Storm Clouds on the Horizon?
Asset managers have begun de-risking their portfolios in response to forecasts of a recession in 2020 or 2021.
- Jeff Roberts
- June 2019
- Recession?: Insurance investors are closely watching indicators of a possible downturn in 2020 or 2021.
- Protecting the Portfolio: Insurers began de-risking their portfolios in the past year to 18 months, and that accelerated after the sharp fourth-quarter sell-off.
- Private Over Public: Insurers increasingly prefer private assets over public, especially private equity, infrastructure debt and middle-market corporate loans.
The warnings began to build over the winter and into the spring.
Slowing global growth, especially in China and Europe. Trade wars. An inverted yield curve in March and again in May.
As the late stages of this credit cycle stretch on, insurance investors are closely watching conflicting—and even troubling—indicators signaling a U.S. recession is on the horizon in 2020 or 2021.
“There are certainly warning signs out there that are telling us that you should have an elevated view of what risk is and make sure that you're getting paid for it very carefully,” said Woody Bradford, Conning's CEO and chair of the board. “There's a lot of yellow signs out there, and yellow tells you to proceed with caution.
“Almost everybody's talking about this. We're a day closer to the next recession. I don't know if that's two years out or one or five, but we're definitely a day closer.”
Many insurers have already started protecting their portfolios, even if a timeline for the next downturn remains elusive. The U.S. economy grew a surprisingly strong 3.2% in the first quarter, and the labor market continues to add jobs while unemployment is the lowest it's been in decades.
But in the past year to 18 months, many carriers have begun mitigating against the heightened risk a recession brings. The number has accelerated in the past six months, driven by the return of market volatility and a sharp fourth-quarter sell-off in 2018.
It marks a shift in priorities for asset managers, especially life insurers, who have pivoted to de-risking their portfolios after years of reaching for yield while mired in a historically low rate environment.
“If you go through the fourth-quarter earnings calls for all the publicly traded insurers, almost everybody addressed this question: What do you do in a downturn? How are you preparing?” Bradford said.
“If you can't answer those questions for your board or your public shareholders at an insurance company today, you should get on it. You're late.”
The common levers for reaching for yield—dropping in asset quality and delving further into riskier assets—could become liabilities in a recession.
So most asset managers are reconsidering their asset allocations and risk appetites, even if they have been disciplined in their approach, working on the margins to find diversification and yield.
Insurers are studying the risks in their portfolios and how a range of downturn scenarios would impact their overall capital positions and key metrics.
And they are searching for safe havens and adequate returns without leaving their portfolios overexposed to credit risk and interest rate risk.
The threat of downgrades looms large, especially with the proliferation of BBB-rated holdings among carriers. One insurer even asked Conning to model the ramifications of selling its BBB securities and moving into A-rated assets.
“The greatest risk to the industry is a ratings migration downward, creating the need for more risk-based capital backing investments,” said John Simone, managing director and head of insurance solutions at Voya Investment Management.
Despite, the concern, the industry is “well-positioned to weather” a recession, said Mike Siegel, global head of Goldman Sachs Asset Management's insurance business. Since the financial crisis, insurers have diversified in asset classes and learned critical lessons in risk monitoring and risk management.
They have also navigated a series of mini-cycles during this expansionary period, including an oil crash, the Greek debt crisis and the emerging market debt sell-off of the mid-2010s.
But a climate of caution remains.
“In the mid-November to mid-January period, there was a little bit of concern out there that the sky was falling and the world was ending,” Bradford said. “If people weren't alerted to the fact that they might face a downturn in the near term, that woke them up.
“One of my clients likes to say they're sleeping with one eye open.”
If people weren’t alerted to the fact that they might face a downturn in the near term, [the fourth-quarter sell-off] woke them up. One of my clients likes to say they’re sleeping with one eye open.
Concern is building.
The 2019 Goldman Sachs Asset Management insurance survey reflected growing unease, even as the economic expansion is widely forecast to continue through the end of the year.
In fact, 85% of responding investors think we are in the late stage of a deteriorating credit cycle, a significant jump from 34% in 2018.
“We saw concerns around recession rise across each of the major markets,” said Matt Armas, the global head of insurance fixed income portfolio management at Goldman Sachs Asset Management.
