The End Draws Near
A Best’s Review panel on U.S. life/health insurers’ investing sees a benign economic landscape in the near term, but the cycle has reached an ‘uncomfortable point’ as its conclusion approaches.
- Jeff Roberts
- October 2018
- Caution: The end of the cycle is approaching, and insurers are growing cautious despite pressure to produce return.
- Opportunity Remains: Opportunities still can be found in CLOs, private debt, commercial mortgage loans and commercial real estate.
- Recession: Although the short-term forecast is benign, the U.S. economy could face significant challenges by 2020.
Bill Rotatori, NEAM
Any time you see the yield curve flatten to where it is today, it raises the question: Is this a predictor of a recession right around the corner?
This economic cycle's days are numbered.
While the U.S. economy is growing at a healthy rate amid record bull markets, low unemployment and high earnings, all good things eventually come to an end.
Insurers are planning accordingly.
“The headline is we're late in the cycle, and so most investors have turned cautious in their investment portfolios to the extent they can,” said Randy Brown, chief investment officer of Sun Life Financial.
Brown was among the experts participating on a Best's Review panel who agree that the late stages of the long-running economic cycle are upon us. They expect the benign investing environment to continue a little while longer, but concerns abound with change on the distant horizon. There's a flattening yield curve, pressure inflicted by years of low rates and declining book yields and concerns over Federal Reserve tightening.
In 2018, U.S. life/health insurers continue their hunt for yield while being mindful of the cycle's approaching end. According to A.M. Best data, net yields on invested assets in 2017 increased to 4.66% from 4.62% in 2016, but remain well below the 2013 mark of 4.98%. Meanwhile, insurers have reduced their asset distribution in bonds compared to 2012 (42.9% of their portfolios from 45.6%), but increased the percentage of mortgage investments (6.8% from 6.0%) and separate accounts (38.2% from 35.9%).
Randy Brown, Sun Life Financial
The way I would state it is, I think the [corporate bond] market plumbing is broken—we just don’t know it yet. The outstanding supply of corporate bonds has more than doubled since the financial crisis.
This year's panelists—Brown; Lennart Carlson, managing director and portfolio manager at Conning; Stewart Foley, managing partner, Insurance AUM; and New England Asset Management Chairman and CEO Bill Rotatori—discussed overall investment trends for life/health insurers, what opportunities they see (CLOs anyone?) and the dirty “R” word.
What's the investing headline for life and health insurers' portfolios?
Brown: The headline is we're late in the cycle, and so most investors have turned cautious in their investment portfolios to the extent they can. As spreads have compressed in general, you're getting less compensated for investment risk. And your investment returns are diminishing, so it's hard to reduce risk further in that environment just because of pressure coming from the business.
Carlson: The headline is insurers continue to expand their horizons in search for income and return. Whether it's in particular fixed-income classes within their core bond portfolio or other asset classes that are complementary to their core bond portfolios, insurers continue to look for new opportunities to enhance income and improve the risk/return profile of their portfolios. We have seen a gradual shift in asset allocation and risk tolerance over the last five or six years.
Foley: The biggest challenge that investors face is the compression of risk premia across asset classes. It is the need for investment income in a protracted period of low interest rates.
Rotatori: We've reached that uncomfortable point in the cycle. Over the last decade, what we've seen is insurance companies increase risk positions to generate return or to preserve yield. And yet it's late in the economic cycle, where the compensation for taking risk has been driven to historic lows, and you've got the Fed taking away the punch bowl. So the risk/return trade-off right now in markets is just not compelling and makes it uncomfortable. The other part of the headline would be it's still safe to go in the water. The economy is doing great. There's historic lows in unemployment. [Gross domestic product] growth of 4-plus percent. Corporate earnings are terrific right now. But we have to recognize where we are in the cycle.
What are the top investing trends you're witnessing in life/health?
Brown: We've seen a push into private credit in various forms by all insurers. We've always had a big private credit book, and we continue to invest there for a lot of reasons. I'm talking about investment-grade, first lien investments in nonpublic securities.
