In this environment of extreme volatility, the best way for insurers to manage risk is to purchase investments with a built-in margin of safety.
Be mindful of tail risk — always, but especially now. That was the main message in our last blog. In my view, one of the best ways to manage risk (tail or otherwise) is from the bottom up. Purchase investments at a discount, and you lock in a margin of safety.
And good news for insurance investors: The current environment is full of discounted opportunities. Take corporate credit, for example. The 10-year cumulative default probability for BB rated public credit is about 9%. Today, BB public credits are trading at a 9%+ discount to par. This price acts like a reserve against the historical probability of default. Plus, investors get the bonus of earning a 5%-or-so coupon carry.
In August 2021, the long corporate index was trading at $123. As of Oct. 12, 2022, it’s at $79. That means bonds issued near the interest rate lows are trading in the $70s or even high $60s. Bond investors are used to demanding a premium for high-dollar price bonds to get paid for their higher downside risk in a credit selloff. But many bond investors, having never experienced this type of movement in interest rates, have been slower to ascribe a premium to the deeply discounted bonds, meaning you can get more downside protection essentially for free. The average recovery of an unsecured bond is 40 cents. If you can buy a bond for 70 cents, the downside is half what it was at par.
Meanwhile, the favorable risk/reward tradeoff is more evergreen on the private side of corporate credit. I’d be lying if I said I wasn’t a little worried about private credit at the beginning of the pandemic. Some businesses saw their prospects change overnight due to the shutdowns. Ultimately, however, the market provided relief to good businesses, ensuring that liquidity challenges from the shutdowns didn’t turn into financial distress.
Within our private credit portfolio of about 400 obligors, roughly 60 were at risk of a covenant breach during the pandemic-driven economic fallout. All 60 of these obligors took the necessary corrective actions — either on their own or through direct engagement with our investment team — to avoid breaching their covenant package (see below). As a result, our private credit investments were not disrupted during the market stress. The Covid environment proved once again the value of structural protections and the ability for the amendment process to shape credit-specific outcomes and create value.
Source: Voya Investment Management.
Margins of safety exist (in abundance) beyond corporate credit. We went from all-time low mortgage rates in mid-2021 to the highest mortgage rates in a decade in mid-2022. Current prices for mortgage-related investments reflect the extreme nature of this move, setting up a compelling opportunity if prepayment speeds rise in a future where rates retreat.
In addition, discount opportunities in senior non-agency RMBS and agency CMBS allow investors to purchase FHLB-eligible collateral into portfolios at realized spreads that are attractive versus single-A corporate bonds. That FHLB-eligible collateral can help investors add investment leverage to boost risk-adjusted returns.
In this environment of extreme volatility, there’s no need to be a hero. Remember, most insurance investors are fixed income investors…on levered balance sheets. If things go right, we typically earn a coupon and get our money back. If things go wrong, there’s a lot of downside. Pick and choose where you add risk, and look for opportunities that have a built-in margin of safety.