2Q 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:
- The continued easiness of monetary policy, historically robust fiscal spending and a reopening economy led us to further increase our base case expectation of above trend growth to be the dominant theme in markets.
- With this accommodative backdrop, we continue to hold a risk-on bias in portfolios and prefer higher beta sectors of the fixed income market.
- We expect the 10-year U.S. Treasury yield to continue to grind higher as the year progresses with a year-end target of 1.875% - 2.125%.*
- Potential risks include:
- Inflation flare-up in excess of market and Fed expectations leads to market dysfunction
- Emergence of vaccine-resistant strain causes further restrictions and closures of economies
*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 the strategy. Please see the full Target Return disclosure at the conclusion of the article.
In this bulletin, we examine these views through our insurance lens and provide insight on how we are positioning insurance portfolios.
Risk markets benefited from an already optimistic outlook that was augmented by various positive economic developments during the quarter. Namely, the combination of the Democratic majority in Congress following the Georgia senate runoffs, passage of another USD 1.9 trillion fiscal stimulus bill, a better than expected vaccine roll-out and a related improvement in COVID-19 data led to sizeable upgrades to economic forecasts across the investment community. A byproduct of this exuberance was a rapid rise in U.S. Treasury yields as investors began to price earlier than expected Federal Reserve (Fed) easing and an ensuing rise in inflation as the economy reopens. Fundamental data continued to improve on both survey measures and hard data. Nonetheless, the Fed remained committed to its easy stance, citing economic fragility and the need to see significant realized progress toward its inclusive employment and inflation goals.
Investment grade credit posted negative total returns on the quarter, as spread compression could not keep pace with the rise in Treasury yields. Under the surface, we observed relative outperformance by COVID-19–affected sectors and lower quality bonds as investors tilted toward risk and yield. Technical factors were mixed, with retail demand consistently positive, while foreign demand faltered later in the quarter given the rapid rise in rates and seasonal factors, such as the end of the Japanese fiscal year. Fundamentals continued their positive trajectory with both gross and net leverage ticking lower and balance sheet cash peaking. Last quarter, we cited incentive for shareholder-friendly activity as a potential risk for bondholders in this environment, and we are seeing anecdotal evidence of this beginning to take root.
Following a record year for supply, the first quarter of 2021 brought over USD 400 billion of gross issuance, on pace for another >USD 1 trillion year. All-in financing rates remain at historically low levels, leading to several jumbo new issue deals, continued liability management (tender and extender) exercises and M&A/CapEx financing. The market remains willing and able to digest high levels of supply, with spreads range bound to marginally wider over the quarter.
Coming out of our 2Q21 IQ meeting, we remain even more confident in our risk-on bias in portfolios given the supportive backdrop and continued economic recovery. We continue to favor debt down in the capital structure and in higher beta sectors. Aside from a material negative development in the public health situation, the main tail risk to our view is a rapid uptick in inflation that causes a quicker than expected tightening of monetary policy and a destabilization of financial markets. While we believe risk markets should continue to perform well over the next three to six months, we remain grounded in the tenets of our investment process: rigorous bottoms-up security selection and stress testing coupled with frequent review of developments in the macroeconomic landscape to protect client portfolios.
U.S. life companies
Perhaps the highest conviction view coming out of our IQ meeting is a growth-induced, gradual rise in interest rates for the remainder of the year. While beneficial for the investment of new premiums, this dynamic can cause negative total returns for existing holdings. On the curve, we are biased toward the longer end, as we expect the belly (5-10-year maturities) to be the most susceptible for a further sell-off given their sensitivity to pricing of future Fed policy.
On ratings, we believe we are past peak negative credit migration and have seen prudence across issuers in terms of cash accumulation and balance sheet improvement. However, we continue to highlight a risk of elevated shareholder-friendly activity given the vastly improved economic outlook, record levels of cash on corporate balance sheets and historically low financing costs. This shift from involuntary to voluntary NAIC 1 to 2 migration is expressed through anecdotal evidence of issuers taking advantage of accommodative market conditions to re-lever and engage in M&A, for example. Companies continue to commit to preserving their investment grade status, however, and we do not expect to see an increase in fallen angels. Given these dynamics, we are biased toward BBB credit vs. NAIC 1.
Use of the entire fixed income toolkit continues to be a necessity for U.S. Life Insurers. In the securitized market, collateralized loan obligations (CLOs) and commercial mortgage-backed securities (CMBS) have been focus sectors for Life clients. Despite elevated re-fi/re-set CLO activity, the sector has been useful in satisfying short-end demand with a yield advantage. We have seen clients use the sector as a short-term solution during periods of longer-end rate volatility and expectations for further negative total returns. CMBS remains on watch given the perceived secular shift in the use of commercial real estate, yet realized fundamentals like rent collections and property valuations have not deteriorated as severely as expected during the onset of the crisis. We are biased, therefore, toward only adding exposure higher in the capital structure. Within the extended credit sectors, our pro-risk bias in portfolios has us favoring higher beta asset classes like subordinated bank paper, high yield and emerging market debt for portfolios permitted to participate.
U.S. P&C companies
The front end of the curve has remained anchored around year-end levels with the Fed on hold, but given the improving economic conditions and an increase in inflation expectations, we’ve seen steepening in 2s/5s and 5s/10s credit curves due to the sell-off in rates. As a result, we continue to see opportunities for attractive roll pickup, as well as some spread compression. Technicals remain largely supportive as money market flows have not fully reversed the inflows seen at the start of the pandemic, and flows into corporate ETFs/mutual funds continue to make their way into short and intermediate credit as the negative total returns experienced this year have been less pronounced than what we’ve seen in the long end. U.S. high yield and investment grade corporate bonds still look attractive given the favorable backdrop.
