Should higher risk-free rates and wider risk premia change the investment approach of balance sheet investors? No…and yes.
Expand the toolkit
- More is still better: Having the ability to allocate to the broadest set of markets helps insurers monetize spread widening and effectively manage risk.
- Structural protections never go out of style: The resilience of private credit and commercial mortgage loans was on full display during COVID-19, and these remain important asset classes to steer portfolios through the tenuous economic environment.
- Spread still matters: Even though the 10-year Treasury offers a more attractive nominal yield, insurers still need spread and the illiquidity premium of private credit/CMLs, levering low-volatility assets like securitized credit, and allocations to alternatives remain the most compelling ways to earn it.
Consider new plays
- Approaches to voluntary turnover must be adjusted: Accretive voluntary turnover is NOT free as it requires delicate management of realized gains and losses and the knock-on effect on IMR balances for life insurers.
- Get tactical: Take advantage of spread dislocations across your complete investible toolbox to enhance risk- and capital-adjusted returns.
- These are not normal times; act accordingly: Attempts to monetize a view on riskfree rates or the shape of the curve (usually inadvisable) can be beneficial in the current macro environment.
No really, this time is different (sort of)
In the decade of ultra-low interest rates, the main headwind for insurance companies was the persistence of new money rates lagging paydown yields. Now, stuck between soaring inflation and the potential for economic malaise, the Federal Reserve has little wiggle room to maneuver, and the risk-free rate has accelerated upwards. Add the tenuous economic outlook to the rapid rise in rates and you have the perfect recipe for volatility.
Though the risk of a recession continues to increase, we believe well-diversified balance sheets should be able to manage market disruptions resulting from tightening policy. One reason is that companies have incentive to invest in the face of challenged supply chains and persistent wage inflation. A handoff to a capex cycle could help alleviate inflation pressure and increase the likelihood of a soft landing.
The question that balance-sheet investors must answer is whether higher riskfree rates, wider risk premia and potential volatility should change their investment approach. We believe it’s worth reassessing core investments to ensure they are maximizing their purpose. But don’t ignore new approaches that seek to capitalize on emerging dynamics.
Expand the toolkit
More is still better
The first step in assembling an effective strategic asset allocation is to make sure you have the right set of tools. Flexibility to invest across a broad spectrum of risk assets is critical, especially in an uncertain macro environment.
With the current market backdrop, expect volatility to remain high and dislocations to occur. Investing across a diverse set of opportunities enhances the ability to monetize spread widening and mitigates the risk of potential ratings migration and impairments.
In this market, securitized credit is an important component of any strategic asset allocation as it provides diverse, structured and customizable access to U.S.-centric risk that seems best positioned to weather any economic uncertainty on the horizon. In addition, the recent risk-based capital (RBC) regime changes offer insurers more granularity from a capital perspective, making skillful security selection even more effective from a risk- and capital-adjusted return perspective.
Structural protections never go out of style
The fluid economic environment means that investors for insurance company balance sheets must continue to balance diversifying opportunities to add risk-adjusted spread while also preparing for a potential economic stress scenario. In our view, private credit and commercial mortgage loans (CMLs) offer tremendous ballast in a broader strategic allocation.
The value of private credit structural protections was evident during the recent Covidrelated market drawdown. Within our private credit portfolio of about 400 obligors, roughly 60 were at risk of a covenant breach during the pandemic-driven economic fallout (Fig. 1). 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. As a result, our private credit investments were not disrupted during the market stress.
Source: Voya Investment Management. Numbers are representative of Voya’s Private Credit Investment Strategy.
The resilience of CMLs was also on full display during the recent economic drawdown. Commercial real estate proved durable and experienced close to zero impairments despite the extraordinary disruption to economic activity that began in early 2020 (Fig. 2). Looking at Voya’s own CML asset base, 9% of our portfolio completed forbearance requests. Of these holdings, only 0.5% were impaired and sold. As of September 2021, all of the remaining properties were out of forbearance and current on their payments.
Source: Voya Investment Management. Data represents Voya’s own Commercial Mortgage Investment Portfolio.
Good, old-fashioned spread is still a healthy part of any diet
Even though nominal rates are meaningfully higher, let’s never forget that spread still matters, and the old-fashioned ways to earn spread never go out of style.
- Capturing illiquidity premium through CMLs and private credit: In any economic environment, borrowers will continue to require access to the debt capital markets and the relative permanence of insurance company capital bases makes insurers extremely valuable sources of liquidity. Insurers can and will be able to extract an illiquidity premium for ready access to our capital, especially when borrowers really need it. That this illiquidity premium is most readily available in two segments of the market characterized by better structural protections and more direct access to borrowers make CMLs and private credit attractive permanent allocations.
