Investing In Investment Grade Credit: Problem solving
Along with pension funds, European insurance companies are the major investors in investment-grade corporate bonds. But they face challenges as a result of current low yields, the prospect of rising interest rates, and the impact of Solvency II, which comes into force on 1 January 2016.
Asset allocation for both the US and European insurance industry is influenced by an acceptance that the capital buffer required to take investment risks should reflect the economic exposures implied by those investments. As a result, insurers’ cost of capital (whether that be the simple marginal cost – the yield of a new bond issue – or a broad-enterprise-weighted average cost) can influence the type of investments it makes: an insurer will assess the yield or expected return on any potential investment asset in the form of a ‘capital adjusted’ return, with the result that, as the cost of capital rises, it becomes more punitive to hold risks with higher regulatory capital charges.
Insurers therefore have to find the trade-off between regulatory capital consumption, the economic risk they take with their investments and their expected returns.
“Portfolios can seek to optimise return on assets or, more efficiently, use capital dependent on the individual insurer’s objectives and capital position,” says Erinn King, a principal at Payden & Rygel.
Eligible for capital relief
The biggest impact of Europe’s Solvency II regulations is on equities and alternatives, simply because equities incur a capital charge of 39% and hedge funds or private equity require 49%.
By comparison, depending on duration, investment-grade credit requires just 5-10%. It is one of the most straightforward asset classes under consideration, and has not attracted the same level of controversy as, for example, the ABS market.
As such, Solvency II has already led to substantial anticipatory shifts in asset allocation.
“There has been a large shift away from equity holdings,” says Mathilde Sauvé, insurance solutions strategist at AXA Investment Managers. “Five years ago, average equity holdings were around 15-20% and now it is around 8% – very different from the pension fund world, which has 30-40% in equities.”
One board member of a major German insurance company told IPE that its application of a risk-based capital approach to asset allocation meant that it moved away from equities into corporate bonds in time to benefit tremendously from the spread tightening that followed the 2008-09 financial crisis. The insurer’s dilemma now is whether it should crystallise its gains and move into other asset classes at a time of potentially rising rates.
As well as lower capital charges, there is the potential for investment-grade corporate bonds to offer investors eligibility for capital relief, arising from Solvency II matching-adjustment rules.
“But this requires a buy-and-hold strategy that ringfences assets and ties them to a specific stream of liabilities,” notes King. “This is similar to the US, where the accounting is such that a buy-and-hold strategy designed for satisfying long-term liabilities would not be marked to market, with just the income being shown and the bonds held at cost.”
There are also strict requirements on the type of bonds that are suitable.
“The whole of the Solvency II matching-adjustment approach is predicated on matching cashflows precisely, so assets where the cashflows are not certain, such as callable bonds, are not generally allowed,” explains Andrew November, director of investment strategy & integration at Aberdeen Asset Management. “Furthermore, Solvency II makes it difficult to sell assets used in matching cashflows. The regulators are trying to discourage changes, so that if a sale is required – for example, because a credit deteriorates – it would need to be signed off by senior management.”
There is some evidence of a shift out of investment-grade corporate bonds into riskier assets – although this comes with regional variations. In Italy, for example, the average yield on government bonds is still a fairly impressive 4%, and insurance companies have been confident buyers, ploughing in as much as 70% of their assets.
“That makes it difficult to find alternatives that yield more,” observes Sauvé.
In addition, typically only 10-15% of balance sheet assets can be non-eligible, so the big challenge is finding higher-yielding assets that are also eligible under local insurance rules. In the UK, anything is eligible whereas, in Italy, much is not eligible. Loans are very difficult to invest in in France and Italy while, in Germany, domestic loans are eligible but others are not.
Nonetheless, there are alternative yielding assets that can make sense in a risk-capital-adjusted context. King notes the improved treatment of structured securities, for example: the most recent changes mean that covered bonds continue to be treated favourably, but capital charges remain punitive for more esoteric structures as well as for some types of ABS.
Moves to private debt
Most commentators agree that emerging market debt offers yields high enough to compensate for the capital charges. King sees greater use of local currency emerging market debt as capital requirements punish unmatched currency exposure, but favour sovereign spread risk. Local currency is attractive for insurers with liabilities denominated in emerging currencies.
The big moves, however, appear to have been into infrastructure debt, real estate debt and other forms of private debt.
“If you move into infrastructure debt, the capital charges are the same as for corporate debt,” explains Patrick Liedtke, head of the financial institutions group at BlackRock.
“In the past, insurers had invested in very
liquid investment-grade debt or perhaps in a portfolio of half sovereign, half credit,” says Sauvé. “What we are starting to see is a move towards high-yield and emerging market debt, and into less liquid debt such as loans, both corporate and real estate, infrastructure and finally structured assets”.
The insurance sector has spent a number of years preparing for the implementation of Solvency II, while also reacting to an environment of low and potentially rising yields.
“Insurers obviously want to enhance their returns and their income but they also want to have a potential inflation hedge when it happens, so they move into new asset classes,” says Liedtke. “They definitely see an opportunity to capture illiquidity premiums and they see a great opportunity to diversify their risk factors, which under Solvency II would lead to a better capital position. It also becomes a neat way to manage the volatility on their books as they would have more levers to operate to do that.”