1Q 2022 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.
Views from this quarter’s IQ:
- Global growth momentum picks up as developed market economies learn to live and work in pandemic conditions. Vaccination progress provides resilience against new variants.
- The services sector continues to recover, providing a positive catalyst for growth as there is still room for catch up versus its pre-pandemic trend.
- Inflation remains persistently high through 1H22 before settling down at a level that is comfortably within Federal Reserve (Fed) tolerance bands, albeit higher than the pre-pandemic trend.
- Global central banks embark on policy normalization from a starting point of extreme accommodation. Strong consumer, corporate and economic fundamentals minimize the immediate impacts of tighter policy.
- Growth reacceleration, policy normalization and structurally higher inflation push 10-year U.S. Treasury rates to the 1.875-2.375% range by 1H22.
- Potential risks include:
- Supply chain issues do not improve, supporting inflation at persistently high levels. High prices weaken consumer demand enough that the handoff from fiscal stimulus to private consumption does not occur.
- Central banks react more aggressively to strong inflation, flattening or inverting yield curves and weakening economies.
- A new, vaccine-resistant COVID-19 strain alongside stricter monetary policy tightens financial conditions rapidly, leading to a destabilization of financial markets.
- Tighter financial conditions exacerbate the slowdown in China, which spills over into emerging and developed markets.
In this bulletin, we examine these views through our insurance lens and provide insight on how we are positioning insurance portfolios.
The U.S. Treasury yield curve twist flattened over the quarter as short and long maturities each told a distinct narrative. Front-end Treasury yields rose alongside growing expectations of a quicker, steeper rate hiking cycle in the face of historically high inflation. Meanwhile, long maturities were lower in yield, skeptical that rate normalization would reach the desired terminal federal funds rate of 2.25-2.50%. Short-end rate volatility was not unique to the U.S., as many sovereign curves began to also price more hawkish policy. The most pronounced episodes of volatility in developed market rates was seen in Australia, where yields on short-term debt rose as high as 80bps (from near zero) as investors fled a perceived hawkish policy shift and end of yield curve control implemented by the Reserve Bank of Australia. To be fair, a rise in short rates was justified given the mounting inflationary pressures witnessed over the quarter. Elevated core goods prices seen since mid-2020 lingered into 4Q21 as intermittent global shutdowns at large manufacturing hubs in Asia and global labor shortages caused longer-than-expected supply chain headaches. Further, fears of runaway commodity prices surfaced as Europe continued to battle a 600-700% year-to-date rise in natural gas prices – a key energy source in the region. As if that were not enough, a persistent rise in “sticky” indicators like wage and shelter inflation tipped central bank scales toward hawkishness. In the U.S., the previously patient Fed turned its focus toward stunting inflation that could no longer be described as “transitory.” At its December meeting, the Federal Open Market Committee (FOMC) bought itself flexibility for rate hiking in 2022 when it decided to double the speed of its taper to USD30bn per month (USD20bn Treasuries/USD10bn agency mortgage-backed securities) while projecting a median of three rate hikes in 2022. All the while, the spread of the Omicron variant – a seemingly more contagious strain – caused bouts of volatility in markets and added another risk to optimistic economic forecasts.
Investment-grade (IG) credit posted modestly negative total returns over the period as spreads finally broke out of their eight-month range, driven by a combination of negative virus sentiment and weaker-than-expected technicals. Lower-quality and higher-beta sectors continued to outperform, with BBB-rated outperforming single-A and Energy, REITs and Capital Goods leading sector performance. Corporate fundamentals continue to be stellar, with revenue and earnings growing by double digits for the median industrial IG company. As a whole, corporations continue to reduce leverage naturally through strong earnings, albeit at a slightly slower pace than prior quarters. This phenomenon appears to be driven by a slight re-leveraging across companies that were able to reduce debt metrics to pre-COVID-19 levels. Laggards in the recovery remain focused on balance sheet improvement. Operating margins remain near all-time highs as companies continue to drive cost efficiencies and increase prices in the face of higher input costs. However, the margin trajectory is not equal across sectors. Energy, Technology and Basic Materials continue to expand margins, as the Health Care, Autos and Consumer sectors appear to be facing headwinds.
Corporate bond technicals finally showed some signs of weakness as 4Q21 supply surprised higher and demand weakened. Year-to-date supply met our forecast of USD1.4trn, on track to be the second highest gross supply year of all time (behind 2020). Following a relatively volatile end to November, which put new issuance temporarily on pause, December supply surprised much higher, tallying USD63bn versus an average of USD23bn over the past four years. On the demand side, retail flows into the asset class proved their correlation with total returns, weakening from their robust YTD pace as spreads widened. Overseas demand remained a positive contributor to performance as hedge-adjusted yields continued to provide a pick up to yield-seeking foreign investors. Taken together, marginally weaker technical factors and seasonally lighter liquidity, coupled with a volatile news flow, allowed corporate spreads to move to the wider end of their 2021 range.
