In Brief

• During Q1 2020, U.S. investment-grade corporate spreads widened from ~100bps on January 1 to a peak of ~400bps on March 23, before settling at ~300bps at quarter end. Given U.S. life insurers’ significant allocation to corporate bonds, many are questioning the resiliency of their portfolios amid the sharp sell-off.
  
  
• To help quantify the relative risk embedded in insurers’ portfolios, we decompose Q1 2020 corporate bond returns for the life industry and identify the key drivers of performance.
  
  
• We find that recent underperformance due to security selection is associated with higher levels of historical risk-taking both within corporate bonds and across other fixed-income asset classes, making a subset of insurers particularly sensitive to economic contractions.

Background

As markets reel from concerns over the economic downturn, many insurers have asked for insight into the investment positioning of their peers. In response to these inquiries, we have worked closely with several clients to develop analyses focused on the investment implications of COVID-19–induced economic pressures. Over the next several weeks, we will share short papers summarizing our findings. In this note, we analyze the corporate bond portfolios of U.S. life insurers in light of recent market volatility.

As of year-end 2019, life insurers held ~USD1.5T in investment-grade (IG) corporate bonds, representing approximately one-third of the industry’s unaffiliated assets. Given their long-term investment horizon and focus on book income, insurers tend to place limited importance on day-to-day trading results.¹ However, significant corporate spread widening could still be cause for concern since it tends to precede adverse credit events, such as downgrades and impairments, which negatively impact insurers’ solvency ratios. Accordingly, the Q1 2020 sell-off in corporate spreads has many insurers questioning the resiliency of their portfolios.

While we are not in a position to precisely forecast downgrades and impairments, we believe there is useful information embedded in recent spread returns that can help quantify the relative risk present in insurers’ corporate bond portfolios. In this paper, we (i) decompose recent spread returns to isolate the key drivers of corporate bond performance and (ii) show that more aggressive security selection in IG corporates (the “safe” part of an insurer’s portfolio) is indicative of increased risk-taking in other fixed-income asset classes.

¹ Most fixed-income assets are carried at amortized cost for regulatory purposes, insulating insurers’ balance sheets from short-term volatility.

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