bonds in insurance portfolios

Having established the advantageous mix of return and economic risk that convertible bonds can offer, we wanted to explore optimal allocation strategies within an insurer’s fixed-income segment. The ideal fixed-income portfolio might include global government bonds, investment-grade securities, and high-yield bonds, so we built an efficient frontier based on those assets, initially excluding convertibles. 

Once we integrated convertible bonds into this portfolio, we saw an improved balance between risk and return. Depending on the insurer’s risk tolerance and capital requirements, multiple strategies can be adopted to incorporate convertibles effectively. Let’s take a closer look at three different options.

• Option 1 shows that when we add convertibles to the asset mix, we can achieve the same returns as the optimal portfolio but with reduced risk.
• Option 2 illustrates that by taking the same degree of risk as the optimal portfolio, adding convertibles can generate an extra 40 basis points of return.
• Option 3 shows that we can generate even greater returns for a small amount of additional capital cost.

Selection criteria for alpha generation

Not only do convertibles offer favourable asset-level metrics, but they also present opportunities for alpha generation with return drivers that complement traditional asset classes. The surge in primary issuance has enriched the convertible bond universe, enabling portfolio managers to be selective and dynamically adjust exposure to maximize alpha opportunities.

Convertible bond portfolios can be tailored to specific regional, sectoral, credit-quality, duration, and investment profiles, aligning with the investment opportunity set and, for segregated mandates, the specific objectives of investors.

A compelling case for convertibles

As our analysis shows, convertible bonds can offer a number of benefits seemingly tailor-made for insurance portfolios. When selected and managed correctly, convertible bonds represent a unique and versatile debt security that blends the benefits of both bonds and stocks. They can offer stronger returns than typical fixed-income securities with lower capital requirements than many equities. They can also enhance portfolio diversification, improve returns, and offer downside protection.

However, they also entail risks and complexities that necessitate careful analysis and selection by investment professionals. But for insurance portfolios with the right investment partner, convertible bonds present a compelling opportunity to optimise returns and manage risk effectively.