The 300-plus chief investment officers and chief financial officers surveyed reported they were most concerned with the deterioration of credit quality in their portfolios and low yields.
Although a decade has passed since the financial crisis, 2007 and 2008 remain fresh in the minds of most executives overseeing insurance portfolios. The late stages of the cycle have them again reconsidering strategic asset allocations.
Most asset managers—or their external advisers—have begun protecting their portfolios by risk modeling and stress testing to reassess their assets and risk tolerance under a series of variables.
“A lot of insurance companies are taking a look at downside scenarios, modeling work and stress tests more frequently,” Bradford said. “A lot of people are asking many, many more questions.
“The three things that people mostly want to know? Show me what happens if '07 repeats. Show me your stochastic modeling of outliers and tail risks that could impact my portfolio. And show me what the impact is on [risk-based capital], on income and on liquidity.”
Macquarie Investment Management has had “on-going and pretty constant conversations” on the same topics with its clients, said senior vice president Chris Hanlon, head of insurance strategy &ALM.
Carriers are not just studying how their portfolios will hold up. They want to understand the risks they hold, demonstrate what value they're getting paid for those risks and how it all syncs up with their risk tolerance.
“We've had conversations with insurance companies where they wanted us to do a deep dive on the risk at the portfolio level, but also at the underlying credit level, the fundamental level,” Hanlon said.
Once carriers comprehend their positioning in downturn scenarios, they then plan how to transition out of their riskier assets.
Woody Bradford, the CEO and chair of the board at Conning, says there are fundamental principles to preparing an insurance portfolio for a recession:
- Understand the risk you’re taking and remain disciplined with your risk tolerance.
- Stay diversified in not only individual credits and sectors, but also strategies that boost a portfolio and mitigate the two principle risks: corporate credit risk and interest rate risk.
- Become more defensive in your positioning.
The bottom line is finding ways to add yield to the portfolio that diversifies against those two principle risks.
There are three fundamental principles to preparing a portfolio for a recession.
First, insurers need to understand their investment risk and remain disciplined with their risk tolerance. Hence that increased modeling.
Second, they need to grow more defensive in their holdings by improving credit quality. Therefore, many are reducing their below-investment-grade positions and increasing exposure to assets that have higher yield per unit of risk—such as collateralized loan obligations (CLOs) and consumer non-cyclicals.
Finally, they need to diversify their strategies, asset classes and individual investments to not only add value to their portfolios, but also mitigate credit risk and interest rate risk.
“The three transcendent rules in credit investing are diversification, diversification and diversification,” GSAM's Armas said. “Appropriate diversification helps manage that single-name event risk.
“The takeaway from the crisis is an incremental diversification through different styles rather than taking large, concentrated market views to deal with the challenge of the low rate environment.”
Other trends are emerging as carriers rethink their strategic allocations.
For instance, insurers increasingly prefer private assets, especially private equity, infrastructure debt and middle-market corporate loans.
Privates generally offer better returns than publics, better recoveries in a downturn and “clients feel that private markets give them better protections” in loan covenants, Armas said.
“We favor private assets over public because not only are we getting better yield, but we get better structure,” Voya's Simone said. “And better structure is really important with where we are in the credit cycle.
“We like private placements, investment-grade quality private commercial mortgage loans extending into below-investment-grade commercial mortgage loans and lower quality private debt, where we see opportunity. We really want to be able to pounce there when the market turns.”
The push into private markets is part of the industry's continued search for investment income beyond traditional, fixed-income assets in the post-crisis environment.
Many insurers have also exited problematic businesses that offered guaranteed rates to free up capital and focus on higher growth opportunities.
“The days of just being able to buy very conservative product at a decent yield are over,” Simone said. “We've been in a low rate environment for so long, you just can't bury your head in the sand and buy A-rated corporates and be happy. The spreads just aren't there.
“You have to look at the BBB space. You have to look at private equity. You have to look at private debt. That's the new view that insurance companies have to have.”
Asset managers probably will go longer in duration and increase their exposure to illiquid assets to enhance yield without dropping in credit quality. Private equity, infrastructure debt, bank loans and mezzanine debt are often cited.
“We see life companies looking for yield enhancement that is [asset liability management] consistent,” Macquarie's Hanlon said. “We see property/casualty and health companies looking for return boosters as well as a way to deploy built-up surplus.”
