Solvency II could drive investors from BBB bonds, EDHEC warns
EUROPE - Investors could shift away from bonds rated BBB or lower under the new Solvency II requirements given the additional marginal cost that could be considered excessive in proportion to the return generated by such assets, a new study has found.
According to an EDHEC Risk Institute study - which looks into the bond solvency capital requirement (SCR) as a risk measure, as well as its effect on bond management within a return-volatility-Value-at-Risk-SCR universe - the new Solvency II requirements could have a deep impact on investors' bond management practices.
Even though the report conceded that SCR - as defined by the Solvency II standard formula - is an appropriate measure of risk for fixed-rate bonds, SCR does not fully reflect the risk associated with long-maturity investment-grade bonds, high yield or unrated bonds.
EDHEC also noted that real credit spread is not strongly correlated with SCR due to the flat-rate treatment of spread risk under Solvency II, which assigns a single risk factor to each rating and does not account for internal variances in ratings.
As a result, the additional marginal cost of long-term bonds could be seen as excessive compared with the return provided by such assets, which would push investors to "neglect" bonds rated BBB or lower.
This, in turn, would lead to "significant" implications for the financing needs of the economy, EDHEC said.
Due to the features of bond SCR - which present a strong correlation with volatility and historical VaR - bond management currently based on the return-VaR-volatility triple factor should evolve under Solvency II, more towards a management approach based solely on the bond return-SCR pair, EDHEC said.
The institute also pointed out that an analysis of the efficiency of risk-taking measured by the bond return/SCR ratio showed that the standard formula favoured low-duration bonds, particularly high yield bonds.
"This management, within the constraints of SCR, could lead to a shortening of durations, given the calibration and current term structure of interest rates," EDHEC said.
The institute lastly stressed that Solvency II, which will come into effect in 2014, would have a significant impact on the way insurance companies, as well as financial markets, perceived risk.
"One of the major changes with Solvency II is the treatment of market risks, which represent an additional capital cost that now needs to be incorporated into the analysis of insurers' investment choices," it said.