Expanding the Search for Yield amid Growing Volatility

Michael Pagano

Michael Pagano

Head of Insurance Portfolio Management

Jeffrey Hobbs

Jeffrey Hobbs, CFA

Senior Insurance Portfolio Manager

The Search for Yield Continues, Volatility Returns

The prolonged period of low rates has forced insurers to counter the margin compression resulting from new money rates lagging portfolio book yields. To offset this yield erosion, insurance investors have multiple levers to pull, including credit, duration, structure, illiquidity, leverage, and alternatives. While each offers distinct advantages, insurance investors must also be mindful of the risks in the current market environment. At this stage of the business cycle, volatility has returned, forcing investors to balance the need for current growth with downside protection.

As insurers expand their opportunity set to maximize risk- and capital-adjusted returns in this environment, we believe four key themes have emerged from within the traditional tool set.

Maximizing Risk- and Capital-Adjusted Returns in the Current Market Environment

  • Lever #1: Credit—Private over public credit
    • Substituting public bond exposure with unique private issuers can enhance yield and total return potential, provide issuer diversification and help minimize downside risk with embedded structural protections
  • Lever # 2: Illiquidity—Capturing illiquidity premium through Commercial Mortgage Loans (CMLs)
    • CMLs offer a pick-up in spread, improved position in capital structure, and advantageous capital efficiency
  • Lever # 3: Structure—Embracing the full spectrum of securitized assets
    • Skillful credit selection can unearth opportunities in NAIC 1 securitized credit that offer a meaningful yield advantage to A-rated corporate credit
  • Lever # 4: Leverage—Levering low volatility assets
    • Financial leverage, conservatively sized and appropriately deployed, can produce attractive risk-adjusted returns relative to un-levered, higher beta assets
       

Lever # 1: Credit—Private over Public Credit

Given current spread levels for public credit and the potential turn in the credit cycle, we believe private credit provides attractive relative value.

Private placement debt instruments are a hybrid between public corporate bonds and commercial bank loans. Private credit can offer the fixed rate coupons and extended terms typically found in public credit, but also have embedded structural protections from a negotiated covenant package similar to bank debt. As a result of these characteristics, private credit has exhibited significantly higher recovery rates versus public bonds.

Substituting public bond exposure with unique private issuers also improves issuer diversification in credit portfolios. With spread-to-publics from the 20 -100 basis point (bp) range, private credit offers the rare combination of the potential for higher returns and lower risk due to strong covenants (Figure 1).

Figure 1. Private Credit: Strong Covenants Help Provide Downside Protection

Figure 1. Private Credit: Strong Covenants Help Provide Downside Protection

Source: Voya Investment Management

Lever # 2: Illiquidity—Capturing Illiquidity Premium with CMLs
For long duration life insurers with well-matched asset and liability cash flows, sacrificing liquidity for a pickup in earned yield can be an appealing tradeoff versus incremental credit risk or duration. In addition to private credit, we also capture this illiquidity premia in CMLs.

The American Council of Life Insurers collects quarterly data for roughly three-quarters of the assets under management in the industry. In 2017, this subset of the life insurance space committed to $49B of CMLs at a spread of 176 bp. That spread is 66 bp wide to the average 2017 spread on the REIT sub-index of the corporate bond benchmark. Keep in mind, of course, that investment grade exposure to REITs is in an unsecured form whereas the CML exposure is secured. The market for public REIT debt is predominantly NAIC 2 with an average rating between BBB+ and BBB. Meanwhile, the majority of CMLs produced by the industry is designated as CM1 based on loan-to-value and debt service coverage ratios, making CMLs capital efficient versus REITs. To summarize, CMLs offer a pick-up in spread, improved position in capital structure, and advantageous capital efficiency.

Figure 2. Why Commercial Mortgage Loans? Higher upfront yields + back end income + lower credit losses = higher risk-adjusted return potential

Figure 2. Why Commercial Mortgage Loans? Higher upfront yields + back end income + lower credit losses = higher risk-adjusted return potential

Source: Bloomberg Barclays, Factset, and Voya Investment Management.
2004-2017. Past performance is no guarantee of future results.

Our commercial mortgage and private placement teams also opportunistically extend out the credit spectrum to capture additional risk premia. In our mortgage origination platform, we originate value-add mortgages, which include transitional loans, construction-to-perm loans, mezzanine financing, and B-notes. On the private credit side, we have built out a successful capability in lending to speculative grade credits, select special situations and workouts, and middle market opportunities.

While managing liquidity risk is a key component of effective enterprise risk management, the tendency of life insurer investment portfolios to be long duration and well cash flow matched can provide opportunities to capture structural illiquidity premia. In CMLs, we believe incrementally sacrificing this liquidity can improve risk and capital-adjusted returns.

Lever # 3: Structure—Investing across the full spectrum of securitized assets
With floating rate instruments and embedded structural protections, securitized credit has the potential to deliver attractive returns while providing the ballast portfolios need to weather future market turbulence.

While some insurers have eschewed certain securitized sectors given scars from the past cycle, the NAIC’s 2009 and 2010 changes in capital requirements for residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS) have made the asset class more capital efficient and capital stable. NAIC ratings are determined by comparing the amortized cost of an investment and pricing breakpoints informed by scenario-based cash flow modelling provided to the NAIC by BlackRock.

While holdings of investment grade corporate credit by the top U.S. insurance companies were tilted slightly towards NAIC 2 credit in 2016, approximately 95% of all non-agency RMBS holdings of that peer set were at prices that translated into NAIC 1 ratings. For CMBS, the figure was even higher.