Carlson: We've seen companies increase their use of BBB and lower-rated securities over the past six years. And we've also seen private placement usage increase slightly, but small and midsize insurers remain underinvested in that class. Life companies also have increased their use of 144a securities in their portfolios. And within the fixed income portfolio, we've also seen a change in structured securities composition. Our exposure to mortgage-backed securities has decreased while asset-backed/[collateralized loan obligation] exposure has seen an uptick. And away from fixed income, certainly commercial mortgages remain a significant part of the life company portfolio. But this is again dominated by large companies.
Rotatori: What we've been doing with our clients and how we've viewed our clients' positioning has definitely changed over the last few years. It really has to do with the Fed's reversal. We're seven rate hikes into this cycle [heading into the Fed's September meeting], and as they brought the front of the yield curve from zero to nearly 2%, we've got a higher level of yield and a flatter yield curve. One of the trends we've been advocating on behalf of our clients and also seen the industry taking up is the use of floating rate securities, securities whose coupon rather than being fixed, adjusts each month or each quarter off of a LIBOR [London Interbank Offered Rate] index. As the Fed brings up the front of the yield curve, the coupon resets higher. So you can buy securities with attractive yields, and they don't have the downside risk of price depreciation based on Treasury rates rising.
The current credit and economic cycles have extended beyond historic norms. The bull market is more than nine years old. When is the end coming?
Carlson: Insurers have been very disciplined in the addition of risk to their portfolios, and I think they are remaining disciplined. That's one of the challenges that we as investment managers and clients face right now. There's an acknowledgement in general that we're closer to the end of the cycle than we are to the beginning. There's concerns about rising rates. There's a concern about a recession in 2020 or shortly thereafter. One of the challenges is trying to balance the desire for additional income and return while being cognizant of the environment and where we are in the business cycle and the capital markets cycle.
Rotatori: It's certainly time to begin thinking about it because we've been at this for some time now. We're obviously watching it closely. Right now there's pretty good momentum in the economy. The U.S. consumer is in pretty good shape. Unemployment rates are very low. Average annual earnings are growing 2.7% - 2.8% year over year. And housing prices have been increasing for five or six years. Both owners' equity in their real estate and consumer net worth are at all-time highs. The consumer is confident, and they're going to continue to spend. We think that means for the next 12 months, the U.S. economy is going to be in good shape. But you have to begin to think about when the next cycle will commence. We think it's probably a late 2019-into-2020 event.
Are insurers outsourcing more of their assets to external asset managers?
Brown: What we are seeing is insurance companies continue to outsource. They're using third-party providers like us in asset classes where they don't have the internal expertise. Things like private debt, commercial mortgage loans, commercial real estate, bank loans, high yield, CLOs, structured securities—all those asset classes that really take a specialty focus—we continue to see an increase in outsourcing.
Are insurers collaborating more closely with external asset managers or even operating on a quasi-partnership basis?
Brown: There's more of a partnership mentality than ever. It's leading to more bespoke solutions. And that's to the benefit of the insurer.
Rotatori: That's exactly right. We notice that insurance companies are looking for more than just a vendor, someone who can understand all the unique aspects of managing money for an insurance company, whether it's regulatory, tax, accounting. It's much more of a business strategy conversation than just a portfolio review.
How much pressure does the low rate environment continue to inflict on portfolios?
Brown: Rates have been stubbornly low. We've come off the low lows significantly, but we're having a very difficult time, for instance, piercing 3% in the 10-year [note] in the U.S. Given that low rate environment and the relatively low volatility environment, insurers have reached for illiquidity risk, having accepted illiquidity as a source for return in the private market.
Carlson: Certainly the driver of trends has been the much-lower yield environment we've been in since the financial crisis and the erosion of portfolio book yields. That is likely to continue as many of the older investments that had very high book yields continue to run off.
Rotatori: The life insurance industry has increased risk on the credit side marginally. But they've taken average durations from five and a half years to just under eight years. And in spite of doing that, both the P/C and the life industries have lost over 150 basis points in book yield over those 10 years. We've had some relief when you think about where rates are today versus two years ago. And the silver lining is, while unrealized gains positions may have evaporated as a result of that, you do have the opportunity to reinvest at rates considerably higher and maybe raise average book yields and earnings power.
How big a concern is the flattening yield curve?
Brown: It's something we watch pretty closely. Typically the yield curve will flatten in this part of the cycle and will actually invert. It's been a pretty good leading indicator of recession. The U.S. economy is doing quite well right now. It feels very Goldilocks to me. But there's a lot of potential risk in the market that investors are overlooking.
