3Q 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:
- While global growth has peaked, significant room for catch-up and continued easy financial conditions should allow markets to price in above-trend growth.
- The near-term uptick in inflation has altered the Federal Reserve’s (Fed) policy toward incremental tightening. However, we expect the taper process to be well-telegraphed and gradual in nature.
- We favor a risk-on bias in portfolios and prefer higher beta sectors of the fixed income markets while remaining short of duration.
- We expect the 10-year U.S. Treasury yield to continue to move higher, with a year-end target of 1.875%-2.125%.
- Potential risks include:
In this bulletin, we examine these views through our insurance lens and provide insight on how we are positioning insurance portfolios.
- Inflation flare-up in excess of market and Fed expectations, leading to:
- A rapid shift toward tightening from central banks, which causes the growth trajectory to moderate.
- Materially higher interest rates that slow economic growth but are ineffective in curbing high levels of inflation.
2Q 2021 recap
Renewed stability in U.S. Treasury yields, easy financial conditions and explosive vaccine-led growth allowed most risk assets to post positive total returns over the quarter. After months of negotiation across party lines, President Biden announced an agreement among a bipartisan group of senators on $579bn of physical infrastructure spending financed through heightened customs, Superfund and broadband auction fees. Top Democrats agreed to a bill of this size subject to conditions that it would be accompanied by a larger spending package in the future, potentially using the Budget Reconciliation process. Senate approval of the initial bill is not certain, as the latest agreement is a product of only five Democrats and five Republicans. 60 votes are required to avoid the filibuster. Inflation data moved sharply higher during the quarter, driven primarily by volatile index subcomponents, supply chain bottlenecks and evolving consumer spending patterns as the economy reopens. Amid the uptick in prices, investors keenly eyed language out of the Federal Open Market Committee (FOMC) for any hints at the path toward policy normalization despite a less robust recovery in labor markets. At its June meeting, the Committee’s median Summary of Economic Projections (SEP) “dots” for the federal funds policy rate rose from the zero lower bound to reflecting two rate hikes by the end of 2023. In the face of a sharp flattening of the yield curve following the release, Chairman Jerome Powell continued to convey patience toward policy normalization as the substantial progress toward its goals are “a ways away.”
Investment-grade credit posted positive total returns amid extremely low volatility on the quarter as U.S. Treasury rates were range-bound to slightly lower and the sector lacked any sustained catalyst to widen in spread. Lower-quality, cyclical and COVID-19–affected sectors outperformed, as fundamentals strengthened and technical factors were supportive. Retail demand continued to exhibit a lagged correlation with total returns as flows slowed during May and accelerated into June. On fundamentals, median leverage improved as corporate earnings flourished; however, we remain wary of the potential for shareholder-friendly activity to increase as borrowing rates are low and CEO confidence high. So far, evidence of this trend is starting to take root in the U.S. while European issuers have been more conservative. Another key focus for fundamental analysis moving forward will be assessing the extent to which inflation pressures impinge the rosy outlook for profit margins or are passed on to consumers in the form of price inflation.
New issue supply continues to be abundant, with over $800bn printed year-to-date. This still trails the $1.2trn printed through 2Q 2020 despite being a historically high figure. Perhaps most importantly, the composition of the use of proceeds year-to-date has shifted toward M&A from CapEx and tender activity with M&A issuance already running at 91% of FY 2020 levels. The market remains willing and able to digest high levels of supply despite inconsistent retail and foreign demand.
Coming out of our 3Q 2021 IQ meeting, we are cognizant of the fact that the peak in growth is likely behind us and the next move for monetary policymakers will be toward tightening. However, above-trend growth remains our base case as the convalescent U.S. economy still has significant capacity for catch-up while monetary policy normalization will be gradual. The main risk to our view is persistent inflation well above Fed expectations that leads to a rapid tightening in financial conditions, destabilization of asset prices and a stalling of economic growth. To succeed in an environment of strong growth, rich valuations and an incrementally more hawkish Fed, it is as important as ever to remain rooted in the tenants of our investment process. We continue to monitor the evolving macroeconomic landscape in conjunction with bottoms-up analysis across securities, sectors and geographies to which we lend our clients’ capital.
U.S. life companies
Coming out of the first quarter of 2021, the U.S. life insurance community was cautiously encouraged by the rapid rise in all-in investment yields. To its dismay, this move stalled out as investors priced in a more aggressive Fed and the possibility of a policy error. We expect rates to resume their slow climb higher as the Fed commences the end of its yield suppression program; however, it is clear that the path will not be smooth.
