Private Placements Likely to Remain in US Insurers’ Portfolios Despite Rising Rates
Direct lending outside the publicly traded realm of corporate bonds found greater favor amid low interest rates. Don’t look for that to change overnight as the Federal Reserve enacts inflation-fighting increases. Lack of trading opportunities, diversification and investment patterns may make it a crawl rather than a rush for the door.
- Terrence Dopp
- September 2022
PLACE OF INTEREST: The Federal Reserve Bank in New York City’s financial district.
- Instrument: Private placements are essentially corporate loans governed by maturities, yields and covenants that don’t involve public bonds.
- Market: They took on a greater role in insurers’ portfolios, particularly to back long-tail life and annuities obligations, as the Federal Reserve kept benchmark interest rates at or near zero.
- Shift: The qualities that made private placements attractive to start with—relative safety and higher yields, as well as longer maturities—mean they’ll stick around even as the Fed inches rates up and bonds become more attractive.
Insurers stepped up their investments in private placements—direct lending done outside of the public bond market—as interest rates hovered at historic lows for a decade following the 2008 financial crisis.
Although the Federal Reserve has been increasing those benchmarks on several occasions this year, industry watchers don't see the asset class losing favor in the near future.
Really a broad category rather than one specific investment product, private placements are typically debt instruments in which the borrowers raise money in a debt sale outside of public markets. They allow insurers to obtain yields above those they would see with more traditional bonds, while also featuring in some cases protective covenants more favorable than bonds.
“As long as issuers come to market providing that excess spread that is expected by those that are wiling to lend to private placement issuers, this market can continue to function very well.”
“As long as issuers come to market providing that excess spread that is expected by those that are willing to lend to private placement issuers, this market can continue to function very well through volatility, through market changes and spread changes in public markets as long as you're continuing to provide that excess spread,” said Cindy Beaulieu, a managing director and portfolio manager at investment management firm Conning.
“As long as valuations make sense I don't see a problem for borrowers coming to this market. There's a natural home in insurance companies for these securities.”
Also affecting the allocation is the buy-and-hold nature of private placements, which have a higher yield partially because they offer an “illiquidity” premium compared to public investments that are more easily traded. Any shift in investor behavior is likely to take place in new dollar investments rather than a wholesale rejigging of companies' portfolios.
Rob Lund, senior client portfolio manager at Income Research + Management, said the scenarios he sees as most likely, given rising interest rates that have raised the yields on more traditional publicly traded bonds, are either a leveling off of the upward trend toward private placement investing or a slight drop. Think a churn as older investments mature rather than an immediate change in behavior.
“Insurance company allocations tend not to be huge moves on day one– they’re gradual shifts.”
Income Research + Management
“Insurance company allocations tend not to be huge moves on day one—they're gradual shifts,” he said. “It's more about where that next incremental dollar is getting invested. You might see that next incremental dollar gets invested at the higher rate ultimately bringing up book yields.”
Investment money follows yield and rather than a wholesale shift, a more likely case is at most a gradual movement as new money “instead of going into privates in some cases going back into the public markets where we're seeing some attractive opportunities,” Lund said.
Lund's firm has $88 billion in assets under management. He said he concentrates primarily on public markets in his role and as such keeps an eye on all fixed-income markets in order to watch trends.
The insurance industry more than doubled private placement investment in the decade from 2009 to 2019, reaching almost $1.4 trillion in the final year, according to a September 2020 Best's Special Report: Private Placement Assets Double in Decade, Now Face Pandemic Pressure. The growth rate of private placement holdings held by insurers increased by an average 8.4% annually over the final five years of that span.
About 84% of that amount was held by the life and annuity sector, according to the research.
Beaulieu said the number of Conning's insurance clients dipping their toes into the asset class has doubled in recent years.
The traditional role of private placement investments within an insurance portfolio isn't likely to shift as interest rates go up, she said. Where she does see movement is in the size of allocations on the part of companies that participate.
“It just changes,” Beaulieu said, referring to the investments' value proposition. “The thing about the private placement market is it always takes some time to change. So one of the things that is very important is to stick with your discipline if you expect to achieve a certain spread over public market.”
