Lower for Longer—Ideas for Insurers in Today’s Low-Rate Environment

Western Asset insights to help insurers maintain a moderate level of income in this low-rate environment.

    Powell Thurston

    Keith Luna

    The year 2020 will long be remembered for the COVID-19 pandemic and extraordinary levels of both geopolitical uncertainty and volatility in markets. As 2021 began, we thought the presidential election and market turmoil were mostly behind us. The events on January 6 in Washington, DC and the Democratic win of two Senate seats in Georgia caused us to re-examine our views. We expect rates to remain lower for longer. From a political perspective, the wins in Georgia evenly divide the Senate, leaving the Democrats in control of the Chamber. However, we do not expect substantial progressive programs to be enacted. This will be limited by more moderate Democrats and the fact that they get one reconciliation bill per year. There are limitations on what this bill can include. We expect Democrats to use the 2021 Reconciliation bill for an additional round of stimulus, likely in late March. As a result, we doubt there will be any major changes to domestic fiscal policy that would drive inflation.

    From a markets perspective, we do not expect elevated levels of volatility because the vaccines provide a light at the end of the pandemic tunnel and the United States Federal Reserve (Fed) has explicitly stated that it will be accommodative for the foreseeable future. With that said, we remain cautious because the sources of volatility are hard to predict. The additional stimulus we expect, combined with monetary policy that is already exceptionally loose (i.e., limited effect from using additional tools available), leaves the economy in a place of having to move forward under its own impetus. While we are fairly certain to see some additional growth—and possibly even some temporary inflation—as we continue to recover from the pandemic-induced slowdown, the likelihood of a slower growth and inflation environment ahead appears most likely to us. Growth was beginning to slow pre-pandemic with no sign of meeting the Fed’s 2% annual inflation target over a sustained time period. The future scenario we envision is one in which the Fed is likely on hold, with rates pinned near the zero lower bound for several years.

    As this “lower-for-longer” period persists, insurers are faced with the problem of continual book-yield decay and what is generally described as the difficult choice between accepting lower yields (thus lower profitability) and reaching for yield but taking on additional risk. Neither option appears particularly attractive at this point in time, making the efficient use of capital a key consideration. The specifics of the problem and potential solutions vary depending on the exact nature of the liabilities in question. Consider the following:

    • Health care liabilities are shorter-term, more total-return oriented and the insurer has the ability to reset premium rates annually.
    • Life liabilities are longer-term with more time to realize returns, but do not have the ability to reset premiums.
    • P&C liabilities can lean in either direction depending upon the type of insurance policy.

    Yields and spreads are both problematic for insurers in this lower-for-longer economic environment. Treasury yields today are materially lower than they were in 2019 and corporate bond spreads have largely retraced the widening they experienced during the pandemic, representing a significantly lower reinvestment yield.

    Exhibit 1: Treasury Yields Remain at Very Low Levels

    Source: Bloomberg. As of 06 Jan 21.

    Exhibit 2: Corporate Spreads Have Largely Retraced COVID-19-Driven Spread Widening

    Source: Bloomberg. As of 06 Jan 21.

    Similar to corporate bonds, agency mortgage-backed securities (MBS) yields have also decayed markedly in line with Treasuries. So, while spreads have moved back most of the way to where they were before COVID-19 upended markets (with the stated goal from the Fed to get levels back all the way to where they had been), there is no expectation that Treasury yields will go back up, leaving the all-in yield substantially lower. Given this environment, where can insurance companies look to stave off a dramatic decline in their book yield income over the coming months and years?

    We believe there are a few corners of the market that provide opportunities to add to yield without increasing outright risk or utilizing additional risk-based capital (RBC). These sectors may help alleviate some of the book yield decay that will inevitably creep into portfolios. While we believe some insurers can benefit from increased use of active management in their portfolios, others are reliant on incoming premium flows as well as principal and interest payments to achieve meaningful reallocations.

    The next section provides a summary of our insights about today’s market environment to potentially help insurers maintain a moderate level of income in this low-rate environment.

    Investment Opportunities

    Mortgage and Consumer Credit

    Fears related to COVID-19 caused widespread selling of non-agency MBS/asset-backed securities (ABS) and resulted in a severe dislocation between fundamentals and valuations. While spreads remain at wide levels, we believe consumer and US housing fundamentals are strong. From a technical standpoint, mortgage credit (both residential and commercial) has lagged corporate credit in the post-COVID-19 recovery as there has not been explicit policy support from the Fed for much of the structured credit asset class. Within mortgage and consumer credit markets, only AAA rated conduit commercial MBS (CMBS) and new-issue AAA rated ABS have been supported by the Fed, which has resulted in a more marked compression of spreads in these subsectors. The lack of Fed policy support is a key driver of the underperformance in mortgage and consumer credit relative to other credit sectors. Additionally, uncertainty over the economic outlook, particularly concerns surrounding the duration and severity of the COVID-19 crisis, has weighed on the market. Exhibit 3 highlights the current spreads of sectors that received support versus mortgage credit sectors that did not, which we believe provides investors with opportunities for increased yields in those sectors.