We expect the investment-grade credit market to continue to tighten as fundamentals improve and technical forces remain strong. Long-end spreads appear to lack a catalyst for widening in the absence of an idiosyncratic event as structural demand out of the long duration community looms large. Within investment-grade credit, we favor BBB vs. single-A rated bonds, as the strong economic backdrop has led to vast fundamental improvement across most of corporate America. This positioning view also considers the risk that management teams use their improved financial footing to reward shareholders through M&A or share repurchases at the expense of single-A ratings. At the same time, we remain of the belief that U.S. corporations value their investment-grade ratings and do not see fallen angels as an elevated risk at this juncture. Our overall outlook for ratings continues to improve as strong earnings and easier year-over-year comps organically reduce corporate leverage. Broad-based ratings upgrades will depend on the extent to which management teams exercise financial discipline in the face of improved results.
Further on the horizon, life insurers will need to account for the new Risk-Based Capital (RBC) factors just recently adopted by the National Association of Insurance Commissioners (NAIC). In our view, some of the most prominent changes include 1.) The decreased capital efficiency of low investment-grade bonds (A+ to BBB-) and 2.) The increased benefit for portfolios with high issuer counts. While we do not expect these changes to lead to vast rebalancing across insurers, the updated factors could require a broader scope of investments to maintain capital-adjusted yield. Increased issuer counts will also become more important to small and medium-sized insurance companies moving forward.
The evolving regulatory environment coupled with historically tight spreads has made it more imperative than ever for U.S. life insurers to utilize the full fixed income tool kit. We continue to see life clients tap the securitized market for diversification and yield enhancement across the curve. Specifically, we have favored floating rate collateralized loan obligations (CLOs) as a way to prepare for rising front-end rates driven by a more aggressive Fed. AAA/AA CLO securities are also expected to be more capital efficient upon implementation of the updated RBC factors. Commercial mortgage-backed securities (CMBS) remain on watch given the opaqueness of the outlook for certain commercial real estate sectors; however, we’ve seen life clients selectively add exposure high in the capital structure to deals with strong collateral and minimal exposure to sectors like hospitality and retail. For portfolios permitted to participate, our extended sector picks are high yield corporates, leveraged loans and bank capital, as these sectors provide attractive carry and room for further outperformance in a risk-on environment.
U.S. P&C companies
Much like long corporates, intermediate investment-grade corporate credit has continued to produce positive excess returns as spreads moved tighter, led by BBBs and COVID-19–impacted sectors. Many of the sectors hit hardest by COVID-19 (autos, chemicals, metals and mining) are now trading through pre-COVID-19 levels on an OAS basis, leading corporate indices to post-GFC tights, especially when adjusting for the longer duration and lower credit quality of the corporate sector. While cost pressures are real, companies have historically been able to pass along some inflation to consumers. With the robust consumer position and our transitory view of recent inflation spikes, we broadly view inflation as manageable from a fundamental perspective. On the technical side, we expect new issue supply to be digestible as demand for corporate debt is supportive, with retail flows slowing and pension and insurance flows remaining robust.
Given our expectation of rising rates, we prefer financials vs. industrials, as they have historically performed better in such an environment. Away from financials, we favor names in sectors that offer better relative carry (e.g. communications, railroads, pharmaceuticals and utilities). We also continue to like names benefiting from the deleveraging story. In the front end of the curve, we are still avoiding bonds trading through make-whole levels, favoring securitized credit where appropriate, preferring to invest in 5-10 year corporates to take advantage of better roll and carry. We continue to see high yield as attractive for accounts that are permitted to invest.
We balance the risks of tight valuations, flat credit curves and waning liquidity premiums with the prospects of robust technicals and solid fundamentals. The reopening of the economy and sizeable fiscal transfers have resulted in strong consumer health, which is revitalizing many parts of the economy. Consumer ABS performance in many cases is better than where it was pre-COVID-19 (excess built up savings, record high Manheim Used Vehicle Index and elevated recovery values), allowing for positive ratings migration in the space to continue and for rating agencies to ease post-pandemic structural enhancements. We see short duration securitized credit as one of our most favored asset classes across insurance portfolios looking for ratings stability and high-quality income compared to competing front-end asset classes. In portfolios, we are focused on taking advantage of primary market supply in consumer ABS, single-asset-single-borrower (relative to Conduit CMBS), single-family rental, CRE-CLOs and up-in-quality CLOs to gain diversification factor benefits while enhancing yield.
