4Q 2021 Global Fixed Income Insurance Quarterly
This paper is a product of the Global Fixed Income Currency & Commodities (GFICC) Insurance Team.
A team of our senior investors just completed the GFICC Investment Quarterly (IQ) meeting and released our views on the global fixed income markets for the next three to six months. We invite investors to read the IQ letter from Bob Michele, our Global CIO, which summarizes our thoughts on unconstrained investing.
Highlights from this quarter’s IQ:
- Global growth momentum has decelerated due to the delta variant, supply chain bottlenecks and Chinese regulatory reforms. We expect these factors to prove temporary.
- The service economy could be a positive catalyst for growth given the high potential to catch up to pre-pandemic levels.
- Inflation is set to moderate from historically elevated levels next year, but shelter and wage dynamics indicate no reversion to a disinflationary trend.
- Despite a tightening bias, fiscal and monetary support in the U.S. remains historically high. We continue to prefer higher beta sectors within fixed income markets and prefer short duration positioning.
- Growth acceleration could push U.S. Treasury rates to the higher end of the 1.25-1.875% range.
- Potential risks include:
- A sustained/non-transitory move higher in inflation leads to tightening across central banks faster than expected, flattening yield curves and raising borrowing costs for businesses and consumers
- Fiscal stimulus does not feed through to private consumption
- Chinese regulatory reforms lead to:
- A slower global growth environment that moderates risk-on sentiment
- Systemic risks that lead to a global growth shock
In this bulletin, we examine these views through our insurance lens and provide insight on how we are positioning insurance portfolios.
U.S. Treasury yields rallied for most of the quarter despite easy financial conditions, robust inflation and historically strong economic growth. Spreads across most risk markets were range bound, leading to positive total returns over the period. Top of mind for market participants was the Federal Open Market Committee’s (FOMC) policy normalization timeline, which began in earnest with discussions about asset purchase tapering at its Jackson Hole Symposium in August. At its September meeting, the committee continued to message hawkishness, most expressly through the revision of its Summary of Economic Projection (SEP) “dots,” which revealed the beginning of liftoff during 2022 (up from zero hikes prior). Investors will look for more specifics on pace and composition of the taper of their Treasury and agency mortgage-backed securities (MBS) purchases at upcoming FOMC meetings. Alongside the perception of an incrementally more hawkish US Federal Reserve (Fed), growth fears were introduced by the rapid spread of the COVID-19 Delta variant – a far more aggressive and contagious version of the virus. Generally, high vaccination rates allowed much of the developed world to avoid economic shutdowns. However, the effect of the virus materialized through a moderation of fundamental data including manufacturing and services indices, retail sales growth and labor market improvement. China was also a focus given its draconian response to an extremely small-scale breakout of COVID-19 cases and its targeted regulatory action against sectors like technology, gaming, for-profit education and property. Most impactful for bond investors was the fear of default of China’s second largest property company, Evergrande, a heavily indebted housing developer. Fears of contagion and systemic risk rippled briefly through risk markets; however, the situation appears contained in the near term. Nonetheless, the expectation for moderating growth and increased regulatory scrutiny in China presents a risk to optimistic outlooks for global growth.
Investment-grade credit posted positive total returns despite a modest widening in spreads from near all-time lows. BBB-rated bonds continued to outperform higher-rated cohorts, while commodity-linked sectors like energy and basic industrials outperformed. Fundamentals across the U.S. corporate landscape remained extremely strong, both on a year-on-year basis and versus analyst expectations. Impressively, robust earnings results were strong enough to naturally de-lever the sector back to pre-pandemic levels. Another key focus for fundamental analysis was on margin pressure, given the historically strong inflationary backdrop. Through 2Q earnings, companies showed the ability to cut costs and increase prices to either maintain or expand operating margins in the face of higher input prices. The effect was more uneven on a sector level as auto manufacturers and basic industrials expanded margins the most, while consumer goods and health care companies had more difficulty.
Robust new issuance continued to grab headlines as the sector remained on track for the second highest gross supply year of all time (behind 2020) at over USD 1.4trn. When accounting for maturities, calls and coupons, supply figures appear more muted as year-to-date net issuance is only ~30% of FY 2020. Outside of public funding markets, corporations took advantage of high margins and favorable earnings to also pay down revolvers and term loans, decreasing debt burdens further. We have cited M&A as an upward risk to leverage metrics, which so far has not materialized outside of anecdotal transactions.
A key takeaway from our 4Q21 IQ meeting was the acknowledgement of growing headwinds to further asset price appreciation: normalizing central bank policy, past-peak economic growth, expiring enhanced unemployment benefits and the persistence of COVID-19’s spread, to name a few. Nonetheless, our bias remains risk-on as we expect growth to run solidly above trend, driven by a strong consumer, relatively easy monetary policy and the possibility for further fiscal support. While we believe the market is well supported, the asymmetric nature of fixed income investing has not changed. We remain rooted in the tenants of our investment process: pairing the diligent evaluation of the macroeconomic landscape together with rigorous bottom-up security analysis and stress testing to protect client portfolios.
