3Q 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.
Highlights from this quarter’s IQ:
Markets are caught between slowing growth and persistent inflation with forecasts for both starting to diverge. This may be creating an unsolvable riddle for central banks with a soft landing becoming more and more aspirational.
Sub Trend Growth is now our base case with a probability of 45%. The recession probability has increased to 25%, while the likelihood of an “Above Trend Growth” scenario has been lowered to 20%. The crisis probability remains unchanged at 10%.
For now, we expect the Federal Reserve (Fed) to raise the fed funds rate by 200 basis points (bps) over the balance of 2022, bringing the rate to a range of 2.75%–3%.
Potential risks include:
Developed market central banks being fully focused on combatting inflation and maintaining an accelerated pace of tightening monetary policy while economies may start to drift into recessionary territory.
Persistent volatility across markets as uncertainty around the macroeconomic outlook translates into uncertainty on central bank actions – only economic data can create confidence that inflation is under control.
In this bulletin, we examine these views through our insurance lens and provide insight on how we are positioning insurance portfolios.
After COVID-19 and its bouquet of implications gradually receded from the spotlight earlier this year, all eyes were on the two R’s – Russia and rates. Over the course of last quarter, the initial reaction across markets following the onset of geopolitical tensions has been mitigated. The focus has now turned toward the implicit effects of both risk factors – namely their contributions to inflationary pressures, which are set to persist. In turn, the narrative around transitory inflation has disappeared as we continue to see macroeconomic data prints that beat all-time highs, rising at a pace we have not seen in decades. In summary, the ongoing Russia/Ukraine crisis as well as lockdowns in China have translated into renewed supply chain bottlenecks and put pressure on prices, mainly in the energy and food space, which cannot be mitigated by monetary policy alone.
In a number of emerging markets, inflation remains stubbornly high despite restrictive monetary policy. This is an ominous sign that developed market central bankers cannot afford to ignore as government bond yields have skyrocketed, along with volatility. This has led to an anticipation of increasingly hawkish central banks implementing additional rate hikes in 2022/2023. As a result, uncertainty regarding a path forward is extremely high and conviction is low as markets are trying to assess if a soft landing may be within scope. Although optimism for a soft landing prevailed at the beginning of the quarter – mainly driven by the strength of corporate balance sheets as well as strong consumer health – conviction has gradually declined and the probability of a recessionary or stagflationary scenario has risen. While central banks across the developed market landscape face a similar challenge on the inflation front, there are regional differences with regards to the ability of the respective economies to operate under tighter financial conditions without entering into a recession.
In the United States, May inflation figures posted strong beats across both core and headline. One-year inflation expectations rose to the highest level since 1981. High prices, combined with rising interest rates and market volatility, have caused consumer sentiment to plunge, with the University of Michigan consumer confidence index dropping sharply to its lowest level on record to 50.2 (58.1 expected). While nominal growth is very high, the labor market remains tight and more reopening pent-up demand is yet to come. We acknowledge that in six months’ time the combination of higher rates, quantitative tightening (QT) and uncomfortably high inflation may weigh on growth.
Unlike the United States, the eurozone is heavily reliant on Russian oil and gas and thus is most exposed to any supply disruptions with sustained high energy prices negatively impacting growth on the continent. For the 11th consecutive month, inflation surprised to the upside in May. In addition, core inflation is on a rising trend, which puts Europe in a more challenging spot. While the European Central Bank (ECB) surprised market participants with a decidedly hawkish lean, announcing it will be ending quantitative easing (QE) on July 1 and expects to begin increasing rates next month, the market assesses the path as too slow given the inflation outlook. At the same time, central bankers have to balance different levels of economic and financial strength amongst members. A new anti-fragmentation tool has been introduced recently and aims to support the peripheral part of Europe as BTP spreads widened sharply.
Similar to the United States and Europe, inflation numbers are pushing higher in the United Kingdom. The April core and headline CPIs printed at a 40-year high. The labor market remains in a strong spot with the differential between vacancies and people looking for a job being at the highest level since the records began in 2001. The fourth quarter is when the Bank of England (BoE) expects the labor market to weaken. The key difference versus the United States relates to a more vulnerable growth outlook. With GDP contracting in March and April, the BoE is concerned about the risk of a real income shock and believes, optimistically, that the tax from higher inflation itself may bring inflation back to target.