We think the Fed will finally begin to ramp up discussions around tapering later this year as the economy proves that it can function without the extraordinary fiscal and monetary support experienced since the depths of the pandemic crisis. Although actual tapering isn’t likely to take place until 2022, we think that portfolios should take advantage of strong technicals (Fed and bank demand) to reduce exposures to lower coupon agency MBS (or rather, let portfolios amortize naturally) with heightened negative convexity and negative option-adjusted spreads. Low mortgage rates, continued home price appreciation and healthy consumer balance sheets are likely to keep the negative fundamental prepayment environment intact in the near term. This leaves a bleak outlook for realized income in portfolios with premium dollar price agency MBS. We are focused on improving convexity through select specified pools, agency CMOs and agency CMBS when opportunities arise, but a better entry point is likely on the horizon.
UK & European insurers
In line with the output from our latest IQ, we expect developed market yields to continue to rise in the coming months, consistent with the improving global growth picture. The continued story of rising global yields offers UK and European insurers the opportunity to reinvest cash at higher yields – a welcome change since the lows of 2020. In the UK, we have likely passed the peak in the yield curve steepening this cycle, with the curve likely to flatten from here as front-end yields price in an earlier and more frequent schedule of hikes from the Bank of England. Although the vaccine rollout in Europe continues to catch up to the U.S. and UK, the market may find it slightly more challenging to further price in hikes from the European Central Bank (ECB) given euro-area inflation expectations remain subdued. Investors will be particularly focused in the coming quarter on the dueling labor market and inflation dynamics, with a keen eye out for any clues about the timing and scope of policy tightening from central banks and governments.
The improving growth backdrop and high consumer savings rates should be a boon for corporates this quarter as we expect corporate fundamentals to remain robust. The credit divergence story is likely to persist in the UK and Europe in the coming months, as some sectors reap the full benefits of the recovery, while others remain under pressure due to the remaining coronavirus restrictions in place. We expect that dynamics specific to the reopening story, such as the global semi-conductor shortage and the return of workforces to the office, should benefit technology and consumer cyclicals, but other sectors, such as airlines and hotels, are likely to continue to face challenges as travel restrictions remain in place. As this bifurcation is likely to persist until restrictions are lifted, we expect that these travel-exposed sectors will remain on our watchlists, given the heightened risk of downgrades, until credit metrics are on stronger footing.
Overall, risk assets should stand to benefit under the benign growth backdrop and low volatility environment that we expect over the coming months. However, we expect carry to be the main driver of returns given the already significant spread tightening we have seen so far in the recovery. Relatively compressed valuations are also pushing buy-and-maintain oriented insurers to increasingly look at the yield advantage offered by cross-currency-hedged emerging market debt and U.S. municipal bonds. ESG continues to be a key focus for our clients – we will continue to engage with clients, issuers and other stakeholders on this front, especially given the upcoming COP26 conference in November (which will likely translate into a carbon pricing agreement, along the lines of previous IFC proposals) and the climate stress test requirements from the Bank of England (which will place further pressure on banks and insurers to assess their portfolios’ sensitivities to climate risks).
The Asian insurance market continues to grow, and with it comes further pressure to preserve portfolio yields through investing across geographies and asset classes. U.S. dollar-denominated markets remain a solution, as the pickup in yield remains attractive for Asian clients. We do note a modest increase in hedging costs for international investors, which could be a contributing factor toward the moderation of the torrent inflows into U.S. markets over the past year. Nonetheless, insurers with USD and non-USD liabilities alike stand to benefit from higher hedged and unhedged yield levels.
We continue to work with Asian clients to expand the scope of investments outside of traditional corporate credit toward securitized assets. Especially with the prospects of rising rates associated with policy normalization from the Fed, clients are more willing to invest in short securitized structures like ABS and CLOs to satisfy their front-end needs while also shortening overall portfolio durations. Much like U.S. life insurers, we see interest in floating rate CLOs as a duration hedge and yield enhancer for Asian insurers. The increase in Asian institutional flows into this sector – a testament to the growing acceptance of the asset class in the region – has led to AAA tranches frequently pre-placed and a modest steepening in credit curves.
Long duration credit remains a structural need to match liabilities, despite clients shorting duration at the margin given the view on rates. Downside risk of adverse credit events, including downgrades and defaults within the sector, has shrunken significantly; however, we are ever cognizant of the importance of credit risk management for Asian clients. We remain grounded in bottom-up security selection and stress testing as we begin the gradual exit from historically accommodative monetary policy.
- Inflation flare-up in excess of market and Fed expectations, leading to:
The target returns are for illustrative purposes only and are subject to significant limitations. An investor should not expect to achieve actual returns similar to the target returns shown above. Because of the inherent limitations of the target returns, potential investors should not rely on them when making a decision on whether or not to invest in a product/strategy.