U.S. life companies
To the dismay of U.S. life insurers, interest rates spent much of the quarter lower, in defiance of strong economic growth and inflationary pressures. Rather, rates markets chose to focus on the risks surrounding Fed hawkishness and the resurgence of COVID-19 globally. We continue to believe the trajectory of rates should be higher; however, a meaningful rise appears on hold until further progress has been made on monetary policy normalization.
While it is clear that investment-grade corporate credit continues to trade at rich levels, we struggle to see a catalyst for material spread widening given historically strong fundamentals and unabating demand. Elevated year-to-date supply has controlled headlines; however, we see a more favorable technical environment. Specifically, our expectation for net issuance (supply net of maturities, coupons and calls) during 4Q21 is approximately zero. In the face of steady flows from retail channels and foreign investors, this backdrop should support spreads. Across ratings buckets, the positive fundamental picture has compressed the spread between BBB and A rated bonds to all-time lows, while also flattening curves. On the new issue calendar, we have observed exceptionally strong demand for new issuers, especially of the domestic variety, as investors look to expand diversification. Outside of unforeseen exogenous shocks, the main risk to our view continues to be a return to shareholder-friendly activity like stock buybacks and M&A at the expense of ratings. We continue to believe this risk only exists between NAIC 1 (National Association of Insurance Commissioners) and NAIC 2 ratings, as investment-grade status remain a priority for U.S. corporates.
In an environment where relative value is scarce, we are focused on expanding the opportunity set in order to add value for life insurance clients. Following modest widening during August, taxable municipal bonds appear attractive versus corporates. Aside from improving yields and diversification benefits, municipals’ higher-quality nature should benefit from the updated Risk-Based Capital (RBC) factors that favor AAA/AA over A/BBB rated bonds. Looking forward, fiscal policy will have a large effect on the asset class. Specifically, the reinstatement of tax-exempt advanced refunding (revoked in the Tax Cuts and Jobs Act of 2017) could be a technical tailwind, while passage of an infrastructure bill could provide more opportunities to access long-duration municipal supply.
Securitized markets continue to be a focus for diversification and yield enhancement. AAA/AA rated floating rate collateralized loan obligations (CLOs) continue to provide a pickup in yield and protection against rising front-end rates driven by a tightening Fed. Additionally, highly rated CLOs provide attractive capital-adjusted yields driven by the new RBC factors. Elsewhere in securitized credit, asset-backed securities (ABS) provide an opportunity for diversification that benefits from strong consumer balance sheets. We remain highly selective within commercial mortgage-backed securities (CMBS), given the uneven recovery in the sector. Life insurance clients have selectively added exposure high in the capital structure to deals with strong collateral and minimal exposure to COVID-19–impacted sectors like hospitality and retail. For portfolios that can participate, extended sector picks include high yield corporates, leveraged loans and subordinated bank capital given their attractive carry profiles and opportunities for further spread compression.
U.S. P&C companies
Intermediate investment-grade credit performance has been relatively muted throughout the summer with spreads moving off their tights through mid-August before partially recovering into the end of September. Total returns for the index joined excess returns in positive territory. The same themes we discussed last quarter remain largely intact. Second quarter expectations for improvement in operating margins and leverage were realized. Consumers across income subsets are sitting on elevated levels of cash; peak inflation in “transitory” components have started to abate and our outlook is still that corporations will be able to pass along inflation to consumers. Though supply chain constraints will likely persist into next year, our view is that this will only serve to push demand and economic growth into the future, rather than extinguish it entirely. The technical backdrop was also supportive as the new issue market remained manageable and secondary trading was orderly.
With most sectors trading at or through pre-COVID-19 levels, we expect spreads to be well contained, as the previously mentioned supply/demand dynamics should keep volatility low. As a result, we are looking to additional carry as the most likely source of performance. Given our positive outlook, we think high yield and subordinated bank debt offer opportunities for total return accounts that can hold lower rated and subordinated paper. We still think banks look attractive relative to industrials on the outlook for higher rates; heavier supply in banks has helped keep spreads wide, and we think this differential can compress with a lower outlook for bank issuance in 2022. As the BBB/A industrial spread ratio continues to trade tight, we are keeping a close eye on what issuers are doing with excess cash. We continue to see value in taxable municipals (specifically hospital systems) as a way to pick up incremental yield relative to other high-quality industrials, but appreciate that opportunities can be scarce in the intermediate part of the curve. We continue to experience front-end bonds trading through make-whole call levels, which makes securitized bonds a good alternative where appropriate.
Within securitized, agency mortgages continue to be driven primarily by price-insensitive buyers in the market (i.e., the Fed and banks) that have led to cycle tights in nominal and option-adjusted spreads. We believe that the Fed will further state its “significant progress” toward its goals and formally announce a plan for taper later this year. Asset purchases are likely to be tapered symmetrically and allow for conclusion in the middle part of next year. As the Fed steps back from the market, we think that there will be growing opportunities for insurance companies to add back exposure to the space. We continue to selectively add better convexity stories such as specified pools, agency multifamily and agency CMOs where warranted. However, we are comfortable remaining underweight as we think that we are not getting paid for the negative convexity risks in the market, especially in lower coupon pools.