Moving away from rates toward the investment-grade (IG) credit space, the story of surging volatility continues and spreads have widened across the U.S., EUR and UK markets. Increased uncertainty mainly relates to the Russia/Ukraine conflict and escalating commodity and input prices, as well as central banks that started responding to sustained high inflation. Despite higher inflation, the broad picture on fundamentals still looks decent. United States profitability margins seem more resilient than in Europe given higher energy price increases in Europe. This is partially playing out in option-adjusted-spread (OAS) moves in the different markets.
While the environment remains challenging, fixed income as an asset class is back as yields have started to reach attractive levels again. We remain rooted in the tenets 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
United States life insurers have finally been reunited with a long-lost friend: yield. The yield-to-worst of the Bloomberg U.S. Corporate Index of 4.99% (as of June 14, 2022) is at a post-Great Financial Crisis (GFC) high, and 178bps higher than the previous decade average of 3.07%. The combination of higher risk-free rates and wider spreads has created opportunities to source investment income across the curve and risk spectrum. Along with this gift, however, comes the challenge of successfully navigating the market turbulence that has accompanied the Fed’s regime shift toward tighter monetary conditions.
The market has swiftly widened spreads to reflect the escalation and pull forward of recessionary risk. Fundamental concerns compound weak demand technicals that have persisted since the latter part of 2021; retail fund outflows persist at a relentless pace while U.S. IG credit is suddenly screening as less attractive to overseas buyers. Maintaining vision over the horizon, however, is crucial, as corporate and consumer balance sheets are entering this point at strong levels, having become cash-strong and lean in debt over the course of the pandemic. Low financing rates over the past decade have suppressed debt servicing costs, financial leverage is at healthy levels and operating margins are coming off multi-year highs. While the tide is now turning in each of these regards – borrowing costs are increasing, leverage is turning higher and operating margins are getting squeezed – strong fundamentals entering this period of QT should help prevent an economic slowdown from becoming a financial crisis. To weather the storm over the coming quarters, we see the best value in corporate credit in higher-quality issues in the intermediate (7-10 year) part of the curve. We remain favorable on fundamentals in the banking sector – capital levels and asset quality are still strong and net interest margin (NIM) should expand with higher rates – though we are mindful that wider spreads are likely to persist given the economic backdrop and heavy supply year-to-date out of the sector.
Meanwhile, securitized credit offers an attractive profile in the current environment: shorter durations, amortizing cash flows, deleveraging structures, strong ratings and diversification. A flat Treasury curve combined with attractive spreads has some subsectors out-yielding higher-quality 10- and 30-year corporate credit. Auto Asset-Backed Securities (ABS) looks attractive, especially seasoned deals at discount dollar prices that have already built credit enhancement and were underwritten at lower asset valuations. We also prefer adding higher-quality collateralized loan obligations (CLOs) now that spreads have reset to wider levels and we think spread compensation is sufficient given our expectations for default rates to remain low and CLO structures to provide adequate principal protection in downside scenarios. Finally, non-agency RMBS – in particular non-QM – remains a top pick. Though housing market activity is slowing, we believe supply-side constraints will keep prices supported.
In portfolios, our focus is on staying defensive and preparing for ongoing market volatility. Using a now-familiar analogy, it’s important to board up the windows and stock up on supplies before the hurricane arrives. Unrealized losses and wide bid-ask spreads increase friction costs for turning over portfolios or raising liquidity. Nevertheless, we have seen very few opportunities over the past decade to pick up investment income with high-quality assets. Leveraging our experienced credit and securitized research teams enables us to add assets with sustainable cash flows with the ability to withstand the full economic cycle.