At our 1Q22 IQ meeting, there was unified acknowledgement of the mounting headwinds to further asset price appreciation: emerging COVID-19 variants, persistent inflation and monetary policy normalization, to name a few. Nonetheless, our view remains that strong economic, corporate and consumer fundamentals should allow risk assets to be resilient over the forecast horizon. Key to this view is our expectation that the Fed will continue to be transparent through its taper and provide clear forward rate guidance, tightening financial conditions on its own accord rather than through a disorderly repricing in credit spreads. While we continue to remain optimistic for risk assets in the near term, we have not lost sight of the asymmetric nature of fixed income investing. Pairing frequent evaluation of the macroeconomic landscape together with rigorous bottom-up security-level analysis will be paramount as we officially embark on a normalization journey from historically easy monetary policy.
U.S. life companies
Despite modestly lower long-end Treasury rates, U.S. life insurers finally witnessed a rise in all-in yields as spreads on IG corporates moved to the wider end of their YTD range. A combination of strong rates, market technicals and a skepticism around the fortitude of the Fed hiking cycle led to a twist flattening of the Treasury curve. We continue to believe that the trajectory of rates should be higher and steeper over the next three to six months as the Fed makes more progress on policy normalization, inflation comes off the boil and the economy continues to perform well.
IG credit valuations continue to reflect a rosy fundamental backdrop for corporate America. Our outlook for the sector remains positive as we expect upward ratings trends, strong fundamentals and solid technicals will allow spreads to be range-bound. We are viewing the recent backup in spreads as a buying opportunity and continue to be thoughtful around allocation of the marginal dollar. In accounts where we have flexibility to add across the curve, we prefer intermediate over long maturities given our view that the suppression of the long end of the Treasury curve should subside as the market prices the Fed terminal rate higher. Targeting this maturity range allows us to be relatively short duration while also taking advantage of the steepness of the 5-10yr part of the curve to benefit from carry and roll-down. Despite the risk-on view, we have become marginally more defensive in sector selection for insurance clients. For new investments, we are less favorable on higher beta sectors like Capital Goods, Autos and Chemicals given our expectation for declining operating margins and the asymmetric risk/reward they present at current valuations. When possible, we are leveraging strong market pricing to shed legacy watchlist positions and reallocate higher in quality. We prefer Banking (U.S. and foreign banks issuing in USD markets), Basic Industrials, Consumer Non-Cyclicals and Utilities, given their strong fundamentals and relative defensive posture.
In an environment where relative value is scarce, much of our focus has been outside of corporate credit in order to add value for life insurance clients. A sector we have continued to flag as attractive has been taxable municipals, given their resilience coming out of the COVID-19 crisis and the diversification benefits they add to portfolios. The recent revision to the RBC factors has provided more granularity, favoring higher-rated cohorts within investment grade. Therefore, AA-rated taxable municipals appear fair to attractive versus A-rated corporates after accounting for the cost of capital increase between ratings buckets. Fiscal policy also remains a key determinant for sector technicals. In past publications, we have discussed the possibility of the reinstatement of tax-exempt advanced refunding as part of the Build Back Better Plan. This provision has been excluded from recent versions of the bill, leading us to believe that only taxable advanced refunding should persist moving forward. We have witnessed issuers that were waiting for clarification enter back into the taxable market, providing more opportunity for long duration investors. The bipartisan “hard” infrastructure bill should also lead to more municipal supply as the current bill only addresses a portion of capital needs for new projects. It remains to be seen if needs are financed through taxable or tax-exempt markets.
Securitized assets continue to be a diversification and yield enhancement tool for life portfolios. The backup in swap spreads witnessed over the quarter has created more relative value for short securitized versus corporates, allowing more of a yield pick up without reaching down in credit quality. Fundamentally, the U.S. consumer has remained a staunch borrower; however, our view has shifted marginally toward neutral from positive as personal savings balances have begun to recede now that some time has passed since the expiration of fiscal transfer programs. The strong pace of home prices and equity market appreciation have bolstered consumer net worth, which is a go-forward risk to consumer fundamentals should those trends falter. With that said, we remain comfortable investing in high-quality asset-backed securities (ABS) with rigorous diligence around the cohorts of end borrowers to whom we are lending. Collateralized loan obligation (CLO) spreads have held in very well despite elevated supply and the recent Omicron-led backup. As such, the sector screens marginally less attractive versus other short securitized sectors. We remain highly selective within commercial mortgage-backed securities (CMBS) given the continued uneven recovery and re-emerging risks from COVID-19 variants. For portfolios that can participate, extended sector picks include high yield corporates, leveraged loans and subordinated bank capital, given their attractive carry profile and opportunity for further spread compression.
