US Fed Rate Hikes, Ukraine Invasion and Lingering COVID-19 Inject Volatility Into Bonds
Without a crystal ball to see what the Federal Reserve has in store in its inflation fight, coupled with Russia’s invasion of Ukraine and stubborn COVID-era supply chain problems, the bond market is seeing volatility rise.
- Terrence Dopp
- June 2022
- Tested: Bonds, both corporate and government credits, have long held an important role in the portfolios of life insurers because they match safety, liabilities and are long-tailed.
- Interest: In May, the Federal Reserve raised interest rates by 50 basis points in its second such action of the year, and more could come.
- Combustible: While life insurers—or any investor really—have bemoaned low interest rates for years, the move has brought about volatility in the normally slow-moving bond market.
On one hand, the good news: After a decade, the U.S. economy may be reverting to seemingly more understandable patterns. The Federal Reserve is starting to hike interest rates and tighten its balance sheet in efforts to curb inflation.
But there's also some (potentially) bad news: The U.S. government pushed out almost $4 trillion in various stimulus programs over three measures aimed at softening the blow of lockdowns and wrestling the effects of the pandemic under control. Pump that kind of money—coupled with quantitative easing—into the market and it might be difficult, if not impossible, to find a quick and smooth path to normal.
The impact can be seen in the staid bond market, a collection of government and corporate debt that historically has been safe turf for life and annuity insurers. Yet for all the years of low rates and easy money cutting into bond yields, the first two increases—and possibly more in 2022—are being met by volatility in the market as participants wait to see what happens. “We've never seen anything as dramatic as what we saw in terms of monetary and fiscal stimulus during the pandemic and now that's being removed,” said Jennifer Quisenberry, chief investment officer at New England Asset Management. “You don't think there's going to be something on the way out that is going to upset all of the spread tightening that we had? Logic would assume that it's going to be difficult to unwind it without some bumps along the way.”
A quick glance at total returns shows the extent to which the age-old equation of how life insurers invest can be found in an AM Best ranking of 2020 total investment returns for the industry by asset class. In 2011, bonds had a yield of 5.41% while common stock had a corresponding figure of 4.6%. By 2020, those numbers had flipped to 4.22% and 6.2%, respectively, and insurance companies largely changed their behaviors based on the simple need to go where the money could be found.
“We’ve never seen anything as dramatic as what we saw in terms of monetary and fiscal stimulus during the pandemic and now that’s being removed.”
New England Asset Management
Shockingly Low Returns
The Best's Rankings U.S. Life/Health — Asset Distribution — 2021 Edition illustrates the percentage of bond investments in this segment of the industry. Among the top 25 largest life insurance companies, ranked by 2020 admitted assets, the amount of holdings ranged from a high of 73% held in Sammons Enterprises Group's portfolio to a low of 8.9% for the Talcott Resolution Group. That slice of the industry held a combined total of about $2.2 trillion in bonds, or an average of 36.6% of portfolios. For the full industry, about $3.4 trillion in bonds equated to 41.6% of portfolios for 2020.
In the current environment, expectations of a quick rise in benchmark rates have prompted higher levels of unrealized losses as well as “pretty shocking” returns that have dipped into negative territory, Quisenberry said. At the longer end of the market, she said inflation was baked into bond pricing.
“The speed at which all of this is happening is something that is taking the market a bit by surprise as well as these negative total returns,” she said. “The message is very much a processing of what the Federal Reserve is saying about their plan to attack inflation. The ongoing narrative is that the Fed has been behind, or the Fed has been behind the curve and not moving quickly enough.”
The consumer price index—a basket of consumables used as an indicator of inflation—rose 1.2% in March and was up 8.5% over the trailing 12 months, according to the U.S. Bureau of Labor Statistics. In May, the central bank approved a 0.5% increase after hiking rates by half that in March and left the door open for additional increases in the remaining half of the year in an effort to curb the rising tide.
The exact nature of how the Fed's inflation fight will impact the life and annuity space “remains to be seen,” according to a March Best's Market Segment Report: US Life/Annuity: Record Capitalization, Strong Liquidity, and Improved Earnings in 2021. While rising rates are sure to be welcomed by the industry, rapidly rising rates won't be seen quite so favorably.
“Furthermore, credit spreads tightened shortly after the onset of COVID-19, but whether bondholders are being properly compensated for the risk they are bearing also remains to be seen,” the report said.
Ed Kohlberg, an AM Best director, said the industry is watching to see how the full year plays out in terms of Fed action, though he said more recently companies have been finding value in so-called alternative and less-liquid assets. While shifts in asset management tend to be at the margins, he said the trend also needs to be developed as asset-liability matching also tends to dictate where investments are made.
As far as volatility in the bond market, Kohlberg said that typically more quiet section of the world doesn't see the “floor may drop out” combustibility that can take place in the public equities markets.
“It's still safe, it's just a matter of whether you can hold out until you can get a more favorable yield,” he said. “It's just, do you hold off and lock in at more favorable rates if you have a strong inclination that in a few months there's a possibility of it being higher? If you can hold off, it might make sense. In addition some companies have used floated rate bonds in their portfolios, which helps to somewhat mitigate some of this risk.”
Any changes are taking place more so on the liabilities side of the ledger, Kohlberg said, as carriers realize many of the same moves that insulated them from low rates—mergers and acquisitions, shedding blocks of business, de-risking and shifting to less interest-rate sensitive products —still make sense in the current climate. “That change is more prominent and significant than large changes in investment strategies,” he said.
“It’s just, do you hold off and lock in at more favorable rates if you have a strong inclination that in a few months there’s a possibility of it being higher? If you can hold off, it might make sense.”
Alton Cogert, president and chief executive officer of Strategic Asset Alliance, said in recent meetings with corporate boards and investment committees that they are beginning to ask whether it's time to start considering any investment changes. The exact outcome of those discussions remains to be seen, though he said potential outcomes for investment-grade bond portfolios could include movement up or down the rating scale as well as a shift in durations.
Both Cogert and Quisenberry cited wage growth as potentially exacerbating inflation, tying into the Fed's next moves. As well, they said the lingering impacts of COVID-19 and supply chain issues are, in part, driving the central bank's actions and attempts to rein in growth of inflation.
Cogert also said the Fed's movement to quantitative tightening after a decade in which easing was the order of the day is sure to be a shock and is adding to the volatility in the bond market. Easing involves the government purchase of private securities to create liquidity. Russia's invasion of Ukraine in late February pushed up energy prices and also can't be overlooked, he said.
“You've just got a lot of variables there causing the market to be a lot more volatile,” he said. “Quantitative tightening changes the game quite a bit in the financial markets. All of a sudden we're not swimming in liquidity—it's just the opposite.”
Like Kohlberg, he said in the short term he expects the mantra to be more of the same. If volatility does prompt a shift in how insurers view bonds, he likened it to turning around the proverbial aircraft carrier—slow and steady, with the results taking time to add up.
“This is new territory,” Cogert said. “That doesn't sit well with all investors, not just insurers. Insurance companies are really good at pricing and understanding specific risks, whether it's on the life side, health or P/C. But some things are outside our control as insurers and the financial markets are maybe the biggest thing.”