U.S. P&C companies
Intermediate IG corporate bonds continued to post negative excess returns through mid-June, though recently spreads have been relatively better contained than other risk assets. The factors driving underperformance haven’t changed from the prior quarter, but have become more pronounced. Broadly speaking, we believe IG fundamentals are robust enough to handle a moderate recession, but believe metrics have already peaked. While firms are still attempting to pass through higher labor and input costs to consumers, they are finding it harder to maintain margins. We anticipate that revenue and EBITDA will continue to fall in 2Q (y/y) but still remain elevated to historical levels. De-leveraging has stopped, with CapEx and shareholder returns being the primary beneficiary of cash flow, but we do not see stress in current ratings. Technicals continue to be a headwind as IG outflows continue, and rising global rates are making competing markets a substitute to U.S. corporate credit; we anticipate that supply will moderate in the second half of the year, which should help offset the weaker technicals.
While we maintain our preference for short securitized, we think front-end A-rated corporate bonds provide appealing up-in-quality yields for those that are limited in their ability to participate in that market. Five - 10 year maturities have underperformed as retail outflows continue to weigh on the belly of the curve, providing opportunities for P&C insurers to take advantage of the relative weakness. BBB corporate bonds have trailed single-A issuers, offering opportunities in the industrial cohort, but we recognize that spread is still below historical averages so we maintain discipline when looking at lower rated bonds. Financials trade wide relative to industrials, and while we anticipate that supply will continue to be a headwind, the higher yields and strong fundamental positions provide attractive yields for income-oriented accounts. Finally, we anticipate consumers will continue to spend more of their marginal dollars on services benefiting those issuers, while recognizing that sentiment has deteriorated and could alter spending habits. In that environment we think discount retailers and providers with strong pricing power will deliver more stability.
Property and casualty insurers focused on investment income can take more comfort in all-in reinvestment yields approaching post-GFC highs. The acceleration of a hawkish Fed, coupled with spread widening across subsectors, has led to a rapid re-pricing within the securitized fixed income universe. The consumer, although in the midst of broad credit normalization, remains bifurcated in terms of financial health. Excess savings is now mainly an upper income cohort luxury, while food, energy and rental inflation will continue to challenge consumers going forward – especially within the low- to mid-income cohorts. Offsetting factors providing stability for the consumer remain job availability, wage growth, borrowing capacity and home equity valuations. Securitized credit market pricing reflects some of these elevated risks, and new issue pricing power is shifting to the hands of investors as opposed to the issuers. If P&C insurers have the ability to offer liquidity in current market conditions, we think it makes sense to add up-in-quality securitized credit. Specifically, we favor seasoned, shorter duration cash flows that offer deleveraging benefits as the cycle matures.
Additionally, the agency Mortgage-Backed Securities (MBS) market is transitioning from a period of QE to QT. The shift in technicals away from significant price-insensitive Fed and domestic money center bank purchases has led to more normal valuations – offering marginal buyers such as insurance companies an attractive long-term entry point. We are conscious of tight OAS and negative convexity risk, but recommend P&C insurers seeking high-quality, liquid and diversifying assets start reducing any underweight to the sector. We look to mitigate negative convexity risk through specified pools and agency multifamily, helping insurers achieve a more consistent and predictable stream of income over various interest rate environments. Production coupon mortgages also offer a substantial spread and yield advantage compared to the tighter trading low coupon portion of the MBS stack.
UK & European insurers
It has become increasingly clear that tempering inflation is a priority for central banks across the globe. However, while they are unified in their objective, each region faces growth and recession concerns at varying degrees, which is leading to a divergence in approach. In Europe and the UK, concerns around slowing growth and a resulting recession are becoming increasingly exigent. Inflation continues to surprise to the upside to +8.1% (y/y) in Europe and to +9.1% (y/y) in the UK. With the war between Ukraine and Russia showing no signs of abatement and with pandemic-related shutdowns still lingering, supply shocks and supply chain disruptions have achieved some permanence, continuing to put upward pressure on inflation.