U.S. P&C companies
Intermediate IG corporate performance has lagged in 4Q21, as the heavier-than-expected new issue calendar led to bloated dealer inventories and added to the broader headwinds imposed by the Omicron variant, inflation concerns and the risk of a Fed policy error. Year-to-date excess returns remain positive. We maintain the view that supply chain issues have pushed out demand, rather than destroyed it, and we are comfortable with the fundamentals underlying the corporate market supported by our expectation for above-trend growth. We expect to see certain sectors prioritize shareholders in the year to come.
While corporate spreads have not seen the same level of volatility as rates and equities, we’ve witnessed enough to push the intermediate corporate index marginally wider year-to-date. Our research suggests that corporate spreads tend to perform at the beginning of hiking cycles, which we expect to be the case this time as well. That said, our expectations have not changed; while spreads could re-test or even break through tights, carry will most likely drive performance. Our expectation is for supply to fall next year, especially for banks, so we will continue to add to favored U.S. and foreign banks issuing in USD markets as room permits. The BBB/A spread ratio has widened recently, which could provide opportunities in names that are still prioritizing deleveraging over those looking to prioritize shareholders. Given our positive outlook, we think high yield and subordinated bank debt still offer opportunities for total return accounts that can hold lower-rated and subordinated paper. Despite the recent widening in front end corporate spreads, we continue to experience bonds trading through make-whole call levels, which makes the securitized sector our preferred alternative where appropriate.
Robust supply was the dominant theme within all securitized sectors throughout 2021. Post-COVID-19 origination came roaring back as the positive fundamental backdrop gave comfort for originators and investors alike. Record issuance across many subsectors, such as agency mortgage-backed securities (MBS) and ABS, however, was met with unprecedented demand from various participants: 1) price-insensitive buyers such as the Fed and domestic banks within agency MBS and 2) investors like ourselves that sought better relative value within securitized credit for our P&C insurance portfolios looking to capture additional income and yield. Although we’ve witnessed nominal spread compression and Treasury/credit curve flattening throughout the year, we still find comfort in short duration securitized credit for our insurance clients amid elevated supply and also as a way to insulate price declines in the event of rising interest rates.
Despite being largely priced in, the acceleration of the Fed tapering program paves the way for a more normalized valuation environment into next year as it exits the market as the dominant buyer. For now, we expect portfolios to remain underweight agency MBS as convexity risk and option-adjusted spreads still remain unattractive given the demand void will not be more apparent until 1Q22/2Q22.
Normalization will also occur within consumer credit. The unwind of various fiscal support programs will leave consumers relying on excess savings and an improvement in the employment backdrop supported by wage inflation finally making a push higher, especially in lower income cohorts. Despite this transition, the fundamental outlook in 2022 should remain favorable for consumer-backed ABS. We recommend P&C portfolios to continue to build a diversified basket of consumer loan securitizations, residential and multifamily credit and selective CMBS and CLOs.
UK & European insurers
The onset of the Omicron variant and its potential impact on activity and growth has introduced an element of uncertainty around central bank policy. The Bank of England (BoE) was expected to increase interest rates at the December meeting as tighter labor markets and wage growth pushed inflation expectations higher. In fact, recent data showed that wage growth is above the unemployment rate for the first time in 20 years. However, it is likely that the BoE will postpone its first rate hike until February to allow additional time to study the impact as social distancing measures are reintroduced in the UK.
Meanwhile, we expect the European Central Bank (ECB) will announce the taper of asset purchases in March 2022 as the Pandemic Emergency Purchase Programme (PEPP) comes to an end. This will mean purchases are likely to drop from a monthly run rate of ~90bn in 1Q22 to ~20bn over time, leaving the ECB to begin to increase interest rates in 2023. While European sovereign bond yields have been low for some time, putting pressure on re-investment rates for European insurers, this is slowly coming to an end as European yields are forecast to rise in tandem with yields globally. However, as discussed in our 4Q21 Insurance IQ, European investors are still attracted to higher yields outside of their home market. U.S. municipals, emerging market debt and U.S. investment-grade assets still offer attractive relative yields, and the Single Platform Investment Repackaging Entity SA (SPIRE) Special Purpose Vehicle Notes is an efficient way for investors to capture that yield advantage.
Over the past 15 months, the focus for insurance companies has evolved. Initially, the concern was geared to the quality of their investment portfolios and how companies would manage through the global downturn. Would asset quality deteriorate and ratings downgrades dominate? Thankfully, that didn’t transpire, and now the focus has shifted to ESG and carbon intensity. We have seen a lot of interest in our carbon intensity framework and specifically its inclusive nature given many don’t want a fire sale of assets. Our focus remains on issuers that have below-average carbon intensity at the sector level or those that have credible targets and plans to reduce their intensity within a given time frame. Those that are at the forefront to transition to a low carbon economy will be the benefactors, and so our investments are geared toward these companies.