Despite supply chain disruptions and the deceleration of global growth amid COVID-19 variants, the manufacturing and service side of the economy remains robust. Savings accumulation has leveled off, but consumer balances are still high compared to pre-COVID-19 levels. We think that the cessation of COVID-19 relief programs and marginal increases to consumer leverage will have modest impacts to the underlying performance within securitizations. Strong payment trends in consumer debt are reflected in net loss rates and delinquency rates hovering at or near all-time lows, boding well for the deleveraging of structures and continued amortization. While the consumer remains a bright spot, we are cognizant of the uncertain outlook within select areas of the securitized credit market, such as idiosyncratic risks within the office, retail and hotel sectors. We think that security selection will have the utmost importance going forward into year-end with flat credit curves and liquidity premiums and valuations making new tights. Portfolios should continue to take advantage of new issue concessions and secondary opportunities within securitized credit, as cross-sector valuations remain compelling despite recent outperformance. Income-oriented and total rate of return accounts can find value in sectors such as consumer ABS, single-family rental, CRE-CLOs and up-in-quality CLOs.
UK & European insurers
In line with the views produced at our latest IQ, we expect developed market yields to rise in the coming months, which should offer opportunities for yield-focused UK and European insurers to be able to invest at relatively attractive levels compared to the recent cycle lows. In the UK, labor market strength and a pick-up in inflation have been front and center of the discussion, and we expect the strength of the economic recovery to allow the Bank of England to begin to withdraw some of its support measures, potentially via a small hike in base rates, by the end of this year. In Europe, the success of the vaccine rollout should be a tailwind for growth, allowing for the ECB to incrementally reduce its ultra-accommodative stance through a reduction of its Pandemic Emergency Purchase Programme (PEPP), but structurally low inflation in the euro area will set a high bar for interest rate hikes from the ECB, likely putting a cap on core European yields. Political developments in Europe are coming back into focus this quarter, given upcoming elections in Germany and the marginally more supportive fiscal policy that could follow if a more left-leaning coalition takes control. Investors will continue to be focused on the tug-of-war between the economic recovery, new COVID-19 variants and measures of sustained realized inflation, as well as the corresponding policy changes from governments and central banks.
The strong economic backdrop and recovery of the labor market should be supportive for corporates this quarter. Earnings have significantly recovered from the pandemic lows and leverage continues to come down. Certain pandemic-related factors will benefit some sectors, such as consumer non-cyclicals, including pharmaceutical companies and medical technology companies, as the global vaccine rollout accelerates and the need for testing remains in place. The successful vaccine rollout in the EU and UK should continue to help retail and service based sectors to bounce back, especially given high savings rates and pent-up consumer demand. However, concerns about the spread of new variants and continued uncertainty around travel may prove to be strong headwinds for sectors like hotels and airlines that have been hit hardest by the pandemic, so these are likely to stay on our company watch lists until downgrade risks subside.
High-quality risk assets should be well supported in the solid growth environment over the coming quarter, but investors are aware that the gradual withdrawal of support from global central banks and already tight valuations may instigate bouts of volatility. We continue to expect carry to be the primary source of returns, given spreads have recovered significantly since the start of the downturn. The topic of ESG remains front and center for our clients – we will continue to collaborate with our clients and peers on this topic, particularly given the increasing focus on net zero transition goals and the upcoming COP26 conference in Glasgow.
Also identified as being of interest to European insurers are SPIRE Special Purpose Vehicle (SPV) notes – a simple, capital-efficient way to access hedged non-EUR fixed income, such as municipals, emerging markets hard currency and U.S. investment-grade credit. Specifically targeting buy-and-maintain and liability-driven investors, the vehicle enables them to lock in extra yield relative to the euro government space while being beneficially treated under Solvency II.
Preservation of portfolio yields remains a paramount objective for Asian insurers in an increasingly competitive insurance market. U.S. dollar assets continue to present an attractive pick up in yields for Asian insurers, especially for USD liabilities. Even when accounting for hedging costs back to local currencies, U.S. rates provide a pick up relative to the opportunity set. We have observed this attractive pick up feeding through to solid inflows from Asian institutional investors (including insurers) during the past quarter.
Much like U.S. life insurers, our Asian clients continue to expand the scope of their investment portfolios to enhance yield and diversification. With the end of extraordinarily easy monetary policy on the horizon, clients continue to take advantage of the busy CLO calendar to add floating rate exposure as a duration hedge and yield enhancer. Our view of an exceptionally strong consumer balance sheet has led us to continue to favor short ABS as well. As ever, long duration credit remains a structural liability need for Asian insurers. Because the sector continues to price in historically strong fundamentals and optimistic forecasts, we have seen clients modestly lower rate targets to align with the reality of the opportunity set. Optimistic market pricing has also given us the opportunity to anecdotally take profits on watchlist issuers and reinvest in higher quality names out the curve.
While we believe the downside risk of adverse credit events has continued to shrink, we are astutely aware of the importance of credit risk management for Asian insurance clients. We remain grounded in rigorous, bottom-up security selection and stress testing as we move closer to the end of historically easy monetary policy.