Offsetting Yield Erosion

Offsetting Yield Erosion

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After Insurance Portfolio Managers have pulled all the portfolio levers, what’s next?

Strategic Asset Allocation: How Can Insurers Find Yield Without Taking Undue Risk?

Since the onset of the pandemic, spreads have largely recovered and are approaching levels that are uncomfortably tight. While the broad economic backdrop is positive for spread sectors, the heavy use of economic stabilizers creates fragility to shocks and will create increasingly asymmetric risk profiles across and within different industries and asset classes.

In many ways we are right back where we started from before the pandemic, as insurance companies are being forced to expand their search for yield without taking undue risk. For insurers who have yet to expand their opportunity set, the major themes we highlighted before the pandemic still apply today.

If You Have Not Yet Expanded Your Opportunity Set, the Playbook Remains Largely the Same

1. Credit—Private over public credit: Across the investment grade and below investment grade ratings spectrum, 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

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

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 comparably rated corporate credit risk

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

COVID Market Dislocation: Lessons Learned and the Path from Here

The COVID-19 market dislocation was a good reminder of the importance of doing the work up front to expand your toolbox. However, in our view, a full toolbox is just one of the four items insurers needed to thrive during the height of the initial market mayhem of the pandemic:

1. Full set of “tools” in your toolbox
2. Risk budget
3. Cash
4. Courage

For insurers who did not have enough liquidity during the most recent COVID dislocation, the context of this market event should help inform future liquidity decisions—as should the current market environment. The yield curve is steep and is likely to remain steep given the twin forces of easy monetary policy and expectations for growing near-term inflation. Against this backdrop, insurers need to carefully consider the mix between “real” liquidity and “contingent” liquidity, thoughtfully evaluating the pros and cons of each type below. Holding “real” liquidity is expensive. Be purposeful in how you measure it and be rigorous in how you think about how much of it you need.

Liquidity – At What Cost?

  • FHLB
  • Reverse repo
  • LOC
  • Inter-company borrowing
  • Cash and cash equivalents

For those insurers who missed out on the uncommon value across private, public and structured debt markets, this framework can help serve as an “after action review” of the last 12 months to help reveal what, if anything, you would do differently the next time opportunity knocks. However, if your current risk budget looks more like ours, meaning you have already expanded your risk envelope, you may be thinking what is there left to do?

In our mind, the narrow spread environment calls for an increased focus on implementation. Security selection, which is always important, has become absolutely critical as the dispersion between “winning” and “losing” investments within sectors will remain wide. In other words, appropriately expanding your risk envelope via asset allocation is an important first step—how you allocate your idiosyncratic exposure within these different flavors of risk has become even more important. In this environment, small decisions can have a large impact on portfolio outcomes. This is a time when “the ordinary” needs to be done “extraordinarily well.”

Some Commercial Real Estate Trends Are Here to Stay—Is Your Portfolio Prepared?

The response to COVID-19 and resulting shift in consumer behavior caused massive disruption in the commercial real estate market. This disruption is ongoing, and some trends are here to stay. For example, e-commerce related leasing demand spiked during the height of the pandemic to nearly half of all activity. As companies like Amazon are forced to solve the “last mile issue” with local delivery, the industrial segment could benefit as defunct retail properties convert to meet the evolving needs of the industrial space.

The future of office properties in a post-COVID world continues to be a topic of discussion as tenants recognize their organizations can successfully work remotely, but also want the benefits of face-to-face interaction including the development of culture, training new employees, and cultivating relationships.

It is likely that travel friction will also last longer than most people expect. An average hotel occupancy rate is 70%. As the pandemic took hold, hotel occupancies dropped to below 20%. While hotels in drivable vacation destinations have seen a slow rise in demand for rooms, profitability remains far out of reach for most of the market. Convention hotels that rely on business travel have been the hardest hit and are expected to be the last to recover. According to a study by hotel research firm STR and Tourism Economics, a full recovery to pre-COVID levels may be three years away.

There are multiple ways to benefit from these trends across commercial mortgage loans, REITS, and CMBS. However, doing so requires a comprehensive view of risk across your entire portfolio. For example, as an overall percentage of their real estate holdings, insurers would likely be inclined to limit their total exposure to the troubled hotel space. However, in the exposure they do have to hotels, vehicles like a single-asset/single-borrower (SASB) CMBS can be relatively more attractive than whole loans, as SASB CMBS offer exposure to higher quality properties and additional structural protection.

Furthermore, on the surface, instruments like agency CMBS may seem like they should count against your total real estate risk exposure. However, like their agency RMBS counterparts, agency CMBS have an explicit U.S. government guarantee or are guaranteed by one of the Government Sponsored Enterprises, which means they carry no credit risk. As a result, it might be more useful to back out these instruments when you are assessing the totality of your portfolio’s exposure to credit-related real estate risk.

Alternatives and the Pursuit of Attractive Capital-Adjusted Returns

Generating positive real returns is always critical for insurance companies. In the current rate and inflation environment, alternatives will likely be an important asset class for insurers to consider going forward. From a pure risk/reward perspective, we believe allocating a portion of investments away from core fixed income and into alternative asset classes is worth the risk.

Of course, most insurers use capital-adjusted returns as an important lens to evaluate asset allocation decisions—will I earn enough on an investment to justify the additional capital requirements? From this perspective, understanding the capital cost of a marginal dollar of investment in alternatives is critical. The covariance benefit is key to understanding capital cost and is real, calculable, and dynamic.

Recall that under the NAIC’s Risk Based Capital (RBC) framework, diversification of risk is rewarded in the form of less punitive capital charges. To help illustrate this point, the chart below shows how initial allocations to alternatives require far less capital because of the diversification benefit.

In this example, as allocations to alternatives increase, the impact of the diversification benefit diminishes, and insurers are required to hold ever-increasing capital net of the diversification benefit. All else being equal, for insurers who have maintained sizeable core fixed income allocations and have yet to allocate to alternatives, the covariance benefit can be particularly powerful in the pursuit of attractive capital-adjusted returns. Importantly, the chart below is purely hypothetical. Calculating the diversification benefit is a nuanced exercise, the output of which will vary significantly from insurer to insurer.

The Pursuit of Attractive Capital-Adjusted Returns: Understanding the Covariance Benefit
The Pursuit of Attractive Capital-Adjusted Returns: Understanding the Covariance Benefit

Source: Voya Investment Management. Based on a hypothetical insurance portfolio. For illustrative purposes only.

Note: RBC Effective Charge does not account for RBC company multiple.

In the pursuit of attractive capital-adjusted returns, delivery mechanisms applied to alpha-generating strategies also matter. So-called A/B notes operate as a “two-tranche CLO” and, if properly structured, are an effective way for insurers to improve capital and balance sheet efficiency. We continue to favor using them to package differentiated fixed income alpha-generating capabilities to drive better capital-adjusted returns.

Conclusion

As always, 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. This is intended to represent our high-level view and serve as a starting point for a more detailed conversation about the idiosyncrasies of each insurer’s balance sheet and objectives.

In addition, it looks like 2021 will be a big year in terms of changes to the regulator capital regimes. Changes to the CMBS regime are being considered and long rumored changes and refinement to credit factors and granularity are likely to be finalized in 2021. Insurers will need to understand these individually and in combination with each other to be in a position to optimize their asset allocation going forward.

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Past performance does not guarantee future results.

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.

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