- Levering low-volatility, high-quality assets still delivers low-risk spread: The consistent availability of collateralized advances from the Federal Home Loan Bank (FHLB) system offers an ability to deliver attractive spread premium with desirable customization and flexibility, with limited downside risk. The liquidity use case for FHLB should also appeal to your Treasurer/CFO as part of broader enterprise liquidity and risk management as the potential for tail economic scenarios emerge.
- Alternatives are still an important asset allocation in a broadly diversified investment portfolio: The historic performance of alternatives since the 1Q20 drawdown has pressured the limit construct of many balance sheet investors. If you conflate exposure with risk, you run the risk of making a decision in the short-term that creates undesirable downstream headwind to your ability to capture sustainable investment income. Insurers should revisit and reevaluate base assumptions to avoid the risk of allowing “recency bias” to overly influence near-term decisionmaking process.
Consider new plays
Adjust your approach to voluntary turnover
Over long periods of time, portfolio yields and new money rates are generally converging. Given the persistent trend of low and tighter yields, this convergence has been in an unfavorable direction as new money rates have lagged paydown yields. However, the sharp pivot higher in rates and spreads means this convergence is reversing.
The related reality is that unrealized gain/loss balances have also taken a hit, which opens a much larger universe of accretive voluntary turnover. Importantly, the turnover is NOT free, since it requires delicate management of the income statement impacts of realized gains and losses and of the knock-on balance sheet effects on interest maintenance reserve balances for Life insurers.
Assets held for closed and open blocks of liabilities must be managed differently (e.g., for insurance companies with open blocks of liabilities, the increase in the risk-free rate sets a higher return target to outperform).
Let’s get tactical
Strategic asset allocations should remain the North Star toward which insurance companies are directing portfolio decisions, since it is the result of a constrained optimization that crystallizes your full-cycle tolerance for an array of risk/return/ capital tradeoffs.
On your way through the cycle, it is worthwhile to adapt this glide path to take tactical advantage of spread dislocations across your complete investible toolbox to enhance risk- and capital-adjusted returns. Based on our expectation for higher rate and spread volatility in the short to medium term, there should be opportunities to be more tactical with marginal asset allocation choices.
Opportunities also exist to get tactical within asset classes. For example, securitized credit, with its range of attractive yields and different flavors of risk, offers the ability to allocate across a diversified subset of underlying collateral that spans residential housing, commercial real estate, business whole loans, consumer loans and corporate credit. While Figure 3 highlights our views across the securitized market, we believe the most compelling opportunity lies in mortgage credit. Between housing market dynamics, economic growth and a well-positioned consumer, the sub-sector looks quite strong. The paradigm shift in the residential mortgage prepayment market presents an interesting entry point: the expectation for front-loaded rate hikes and the accompanying rise in mortgage rates should greatly improve the prepayment outlook, which was a thorn in the residential mortgage market’s side for much of 2021.
June 30, 2022. Source: Voya Investment Management.
Extraordinary times call for extraordinary measures
Under normal circumstances, we are not advocates of trying to add value in insurance mandates with trades that attempt to monetize a view on risk-free rates or the shape of the curve. These are not normal circumstances. For maturities 10 years and in, the yield curve is very flat, which opens spread opportunities in the front-end that provide investible all-in yields not previously available. A kinked Treasury curve beyond the 10-year creates interesting yield picks if you can find spread product in the right part of that curve. The sharp move in interest rates also has greatly increased the amount of low-dollar-price, long-duration securities with attractive convexity profiles that may not be readily appreciated by the marketplace.
Floaters, pricing substantial expectations for Fed tightening, look compelling outright, on a swapped basis or relative to WAL-matched borrow. Leaning into a duration extension, especially in the long end in deep-discount positively convex securities, could be compelling if you fear the Fed may over-tighten and need to quickly reverse course.
Be on the lookout for modest, incrementally accretive tilts. Enough small wins can add up to real money
Bottom line: Time for action
The rapid rise of the risk-free rate and the uncertain macro environment means that insurance companies need the necessary flexibility to prepare for many different scenarios amid the likelihood of increased volatility and market dislocations. Internal approvals for allocations to new asset classes can take time. Consider expanding your toolkit now so you can be ready to strategically and tactically adjust your asset allocation when opportunity presents itself.
Voya’s Insurance Solutions team welcomes the opportunity to discuss the idiosyncrasies of your specific balance sheet and objectives.