Also shifting, she said, is the nature of the borrowers themselves.
Utilities providers and so-called industrials were early borrowers on the private market with maturities stretching out 15 years or more—making them a strong fit for life insurance and annuities obligations. With longer-term liabilities, the illiquid aspect wasn't such a factor.
Interest rates hit an all-time high of 20% in 1980 as inflation spiked in the double digits. It was all downhill from there.
Benchmark interest rates effectively hit zero amid the Great Recession in 2008 and stayed there until 2015, a span that coincided with the rise of private placements as a go-to investment as companies sought to push up yields.
The Federal Reserve uses a target of between 2% and 5% that is deemed a good level to keep the U.S. economy chugging along but diverges from that figure at times to regulate conditions. And in the near past, the central bank embraced that divergence and for an extended period.
After hovering at various levels of low for about a decade after the crisis, benchmark interest rates scratched zero again in March 2020 as the COVID-19 pandemic put a collar on economic activity. With blinking lights warning of recession and inflation again rising as a top-of-mind concern, the Fed raised rates four times during the first eight months of 2022, including a 0.75 percentage point increase in July.
Lund, of IRM, said part of the increased interest in private placements had been a pure reaction to the low rates. Now for the first time in recent memory, a high-quality corporate bond with a 5% yield isn't out of the realm of possibility, he said.
“You could make the argument that now might be a time when you could see more start to go up in liquidity, maybe up in quality,” he said. “There's a lot of uncertainty in the markets. We've seen an uptick in conversations around the public markets just given the more attractive yield levels we're at today.”
In recent years, the market also has seen the entrance of financial firms such as business development corporations that borrow directly rather than issue a public bond offering, Beaulieu said. Because these firms often issue medium-duration maturities of as little as three years, the market has seen more interest from property and casualty carriers in addition to life companies, she said.
“When you start to talk about some of those financials, that gets into an area where you really need some deep expertise to really understand what's going on inside the entity—what type of lending they're doing and how you as the lender will ultimately get paid back,” Beaulieu said.
Ed Kohlberg, an AM Best director, said that sort of investing is tailor-made for newer players in life insurance.
“The traditional players might not still be in that spot where they feel they need to increase that private placement allocation. It depends company by company and by liability profile.”
The admitted assets of private equity-owned insurers swelled since the 2008 financial crisis, while at the same time, traditional insurers, stymied by low rates and on a hunt for yield, grew more willing to enter into investment partnerships with PE firms.The interplay became symbiotic, as the firms saw insurers both in-house and external as a new market for the credit and lending products they sell.
“Not so much for the current players, I think it's new players in the marketplace that have an expertise about private placements,” Kohlberg said. “I'm talking about the investment managers, companies that come and start getting into the insurance business. They might have a more aggressive allocation to private placements than traditional companies.”
A traditional life insurer that has a hypothetical 10% allocation in the asset class may not see as much utility for the investments as yields rise in the public market, Kohlberg said. At the same time, they could comprise 15%-20% of portfolios for the newer companies that may have a greater appetite for private placements.
“The traditional players might not still be in that spot where they feel they need to increase that private placement allocation,” Kohlberg said. “It depends company by company and by liability profile.”
In its research, AM Best found during the period 2009-2019 purchases of private placement actually exceeded the number of public bonds bought in the life and annuity, property and casualty, and health segments.
In life and annuity, the portion of bond holdings consisting of private placements reached 35.5% from 24.9% at the start of the period. Property and casualty also saw an increase to 16.3% compared to just 5.1% in 2009.
“You wonder how high that number can get,” Lund said. “Now there are some more attractive numbers in the public markets, so I think potentially you can start to see that number slow down.”
Kohlberg of AM Best said there's another factor at work that guarantees private placements will remain: lack of tradeability. He was quick to point out that the market has remained solid and companies have grown more comfortable in the relative safety of the loans.
Still, nothing comes without even a small level of risk.
“There isn't a public market for this like a stock where if you aren't happy you sell it,” he said. “There is no marketplace like that and sometimes you're stuck with a nonperforming one.”