In corporate credit, investors are subject to quality migration with the business cycle, secular industry forces, and dynamic capital structure decisions. The source of repayment for securitized credit is limited to a defined and legally segregated pool of assets.

Purchasing securitized credit at a price that takes into account a sufficiently severe scenario allows for low risk of loss on that asset, which should lead to low and stable capital consumption over time. In risk-off market environments, the risk of negative ratings migration in corporate credit rises, whereas in RMBS and CMBS, an increase in market risk premia and the resultant lower securities prices, absent any change to the cash flow modelling assumption, may actually make securities more capital efficient.

Outside of RMBS and CMBS, asset-backed securities (ABS) and collateralized loan obligations (CLO) can offer investors opportunities to garner attractive risk- and capital-adjusted spread. The proliferation of non-benchmark ABS in the post-crisis era has expanded collateral types meaningfully. Investors with resources dedicated to analyzing these unique collateral pools can capture attractive spread relative to similarly rated corporate credits. The weighted average life of securitized credit investments also varies within and across subsectors, providing additional diversification benefits in a broader portfolio.

While insurance companies have historically been large participants in corporate credit markets, there has been an increased interest in recent years in CLOs. Insurance buying has predominantly been in the investment grade rated tranches, which are essentially de-levered exposure to speculative grade senior bank loans. The historical loss experience of investment grade CLOs is better than that of similarly rated corporate credits, and these tranches currently offer incremental spread versus corporate alternatives.

Figure 3. Securitized Credit: The opportunity for an attractive long-term allocation across the risk/return continuum

Figure 3. Securitized Credit: The opportunity for an attractive long-term allocation across the risk/return continuum

Source: Voya Investment Management.
As of 05/31/2018

Lever # 4: Leverage—Levering Low Volatility Assets
Leverage is a familiar concept for insurers who make investment decisions that weigh the attractiveness of securities with differing levels of implied leverage. Examples include public IG credit versus public below IG credit, and CLO exposure versus senior bank loans. Depending on the relative cost of the implied leverage of these assets and the explicit leverage available in the financing markets, introducing explicit leverage to assets with low implied leverage can produce more attractive returns.

Across market cycles, the Federal Home Loan Banks (FHLB) have been reliable and consistent source of cheap, explicit leverage for insurers. FHLB funding is available in the form of secured loans, called advances:

  • Tenor and Structure:
    • Maturities range from overnight to 30 years
    • Fixed and floating rate structures funding are available
  • Collateralization:
    • Advances are secured by eligible collateral, mainly mortgages1
    • The borrowing value is subject to a “haircut” which varies by collateral type
  • All advances require purchase of FHLB activity stock (~5% of advances)2
    • Pricing:
    • Based on the borrowing costs of the FHLB system, which accesses capital at an attractive cost slightly above comparable maturity Treasury securities
  • Financial Treatment
    • Depending on the borrower’s state of domicile, the “advance” is treated either as “operating” or “financial” leverage

 

1 Government securities, agency mortgage-backed securities, commercial and residential mortgage loans, and high quality private label commercial and residential mortgage backed securities are commonly used securities to collateralize FHLB advances.

2 Can be part of the reinvested asset portfolios; dividend rates are determined independently by each FHLB

Figure 4. Applying leverage: The ample supply of high quality floating rate assets

Figure 4. Applying leverage: The ample supply of high quality floating rate assets

1 Data as of 02/28/2018;
2 Y/N: Eligibility requirements differ by bank.
3 Select bank dividend rates less 3ml

Against a portfolio of floating rate FHLB “advances”, there are ample high quality floating rate assets to buy at attractive spreads. As Figure 4 highlights, these assets fall mainly in the major sub-sectors of the securitized credit markets. Depending on the member-defined risk profile, a diversified portfolio can be constructed with a range of maturities, NRSRO and NAIC rating profiles and sector allocations.

Thoughtfully constructed, prudently implemented and vigilantly monitored, a program that marries customizable FHLB “advances” with low volatility, liquid assets can be an attractive diversifying source of explicit leverage to complement exposure to assets with higher implicit leverage.

Conclusion

While this represents our high-level view, the nuances of applying these four levers will depend on the objectives of each insurer. Taking corporate credit exposure and risk in securitized credit must be informed by the prevailing portfolio allocations. Decisions around illiquidity must be mindful of liability characteristics.

We offer these viewpoints as a basis for discussing how we can meet the unique needs of each insurance investor in what remains a challenging investment environment.

In this still challenging rate and spread environment, insurance investors continue to struggle to deploy new capital into the market where new money yields frequently lag portfolio yields.

Faced with this challenge, we have offered a combination of customizable investment levers, deployable across an array of portfolios, that we feel will help lean against this persistent headwind.

Since the applicability of each of these levers will depend on the unique circumstances of each investor, we look forward to discussing our own experiences using these levers and how our insights might be applicable to your portfolios.

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Investment Risks
All investments in bonds are subject to market risks. Bonds have fixed principal and return if held to maturity, but may fluctuate in the interim. Generally, when interest rates rise, bond prices fall. Bonds with longer maturities tend to be more sensitive to changes in interest rates.

Important Information
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities. This document or communication is being provided to you on the basis of your representation that you are a wholesale client (within the meaning of section 761G of the Act), and must not be provided to any other person without the written consent of Voya, which may be withheld in its absolute discretion.

Past performance is no guarantee of future results.

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