AAM, founded in 1982, is one of the few investment firms that specialize solely in managing portfolios for insurance companies. Majority-owned by Stone Point Capital, LLC since December 2007, AAM (original name: Asset Allocation & Management Company) has nearly 100 insurer clients and manages approximately $15 billion in general account insurer assets, ranking it in the top five among managers who cater to insurers exclusively.

In a recent interview with IAM, Joel B. Cramer, AAM's director of sales and marketing, explained why AAM believes that convertible bonds, which took a particularly severe hammering in 2008, should not be ostracized for this reason by insurers, but should instead be considered as a compelling alternative to equities. Cramer has been at Chicago-based AAM since 2003 and, aside from his memberships in the CFA Institute, the CFA Society of Chicago and the Association for Finance Professionals, has the commendable distinction – for an investment professional -- of earning a Psychology degree from Columbia University, New York. IAM editor Alex McCallum asked the questions.

IAM: Convertibles took a beating in 2008 from the collapse of credit, the sharp drop in equities, and a host of other contributing factors. Why should risk-averse insurance companies start considering portfolio allocations to convertibles so soon afterwards?
Cramer: Since last year, insurance companies have been focused more than ever, of course, on preserving principal and limiting portfolio volatility. Because of this, I would argue that convertibles should certainly be added to insurer portfolios as they offer compelling diversification benefits. More importantly, when you are taking a long-term view, convertibles keep insurers connected to the upside potential of equities even as they reduce their direct allocations to common stocks.

IAM: If insurers are decreasing their allocations to common stocks and yet you are recommending convertibles, what is persuasive about these hybrids at this point in time?
Cramer: As we have seen recently, higher volatility, lower income potential and higher risk-based capital charges can be deterrents for including equities in an insurance portfolio. The distinct advantage of convertibles for an insurance portfolio is that they mitigate and/or eliminate these concerns, while their shorter durations have less interest rate sensitivity than a traditional aggregate-based fixed income portfolio. In the current climate, convertibles offer above average effective yields with limited interest rate risk and should continue to benefit from a normalizing market that encompasses narrowing credit spreads and higher equity valuations.

IAM: But don't convertibles generally yield less than traditional fixed income securities? Do convertibles have any other advantages in comparison to equities?
Cramer: Perhaps one of the key advantages of convertible bonds for an insurance portfolio when compared to equities is the ability to carry the securities on Schedule D as bonds with the corresponding risk-based capital charges. This eliminates the surplus strain of higher risk based capital charges commonly associated with equities. Moreover, because quarterly market value fluctuations for investment grade bonds generally do not affect insurance company statutory carrying values, realized balance sheet volatility is further reduced relative to a portfolio of equity securities. I have spoken with several insurance companies recently that have had their risk-based capital decline significantly in the past year, so they are interested in capital management strategies to help improve their RBC ratio.

IAM: What else do convertibles have going for them in the current market?
Cramer: One useful development this year has been a resumption of new issuance within the fixed income markets, including convertibles, with deals priced at attractive terms. New issuance provides investors with an expanded set of options across the convertible price curve that offers balanced risk and reward characteristics. Although valuations have improved dramatically this year, we still believe convertibles should find a place in insurer portfolios and are expecting the new issue pipeline to pick up again this fall.

IAM: If the world was perfect, what would be the ideal price to purchase a convertible bond?
Cramer: The ideal price would be at the intersection of the bond floor and the equity conversion value -- a point where the security would lack sensitivity to stock price declines, with the ability to participate one-for-one in any upward movement in the underlying common stock. The goal would be to structure a well-diversified portfolio of convertible securities that are positioned as close to this intersection of the two lines as possible so that the portfolio is protected on the downside by being close to both floors, yet able to participate directly in the upside of the equity.

IAM: That sounds easy! But, seriously, how close to this goal can you really get?
Cramer: The potential for a favorable asymmetric risk/return payoff – even without achieving perfection -- should be attractive to insurance companies that are focused on preserving principal and limiting portfolio volatility through fixed income investments, yet desire the long term surplus growth potential of equity securities. Yes, you can get close to your goal with careful, astute planning. But to do this, I’d caution potential investors against forming an opinion of the convertible market based simply on an analysis of the various convertible benchmarks. In our experience, the benchmark attributes are often weighed down by a large number of securities that are not suitable for our strategy and the portfolios of our insurance clients.

Click here for a copy of AAM's recent convertibles report:
Risk Control and Equity Upside: The Merits of Convertible Bonds for an Insurance Portfolio

 

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