While many insurers have kept a consistent risk profile, some have begun storing up dry powder to take advantage of market dislocations.
“If you're getting into a recessionary environment and you're generating cash flows, you have dry powder to invest in opportunities both in the primary and the secondary private equity market,” Simone said. “When you're in a recession, commercial mortgage lending spreads tend to blow out and you have great opportunities to underwrite excellent properties with disciplined sponsors to take advantage of that market.
“In private debt, you're able to take a look at fallen angels in terms of below-investment-grade privates. We think there's going to be some tremendous opportunities in that market, as well as the middle market.”
Meanwhile, P/C and health insurers have been exploring an exit from U.S. equities. They've been asking questions about how to reallocate “a very successful portion of the portfolio over the last seven, eight, nine years” thanks to the U.S. bull market, Hanlon added.
P/C carriers also have made material changes to their tax-exempt municipal bond holdings after the 2018 tax law changes reduced the value of the shield. Instead they're buying commercial mortgage loans and private placements—two spaces in which they historically were not large players.
But demand for taxable munis remains among life companies, according to Hanlon.
Many insurers also continue to reduce investments in hedge funds and other mark-to-market assets, and some have grown sensitive to any whiff of corporate scandal, remembering the rapid fall of some companies during the crisis.
But when it comes to reducing exposure, BBB holdings—which could be prone to downgrade or default in a recession—are drawing the most discussion.
The greatest risk to the industry is a ratings migration downward, creating the need for more risk-based capital backing investments.
Voya Investment Management
The sheer amount of BBB holdings within the industry has many concerned.
More BBB securities are being issued, so insurers have increased their exposure.
“There's so much migration in the market from A-rated credits to BBB-rated credits, so much so that the Bloomberg Barclays Global Credit Index is a BBB-plus index when it used to be an A or A-minus rated index,” GSAM's Armas said.
BBB assets made up 30% of P/C insurers’ corporate debt allocations in 2010. They now make up 40%, Bradford said. Life companies increased their BBB allocations from 45% to 49% of their corporate debt.
Some fear an abnormally large wave of downgrades into high-yield, overwhelming some big balance sheets with below-investment-grade credit.
“The really big question is credit,” Bradford said. “If you do have a recession that has some staying power, what happens to the credit exposure in your portfolios, and in particular, all those BBB holdings?
“That question probably has most people quite concerned. That's certainly an elevated level of risk in many insurance company portfolio holdings that I think should bear concern if we go into a recession.”
But GSAM sees fears over BBB corporate credit easing, as it has witnessed initial signs of stabilization and even debt reduction across the investment-grade market. And the longer the economic expansion continues and companies have stable-to-improving cash flows, the less of a concern it becomes, Armas said.
That expansion likely will become the longest in modern U.S. history this summer. GDP remains strong. Unemployment low. Profits generally high.
Simone says Voya likes BBBs in private markets, especially in the CML market, because they have better spreads than public securities, the default history is much lower than publics of a similar rating and their make-whole provisions can generate additional return if a covenant is missed.
“The BBB drumbeat that everybody's talking about—yes, there is some level of concern of downgrades,” Simone said. “But the concern over actual default risk we think is a little bit overblown.”
Many see healthy economic growth continuing through at least 2019.
However, a reliable indicator of recession—the inversion of the yield curve—occurred in March and again in May. Each time, the yield on the 10-year U.S. Treasury note fell below the yield on the 3-month bill.
An inverted yield curve has preceded each U.S. downturn over the past 50 years. The last seven times it inverted among the 3-month and 10-year bonds, the economy went into recession within 15 months with one exception.
But many have downplayed the importance of the inversions this time, given the unusual period of monetary policies since the crisis.
“[The inverted yield curve] created a lot of news headlines,” Simone said. “Keep your head at full swivel, but we think it just feeds into volatility. And volatility spells opportunity that we're going to take advantage of.”
Although the macroeconomic indicators remain strong as of mid-May, the industry knows the cycle is reaching its end.
Facing a framework of strict regulation, capital constraints and contingent liabilities, insurers are always on the lookout for the next downturn.
So their portfolios need protection. But that requires a deliberate process.
“Insurance companies don't make asset allocation moves in large waves,” Simone said. “It's sort of like steering a battleship.”