    Exhibit 3: Mortgage-Related Sectors That Received Fed Support vs. Those That Did Not

    Source: JPMorgan, Bloomberg Barclays. As of 31 Dec 20.

    Emerging Markets

    Emerging markets (EM) may represent another opportunity to increase the overall yield while diversifying risk and maintaining credit quality. Like-rated EM corporate bonds trade approximately 80 basis points (bps) cheaper compared to US corporate bonds. We would expect that as global growth normalizes, EM securities should benefit more than US corporate debt, for a better total return as well.

    Private Placement Investment-Grade Corporates

    Yet another option is greater utilization of private placement credit in portfolio construction. Traditionally, the US private placement market has been dominated by and has catered to the large life insurance companies. More recently, the trend has been fueled by a broadening of the investor base and opportunities to invest along the yield curve to match differing liability profiles. This has led to increasing opportunities in a diversified set of names and structures for insurance investors of all types.

    The private placement market allows insurers to trade a degree of liquidity for added yield—in other words, a liquidity premium. If that were the only trade-off, the opportunity—while still beneficial—would not be as compelling. There are additional benefits, however, to making these investments. Insurers can diversify their corporate risk with access to companies that don’t issue in the public markets. Private placements typically offer covenant protection that is not found in like-rated public issues. These securities also typically have greater price stability, creating less mark-to-market impact, as trading tends to be more limited.

    Private Mortgage Debt

    Both residential and commercial whole loans can offer attractive yields with low capital charges. Due to a number of factors, including the relative illiquidity of these whole loans, the valuations of such assets have lagged other credit sectors in the rebound since March. The largest dislocated opportunities appear to be in residential and commercial mortgage credit.

    Collateralized loan obligations (CLOs)

    Last, we also continue to find value in the CLO market, which we believe offers a compelling return on capital relative to other asset classes. While CLO spreads have narrowed, they are still not all the way back to their tights. CLO structures have been vastly improved since the last major crisis, and we believe they can withstand severe shocks without suffering impairment. A-rated tranches, for example, are unscathed—even under a scenario that assumes two times the defaults experienced during the Great Depression. In addition, since CLOs are floating-rate instruments, the coupon income investors receive today is likely to be at the lowest level one will earn over the life of the investment, with upside potential should markets return to growth and normality.

    In Summary

    With spreads generally having retraced much of the pandemic-induced widening and risk-free rates still pinned at zero, we do not expect that the yield situation will get worse in the coming years (at least to any significant degree). However, it is likely that we could be in this range for a sustained period of time. Depending on the pace of book-yield decay, we think that insurers could consider these possibilities to prudently adjust the risk profile of portfolios in a way that increases future investment yields. Counterintuitively, there are some cases in which total-return-oriented strategies might be appropriate for longer-dated liabilities.



    DEFINITIONS:

    Zero lower bound is the lower limit that rates can be cut to, but no further. When this level is reached, and the economy is still underperforming, then the central bank can no longer provide stimulus via interest rates.

    Book yield means the ratio (expressed as a percentage) of interest income to the average amortized cost for all or a given portion of invested assets during a specified period. If interest rates stay in place, buyers of yield-based options will lose money i.e. experience decay.

    Property and casualty (P&C) insurers are companies that provide coverage on assets, as well as liability insurance for accidents, injuries, and damage to others or their belongings.

    UST is the abbreviation for the United States Treasury, the federal government division that manages U.S. finances. UST is commonly used to reference debt that is issued by the United States.

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations. Looked at another way, the Treasury yield is the effective interest rate that the U.S. government pays to borrow money for different lengths of time.

    "AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality, and are commonly referred to as "junk bonds."

    An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.

    Tranches are segments created from a pool of securities—usually debt instruments such as bonds or mortgages—that are divvied up by risk, time to maturity, or other characteristics in order to be marketable to different investors.

    A floating-rate note is a debt instrument with a variable interest rate.

    A coupon rate is the yield paid by a fixed-income security; a fixed-income security's coupon rate is simply just the annual coupon payments paid by the issuer relative to the bond's face or par value.

    A private placement allows the issuer to sell a more complex security to accredited investors who understand the potential risks and rewards. The light regulation of private placements allows the company to avoid the time and expense of registering with the SEC.

    A private mortgage is a loan created between private individuals for the purchase of real estate.


    WHAT ARE THE RISKS?

    Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.