Insurers and asset managers have long bemoaned the challenges of persistently low global interest rates and the impact that this has on insurance balance sheets in particular. Many life insurers wrote policies in decades where interest rates had reached levels that are unlikely to be repeated any time soon; they have been especially hard hit. But any insurer who has been looking to portfolios of investment grade credit as the panacea for liability matching or actually driving investment returns is sure to be disappointed.
The current backdrop of painfully low yields has prompted a number of responses by insurers and their asset managers. The prevailing response has been an almost insatiable appetite for ever more esoteric fixed income asset classes – equity release mortgages, commercial real estate debt, aircraft leasing, infrastructure debt are some examples. Insurers seem happy to surrender some liquidity and accept a greater governance burden in return for a decent yield over and above traditional investment grade credit. As a result of this heightened appetite, market participants have acquired a greater knowledge than ever before of the complexities of these alternative fixed income asset classes. In truth, they have little choice: the Own Risk and Solvency Assessment (ORSA) process obliges insurers to provide comprehensive evidence that they know precisely the risks to which they are exposed.
The interest in alternative fixed income is entirely understandable in an investment environment where every basis point counts. It is also an environment in which insurers have become increasingly familiar and comfortable with hedge funds and private equity, in spite of the high capital charges and comprehensive governance burden attached to these asset classes.
The supply of the alternative flavours of fixed income may begin to thin out, or the burden of regulatory compliance that accompanies such investments may become excessive
At the same time, however, we have witnessed an increasing focus on those lowly investment grade credit assets that traditionally sit at the very core of an insurer’s portfolio. This focus is prudent and common sense: after all, the supply of the alternative flavours of fixed income may begin to thin out, or the burden of regulatory compliance that accompanies such investments may become excessive.
Hence, the desire to wring out any available basis points of yield from more traditional corporate bond investments.
The core fixed income portfolios held by insurers tend to be managed on a ‘hold-to-maturity’ basis (although cynics might describe this as ‘buy and forget’). Here, a bond is identified that ticks all the right boxes for inclusion in the core portfolio. There it sits until it matures, and is replaced by another suitable bond issue. Turnover of such portfolios is naturally very low, typically taking place only when a bond matures or a default event occurs. The result is a stable, often low-yielding portfolio. But the approach results in a low level of interaction with the market, leading to the danger that any credit deterioration might be spotted too late.
In contrast, the managers of active credit portfolios interact frequently with markets. Therefore, they are able to identify opportunities more readily as they look to outperform their benchmarks. Active global managers have well-resourced credit teams and deep research resources focussed on identifying broad investment opportunities for their active portfolios, both in domestic and international markets.
This puts asset managers in a strong position to provide a strategy that is growing rapidly in popularity among insurers – ‘buy and maintain’. We’ve also seen it called ‘buy and build’ or ‘buy and nurture’, but the overall approach remains the same. The logic is that you take the essential stability of a typical hold-to-maturity portfolio and pair that up with deep credit research disciplines and relative value skills. This approach allows the fund manager to build out a portfolio comprising higher-yielding bonds that may have been overlooked by internal insurance fixed income teams who have no cause to interact frequently with the market.
The buy and maintain concept is often regarded as ‘passive’ in nature, but our experience shows that it is anything but passive
The buy and maintain concept is often regarded as ‘passive’ in nature, but our experience shows that it is anything but passive. Buy and maintain mandates can be tailored in some unique way to the requirements of the individual insurance company: this makes logical sense when you consider that each portfolio is matching off against very individual sets of liabilities or yield target. But the one defining characteristic common to any of these mandates is that they involve very active relationship management. Insurance liabilities are not made equal; accordingly the portfolios that match them must be uniquely tailored. Such mandates require the asset manager to engage in very close dialogue with the client, and our experience shows that the initial discussions that allow a mandate to be agreed are crucial to ensure the design of an appropriate portfolio.
Thereafter, the relationship between insurer and asset manager remains an active one. It involves close dialogue about how we should invest bonds with varying maturities and about the appetite for appropriate replacements within the portfolio during default or downgrade scenarios. This necessitates a close relationship between insurance client and asset manager.
Buy and maintain credit portfolios can never fully address the ever-present pressures facing insurance companies when it comes to targeting yield within their investment portfolios. However, if they are employed carefully alongside the array of other interesting investment opportunities available to increasingly sophisticated insurance investors, a bit of tender loving care applied to the core bond portfolio can certainly go some way to alleviating that pressure.