For instance, tax cuts were stimulative while we're in full employment. We have more restrictive immigration, which limits the labor pool. We have tariffs, which raise the cost of goods in the U.S. It's all potentially inflationary. And there's a tremendous amount of geopolitical risk. There's a lot of risk in the market that is creating the potential for dislocations. At the same time, rates are pretty benign, volatility is pretty low, stock markets are near all-time highs. So it feels very Goldilocks, but I think there's a very large headwind in the market. I don't see a recession on the near horizon, but on the horizon? Yes. We think that's a back-end of 2020 phenomenon.
Carlson: We do not believe that flattening of the curve is a harbinger of recession. It's inversion as opposed to just flattening that is associated with subsequent recession. We have had periods of flattening in the past that were not shortly followed by recession. So while it's possible, we do not expect an inversion of the twos-tens curve. The Fed's also closely watching the curve, and inversion would likely elicit a policy adjustment. They do not want to go too far in tightening policy. Our outlook for growth is about 3% this year, in the 2½% to 3% range next year and somewhere around 2% to 2½% in 2020. So we're not expecting recession in our base case forecast.
Rotatori: Any time you see the yield curve flatten to where it is today, it raises the question: Is this a predictor of a recession right around the corner? Our view is that there's some technical elements influencing the shape of the curve right now. As those fade, we probably will get not big steepening, but a little steepening. Based on current economic strength, a recession is not in the cards.
There's been a lot of talk about declines in liquidity in the corporate bond space. Do you share those concerns?
Brown: The way I would state it is, I think the market plumbing is broken—we just don't know it yet. The outstanding supply of corporate bonds has more than doubled since the financial crisis. The balance sheet dedicated to market-making of brokers/dealers is down about 90% in the same period. The introduction of perceived liquid vehicles has increased, i.e. more individuals in corporate bond mutual funds and [exchange-traded funds]. All of that has compounded the sense that when there's a market dislocation and you need to transfer risk from one set of owners to another, the risk-transfer mechanism has been diminished. And therefore, you will see increased price dislocation compared to prior cycles. That then creates an opportunity.
Carlson: By some measures, liquidity in the corporate bond market has decreased. Trading volumes relative to the total size of the market are lower than they were pre-crisis. But that market turnover has actually been fairly stable for the last few years after the post-crisis decline. Turnover in smaller issues or issues that have been outstanding for a while has decreased. This could make selling these types of issues out of a portfolio more challenging. But conversely, market breadth has improved as trading is less concentrated in a smaller number of issuers than pre-crisis. I share some concern about the decrease in liquidity, but some of the talk has resulted from the creation of liquidity products backed by less-liquid assets like high-grade or high-yield corporate bonds.
Rotatori: I think there's been a meaningful change in market structure in the corporate market. The ownership by ETFs of the outstanding corporate bond market is growing significantly and the broker/dealer support for those markets has declined significantly when you measure it by how much overnight inventory they carry relative to 10 years ago. It's a fraction of what they used to carry. We're not seeing it today because we're not in a period of stress.
Where are you seeing opportunities?
Brown: The thing that we're finding the most attractive is still the private debt market. The reason is we're lending to a diversified set of borrowers than what you're finding in the public space. We are first lien. We have collateral protection. We have covenant protection.
Carlson: We've seen small, gradual increases in things like private placement, different types of structured securities, asset-backed securities and CLOs, emerging market debt. Some of those still have some additional opportunity to add value, income and to improve risk/return profiles. When you look at privates, certainly relative to public bonds right now, you can earn an additional 20 to 40 basis points over publics—and in some cases up to 100 basis points or more depending on the complexity of the particular transaction. And thinking about the downside in a potential recessionary environment, private placements have historically exhibited lower default loss experience.
Rotatori: Given the current environment, we do find a few attractive things. One example would be CLOs. You can buy a AAA-rated tranche of a CLO at three-month LIBOR plus 115-basis points of spread today. What we like about that is it's highly rated, these are securities types that performed relatively well in the financial crisis and the spread at 115 basis points for a AAA-rated security is very attractive relative to other highly rated alternatives. Because it's a floating rate security, it's got a duration or an interest rate sensitivity of next to zero.