As we moved through the end of 2020, we started to see stabilization in rating agencies’ outlooks; that trend has continued and could be set to accelerate. This should provide an opportunity to invest in the more COVID-19–sensitive names that we may have shied away from when the agencies were still on negative outlook and the recovery was less certain. While this bodes well for credit in general, we do see an uptick in risk with firms taking advantage of the improving economic conditions to finance more M&A and shareholder-friendly activity with debt than we expected last quarter, especially in higher quality industrial names. This isn’t to say we will outright avoid these names, but will want to make sure we are being compensated for the potential of lower ratings. Broadly speaking, we continue to like banks, taxable municipals, industrials committed to deleveraging and utilities in favorable regulatory environments. In the front end of the curve, we continue to be mindful of bonds trading through their make-whole calls. Lastly, given the backup in rates we have found some opportunities to improve book income on swap; we will continue to take advantage of these opportunities as guidelines and markets allow.
We expect underlying fundamentals within the securitized space to show continued improvement as we see a clearer path toward a degree of herd immunity given the initial success of vaccines. Although we’ve seen a marginal decline in credit enhancement levels in recent securitizations, we view post-COVID-19 deals as some of the cleaner collateral and structural stories since the global financial crisis (GFC). Improving fundamentals across the commercial real estate market and an unprecedented tailwind from fiscal transfers aiding the consumer give us comfort in continued amortization and capital structure deleveraging across the securitized market. We are cognizant of tight credit spreads, flattening credit curves and declining liquidity premiums, but continue to favor short, high-quality asset-backed securities (ABS) and CMBS over competing asset classes such as corporates and agency collateralized mortgage obligations (CMO). Up-in-quality CLOs also provide opportunities for portfolios to capture carry and income.
Looking forward to 2Q21, we expect the Fed to continue its commitment in buying USD 40 billion/month (net) in Agency MBS—largely crowding out private investors, especially when also factoring in the torrid demand from banks (deposit growth remaining resilient). Nominal and option-adjusted spreads (OAS) appear tight across the mortgage universe given the following risks on the horizon: 1) uncertainty regarding Fed tapering of mortgage holdings, 2) potential extension risks amid a further rate sell-off and 3) elevated levels of negative convexity approaching post-GFC highs. We think mortgages deserve a home in portfolios, but would be patient for a better entry point to move overweight. We see limited opportunities in agency CMOs and agency CMBS with spreads near historical tights. Fundamentally, we think the housing sector will remain intact, even in an environment of higher mortgage rates. The dominant driving forces of improving demographics (% share of those entering prime homeownership age) and housing supply at an all-time low should keep conditions supportive.
UK & European insurers
The rise in inflation expectations and yields is a global theme. It’s a welcome change for insurance asset managers, providing some relief to the ongoing decline in book yield experienced over the past few years. Moreover, the economic outlook derived at our IQ meeting suggests the opportunity to reinvest maturing bonds at more attractive yield levels will be present for the foreseeable future, given the expectations of a rebound in global growth. As the macroeconomic situation continues to improve, corporate fundamentals will strengthen and enhance our comfort level in adding corporate risks to portfolios, further amplifying reinvestment yields.
Corporate balance sheet improvement is evident from the operating trends witnessed in 4Q earnings with both gross and net leverage moving lower. While cash levels have peaked, focus should remain on the use of that cash going forward to determine the trajectory of fundamentals. Importantly, rating trends have reached an inflection point with ratings upgrades now slightly outpacing downgrades for the first time since the onset of the pandemic. Ultimately, the improvement in this trend is important for an insurance company’s solvency capital requirement. Given this trend in ratings, we have been able to remove certain issuers from our client watchlists. However, certain issuers within the lodging and REIT sectors remain as watch items until we see these companies benefiting from a relaxing of lockdown restrictions.
While news flow around the virus and the vaccines ebbs and flows, providing us with tactical investment opportunities, client attention on carbon intensity of their portfolios has increased. Our recent whitepaper, “Building carbon transition fixed income portfolios,” has been well received by clients who are interested in adopting the framework to achieve net-zero emissions by 2050, in line with the Paris Agreement. Clients are endeared to the non-exclusionary approach we have adopted and the process of engaging with company management to encourage them to comply with global warming targets. Our approach ensures that companies that are part of the problem should be part of the solution.
Partnering with Asian insurers provides an opportunity to witness rapid economic growth’s creation of a fiercely competitive insurance marketplace. To remain competitive, yield preservation is essential. As a result, insurers continue to use the U.S. dollar market to enhance yield for dollar and non-dollar liabilities alike. The rise in all-in yield has increased the attractiveness of incremental yield for U.S. dollar liabilities, while hedging costs have continued to be a tailwind for local currency liabilities. We continue to work with our Asian clients to find solutions across the curve, implemented through various structures and regions to enhance return on assets.
With the Fed keeping front end rates pinned, investors are increasingly enticed to step out of near-zero yielding money market instruments and cash equivalents into products with yield. We have continued to see Asian insurers step into ABS and CLOs to satisfy this front-end need. Further out the curve, we have seen elevated inquiry in emerging market debt (corporate and sovereign) as well as high yield debt given the outlook for strong global growth moving forward.
Long duration credit remains a core solution for Asian insurers. We continue to favor the longer end of the curve as continued technical tailwinds and a steep yield curve will help lock in rates and increase expected returns. Despite all-in rates rising over the quarter, we have seen clients lower minimum yield targets to allow asset managers to continue to invest funds in the low rate reality. As ever, default and downgrade risk management is essential for our Asian clients. We are focused on participating in what should be a positive environment for risk assets, but remain grounded in bottoms-up security selection given the asymmetric risk of fixed income investing.