This quarter, the ECB took a decidedly more hawkish turn than what it had originally indicated the previous quarter. As a reminder, in March, the ECB announced the end of the Pandemic Emergency Purchase Program (PEPP) and that it would taper the Asset Purchase Program (APP) at an accelerated pace. At the time, it kept rates unchanged and reiterated the intention to reinvest proceeds for as long as necessary to maintain favorable liquidity conditions and an ample degree of monetary accommodation. Then in April, based on elevated inflation data, the ECB concluded that the APP should end as of July 1. As a result, fragmentation in the market accelerated, culminating in wider spreads of 5-year Italian government bonds. The ECB subsequently outlined broad principles for a new anti-fragmentation tool with a framework that would target debt sustainability. Following that, the ECB held an extraordinary meeting to “discuss current market conditions,” which resulted in a decision to apply flexibility in PEPP reinvestments in order to preserve the functioning of the monetary policy transmission mechanism. The 5-year Italian bond spread tightened 50bps in response but volatility remains highly elevated. The ECB next meets in July, when it is expected to raise rates at least 25bps.
In the UK, the BoE hiked rates in June by 25bps to 1.25%. This was its fifth rate hike since December 2021. Inflation has reached levels not seen since the early 1990s and is forecast to peak at 11% in October, with Brexit impacts exacerbating inflationary pressures. The UK labor market remains exceptionally strong with upward wage pressures rising. The currency weakness could also further magnify the inflation pressure. Though the BoE stated that it was “ready to act to forcefully stamp out dangers posed by an inflation rate heading above 11%,” it opted to take a more modest, gradual, data-dependent approach. However, it opened the door to bigger increments. The market is currently pricing in a terminal rate of 2.75%-3.00%, which implies at least two of the next four meetings would include 50bps hikes.
Over the quarter, global IG spreads widened across the board. However, European IG spreads have meaningfully underperformed vs. U.S. and UK IG spreads. Since the beginning of the year, European corporates widened +99bps, whereas U.S. corporates only widened +51bps to Sterling corporate’s +78bps. The main reason for European IG underperformance is the ECB’s announcement to end the Corporate Sector Purchase Program (CSPP) by July 1. The absence of European IG’s biggest buyer creates a vacuum in the market. This negative technical is somewhat mitigated by lighter primary issuance, which is -10% y/y. Additionally, underperformance is exacerbated by rate volatility, fear of market fragmentation and growing fears of a recession. Having said that, fundamentals broadly remain healthy. Corporate balance sheets are prepared for a less favorable economic backdrop. Deleveraging continues in Europe. However, we are aware of looming risks. Higher input costs as well as other supply shortages are increasing margin pressure. Similarly, the UK IG market has also underperformed vs. the United States due to the announcement that the BoE would be selling down its £10bn of corporate bonds by the end of 2023.
The current environment proposes a conundrum for UK and European insurers. Yields and spreads are at historically attractive levels but insurers are stymied in their ability to turn over portfolios due to gain/loss restrictions. Uncertainty is at an all-time high and conviction is low, which inhibits the ability to position aggressively. Our recommendation would be for clients to take a measured approach to rotating into book yield accretive trades, to limit losses by selling outperforming or shorter bonds and to steadily rotate into shorter tenor bonds of high-quality, defensive names with attractive yields.
In anticipation of growing recessionary risks, we’ve been de-risking across portfolios and migrating toward more liquid and less rate-sensitive sectors in an effort to protect against negative total returns. In portfolios that are sector and duration constrained, we let cash build to bring duration toward the lower bounds and have remained patient as we watched yields rise throughout the year. We too expect volatility over the near term as the Fed raises short-term rates and begins QT2, but with volatility comes opportunity. We continue to remain vigilant in our efforts to identify new opportunities from a top-down and bottom-up perspective, while simultaneously surveying our portfolios for any weak links.
Outside of direct investment strategy, we’re seeing a growing interest in securitized assets, particularly those that outperform during rising rate environments. For those already invested in the space, this has been a helpful addition to portfolios of late and highlights the importance of floating rate and other amortizing assets when building an all-weather portfolio. We’ve also seen interest in utilizing leverage to further enhance yield. While our clients still remain concerned about credit deterioration and de-risking portfolios to be clear, there is undeniable excitement about this new rebound in yields and how best to capitalize on it. It’s important to remain patient, stay disciplined and buckle up for a bumpy ride.