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Insurers and absolute return fixed income

March 2020

Insurers and the low yield conundrum

Why insurance companies should consider absolute return fixed income strategies as part of their bond allocation.

For non-life insurance companies, bonds are an investment staple. And for good reason. Insurers’ liabilities – current and future expected losses from claims – tend to be of short duration, between two to four years on average.

Which means the ideal return-generating, or liability-matching, asset is one that is exceptionally liquid, produces stable streams of income, and holds its capital value.

The trouble is, fixed income markets are not as dependable as they used to be.

In fact, in the decade since the US housing market crash, fixed income investors have had to abandon several of the beliefs they once held dear. It turns out, for instance, that negatively-yielding bonds are no longer an absurdity. Thanks to sustained quantitative easing, the volume of fixed income securities trading at negative yields has never fallen below USD6 trillion since 2016. (The figure leapt to as high as USD17 trillion in September last year).

Also consigned to history is the notion that developed government bond markets are oases of calm. On one eventful day in May 2018, the yield on Italy’s two-year bond spiked by more than 150 basis points, the sharpest one day sell off in more than 25 years. This was preceded by the US 'flash crash' of October 2015, which saw yields on 10-year Treasuries move up and down by 160 basis points within just 12 minutes. As the US Federal Reserve warns, such episodes will be more frequent in future as passive investing and algorithmic trading gather pace.1

(The extreme moves seen in the wake of the coronavirus outbreak -- equities and corporate bonds selling-off sharply and government bond yields dropping dramatically -- testify to this new, more volatile market climate). 

Fixed income investors have had to abandon many of the beliefs they once held dear.

On top of wafer-thin yields and higher bond market volatility, insurance companies face an added complication. The definition of a diversified bond portfolio has also had to be torn up. That’s because the various fixed income asset classes that constitute the global bond market2 have been tracking one another more closely in recent years. The correlation of the returns of US Treasuries, corporate debt and US dollar-denominated emerging market bonds has been higher in the past three years than in the past 10.

 

It is unlikely that insurers can accommodate this new reality for much longer. Holding a more volatile portfolio, or one that contains a greater proportion of higher yielding but lower quality bonds, is an impractical and potentially risky option. Not least because regulations such as Solvency II have made it costly for insurance firms to hold riskier assets.

 

But there is an alternative to traditional bond portfolios, and comes in the form of an absolute return fixed income (ARFI) strategy.

Risk control

ARFI strategies’ appeal has much do to with their approach to risk. They are designed to produce a better trade-off between bonds’ inherent risks and their prospective return and preserve capital whenever markets stumble.

To achieve that, they use techniques and processes generally unavailable to buy-and-hold investment managers.

A distinguishing characteristic is that they are not tethered to reference bond indices. Investment targets often take the form of a percentage gain over Libor or inflation over a specified period. This gives ARFI portfolio managers the freedom to seek returns from a wider variety of sources. That includes changes in interest rates (duration), bond issuer creditworthiness (credit premia) and movements in currencies. Emerging market bonds and currencies, investment and speculative-grade bonds, and other credit instruments such as credit default swaps consequently form part of the investment mix. In diversifying sources of risk and return in this way, ARFI strategies are better equipped to deliver investment gains across all phases of the economic cycle.

ARFI portfolios also give greater emphasis to containing risk. Unlike traditional fixed income funds, many ARFI strategies use a wide variety of sophisticated investment and risk-management techniques. They make extensive use of interest rate and credit default swaps and other derivatives to temper the volatility of bond returns. The aim is to deliver a bond-like return from a portfolio that is less volatile than a traditional fixed income investment.

Rewarding risk control

Solvency Capital Requirement, %, selected fixed income asset classes

ARFI insurers.png

Source: Pictet Asset Management. Average SCR ratio calculated from monthly observations over period 31.03.2016-31.12.2019. Data taken from representative accounts of Pictet Absolute Return Fixed Income, European High Yield and Global Emerging Market (USD) strategies. 

At a time when regulatory oversight is tightening, these are outcomes insurers increasingly value.

Solvency II regulations which came into force in 2016 have made it more expensive for insurers to invest in riskier securities to boost yields.

The Solvency Capital Ratios (SCRs) assigned to bonds such as speculative grade and emerging market debt are now in the region of 20 to 30 per cent. This means insures would need to set aside some USD20 to USD30 million per USD100 million invested, rendering such assets close to unaffordable in many cases.

This is where an ARFI allocation could help.

What the tighter regulatory framework also does is favour strategies that deploy strong risk controls. Contained within the rulebook is what is known as the ‘look-through’ principle. This is designed to encourage insurers to make more efficient use of their risk budgets. Genuine diversification is rewarded, as is the systematic hedging of investment risk.

The most diversified and risk-sensitive ARFI portfolios tend to fare particularly well under the new framework. By spreading capital across the broadest range of countries, currencies and fixed income securities, these portfolios can generate returns that are both less volatile than - and independent of - those of the broader market.

The result is that, in most cases, ARFI strategies incur lower SCRs than many other popular yield-generating assets. Using historical data from our own bond portfolios, we find that for every USD100 million insurers invest in an ARFI strategy, they must set aside about USD10 million in reserves. For investments in high yield bonds and emerging market debts, however, the capital cushions required are far plumper.

So it appears, then, that even in a world of paper-thin yields and tighter regulations insurers still have attractive investment options. ARFI strategies offer new possibilities. They can provide higher yields than traditional government bond-heavy portfolios but with a degree of risk control that regulators favour. An investment tailor-made for the new normal.