IN BRIEF

  • Changes to regulatory capital requirements for 2017 will encourage U.S. life insurers1 to make larger allocations to high yield bonds.

  • Conversely, listed insurance companies that file U.S. GAAP and hold public equities in their portfolios will experience more GAAP earnings volatility starting in fiscal years ending after December 15, 2017.

  • The likely shift away from public equities should have limited impact on this large and liquid market, but this scale of flow into high yield should provide support for that asset class at the margin.

  • We reiterate our positive view on high yield credit within our multi-asset portfolios.
 

Shifting insurance company allocations: Implications for high yield

In making asset allocation decisions, we need to take into account the behavior of large market participants, including insurance companies. In this report, our colleagues in Global Insurance Solutions share their views about the likely consequences of proposed changes to regulatory capital requirements for U.S. life insurance companies expected in 2017 as well as U.S. GAAP accounting changes for insurance companies that file U.S. GAAP, starting in fiscal years ending after December 15, 2017. The potential increase in structural demand for high yield bonds has implications for our asset allocation views.

A global growth slowdown is certainly under way. Developed market growth is close to trend, but is being dragged down by slowing, below-trend growth in the emerging markets. But a global recession, while inevitable, is not imminent. Short-term tailwinds from extremely accommodative central bank policy should help keep a global recession at bay and provide the liquidity to support risk assets in the near term.

Greater capital efficiency from high yield allocations

Changes to regulatory capital requirements (that is, to risk based capital [RBC] charges) expected by year-end 2017, are likely to shift the relative appeal of bonds across rating categories for U.S. life insurers.

In the current framework, bonds are given a rating indication (from 1 to 6) by the National Association of Insurance Commissioners (NAIC) and this rating determines the RBC charge. Ignoring some complexities, these ratings translate to average Nationally Recognized Statistical Rating Organization (NRSRO) ratings (for example, NAIC 1 corresponds to NRSRO ratings between A and AAA, etc.). This framework is broadly applicable to all fixed income public and private securities, regardless of maturity, with a few exceptions.2

The proposed 2017 changes (applicable only to corporate bonds)3 generally lower capital charges for high yield bonds as well as very high quality bonds (AA+ to AAA), while generally increasing capital charges (sometimes quite significantly) for BBB- to AA rated bonds.

EXHIBIT 1: PROPOSED 2017 CHANGES TO RBC CHARGES FOR CORPORATE BONDS, BY RATING CATEGORY

Proposed changes to RBC charges for U.S. life insurers could encourage these insurers to invest more in high yield bonds and less in BBB- to AA rated bonds. Note: CM1 and CM2 are ratings for privately placed commercial mortgage loans and are not slated to change.

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Source: NAIC, J.P. Morgan Asset Management; data as of April 2016. For illustrative purposes only.

To get a sense of relative capital efficiency across sectors, we look at the ratio of a sector’s historical spread to its proposed RBC charge (Exhibit 2). By this measure, excluding AAA bonds, mortgage loans are the most efficient asset class. More importantly, the ratios are clustered together across different rating categories. The implication: Under proposed charges, high yield is similar in capital efficiency terms to higher-rated sectors. This will free U.S. life insurers to invest more in high yield if they find it attractive.

EXHIBIT 2: RATIO OF OPTION-ADJUSTED SPREADS (OAS) TO PROPOSED RBC CAPITAL CHARGES

A comparison of capital efficiency ratios (the ratio of historical OAS spreads to proposed RBC capital charges) implies similar capital efficiency across different credit quality bonds. This suggests an increased appeal of the high yield sector from a U.S. life insurer’s perspective.

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Source: Barclays POINT, J.P. Morgan Asset Management; data as March 31, 2016. For illustrative purposes only. *RBC charge is scaled by 450%.

Under the current RBC rules, high yield receives punitive capital charges that make large investments untenable. J.P. Morgan Asset Management's Global Insurance Solutions team has determined the composition of portfolios that would have minimized RBC at a given yield target at each month-end over the past 10 years. In many market environments during that period, the most efficient portfolio from a yield vs. RBC perspective would have included substantial allocations to high yield under the proposed—but not under the current—RBC framework.

Sizing the potential impact for high yield

Somewhat surprisingly, corporate bonds only account for 45% of overall U.S. life insurance fixed income holdings.This is driven by regulatory and rating agency capital models that result in more favorable yield-to-capital relationships for commercial mortgage loans, taxable municipal bonds, CMBS, non-agency RMBS, agency CMOs and CLOs. Most corporate bond purchases were invested in NAIC 1 (A or better) or NAIC 2 (BBB). Given changes to RBC, U.S. life insurers would likely treat corporate high yield as a substitute for investment grade corporate bonds as well as other structured assets.

In 2015, U.S. life insurers purchased about $750 billion in fixed income and mortgage loans. Of this, corporate high yield purchases accounted for around $30 billion. If RBC changes result in just an incremental 2% allocation to high yield corporates, that would result in about $15 billion of incremental demand for high yield bonds. This is relative to the $293 billion of high yield issuance in 2015.

A GAAP-induced shift from public equity

A second change, this one, accounting related, is likely to impact insurers’ equity allocations. Currently, insurers that file U.S. GAAP can hold public equity as available for sale (AFS) on their balance sheets. The result is that market value movements in public equity don't impact net income, unless the equity position is impaired or sold.
According to FASB Accounting Standards Codification (ASC) 825, starting in fiscal years beginning after December 15, 2017, equity will have to be held as a trading position. This will result in mark-to-market movements going through earnings. Given public insurers’ concern about earnings volatility, we could expect a reduction in public equity holdings in favor of other assets.

The overall allocation to equity instruments by insurers that file U.S. GAAP is relatively small, especially when compared to the public equity market as a whole. As of year-end 2015, the allocation was just under $80 billion (excluding the $111 billion of equity held by Berkshire Hathaway). The likely minor shift away from public equities should have limited impact on this large and liquid market, but this scale of flow into high yield should provide support for that asset class at the margin.

Asset class implications

We have held a positive view of high yield credit since late 2015, primarily because the earlier sell-off pushed spreads to quite wide levels by historical standards, ones rarely seen outside of recession. We remain comfortable with our expectation that the U.S. economy will avoid recession in 2016, sustaining a favorable atmosphere for corporate creditworthiness. At the same time, high yield spreads have rallied sharply, by more than 250bps since early February, and no longer appear to be pricing in a significant probability of severe economic downturn. Nonetheless, we remain overweight. Spreads remain slightly wide compared with the long-term average. Against the backdrop of very low yields on many global government bonds, we think the relatively high coupon on offer in high yield will continue to attract interest from many investors. And, as discussed above, pending regulatory and accounting changes will likely encourage inflows to the asset class from a major buy-and-hold source, insurance companies.

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