Direct lending and other shifting trends in insurance portfolio investing

admin | October 26, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Insurance portfolios have led the way in direct lending in the last few years, become much more comfortable with CLOs and have continued to sponsor both legacy and new private RMBS. But change is on the way. Risk premiums in some parts of the corporate market look thin, and proposed changes to NAIC capital factors could drive reallocation across rating categories in corporate debt and structured products. These issues and more surfaced at the APS Insurance Portfolio Strategy Conference held October 24 in New York.

Investment trends among insurance portfolios

The panels and presentations at the APS conference highlighted at least four major trends in insurance portfolio investing:

• Disintermediation of banks. Property-casualty and life insurers have increased their direct lending programs faster than the market overall, with particular focus on commercial and residential mortgage loans. Multi-year efforts to develop the expertise and technology needed for direct lending are paying off, and asset allocation to these programs looks likely to grow. Benefits from these programs include incremental yield, more control over portfolio diversification across collateral, more control over loan servicing and better loan structure, including terms and covenants. Disadvantages compared to owning competing securities include much lower liquidity, the contingent liability of undrawn capital, and operational risk of lending, servicing and originator monitoring.
• Increasing allocation to CLOs. Low correlation to other asset classes and competitive ratios of risk and return through and since the 2008 financial crisis has increased their popularity. Highly rated, floating rate CLOs have become good options for some P&C portfolios or those shortening duration in a flat yield curve. There is increased demand for bespoke deals. Risks include rising interest rates, weaker covenants, exposure and differing performance across managers.
• Shifting competitive advantage across legacy and new RMBS. Several industry experts evaluate legacy RMBS positions around portfolio constraints, including whether the portfolio is managed to a total return or book yield basis. The price of acquisition of legacy RMBS impacts the capital treatment, though broadly speaking insurers still have a capital advantage over banks in holding these assets and they remain a desirable asset class. The capital treatment of new production RMBS is on a more level playing field to that of banks. Many insurers are buying private securitizations or competing directly with banks via origination or asset finance.
• Shifting strategies in corporate and structured debt. Both current risk premiums and potential capital treatment are shifting insurer strategies in corporate debt.  The low risk premium for investment grade corporates generally, and ‘BBB’ rated debt in particular, has made the risk-return profile less attractive compared to leveraged loans, residential mortgages and other highly rated structured products. Also, the NAIC is currently reviewing and amending risk-based capital recommendations for insurers and intends to publish the recommendations by the end of 2019. Current proposals would replace the six NAIC life RBC bond capital factors in place since 1991 with 20 that vary more across rating categories. Among other things, the new factors would lower the capital charge for ‘AAA’ debt and raise it for ‘A’ debt. The differences in risk premiums relative to ratings category are likely to encourage managers to reallocate from ‘A’ to ‘AAA’ debt, which would favor the large ‘AAA’ supply in structured products. However, the NAIC has been weighing capital revisions since 2011, so timelines could extend.

Source: NAIC

The surrounding landscape

Economic fundamentals in the US remain broadly supportive of continued growth. A moderate easing of regulation combined with lower corporate tax rates resulted in a pick up in business investment, which has been trending up since 2017. Poor worker productivity has been a drag on growth post-crisis, but early signs of improvement in 2018 should accelerate as business investment continues.

Financial conditions remain loose as the Fed is still several hikes away from neutral. Fed rate projections through 2020 are more aggressive than what is currently priced into the market, so realized rates should flatten faster than forwards.

Corporate balance sheets bulked up, as both interest rates and credit spreads spent many of the post-crisis years near historical lows. The low cost of debt relative to equity financing allowed investment grade corporations to increase leverage to fund acquisitions, conduct share buybacks or do capital improvements. One consequence of the higher debt load has been that the bulk of the investment grade universe has gravitated towards lower ratings: over 50% of the investment grade universe is now rated ‘BBB’, up from 31% a decade ago. Debt service ratios and extended maturity profiles remain manageable while corporate profitability is strong, but compensation for the additional risk seems inadequate should the economy stumble.

By contrast, household balance sheets are quite strong. Household income and net worth have notched new highs and debt service as a proportion of disposable income is near record lows. Subprime autos and student loans are experiencing some weakness with rising delinquency rates, but MBS and card delinquencies continue to scrape near rock bottom.

A new generation of residential mortgage-backed securities has started to rebuild the private market. New and seasoned performing loans dominate production, as new RMBS outstanding has grown from $0 in 2010 to $110 billion. Rising GSE fees have opened the door to private securitization and investors are buying cusips and stepping in as direct lenders.

Leveraged loans and their CLO offspring are the among the best dance partners in fixed income. Leveraged loans have eclipsed the high yield debt market this year, with $1.22 trillion of leveraged loans outstanding compared to $1.21 trillion of high yield corporates. CLOs  alone outstanding total $550 billion – about the size of the ‘BB’ universe – compared to $350 billion pre-crisis, with issuance forecast to be $135 billion for 2018. Thanks in part to rising interest rates, floating rate leveraged loans have outperformed high yield bonds by a wide margin this year on a total return basis. Among the risks for loans include the transition to lighter covenants and lower liquidity, particularly in the event of a significant market correction. There is renewed focus on evaluating CLO managers as a potential tool for tracking and differentiating performance.

Clowns to the left of us, jokers to the right

Tom Bevan from Real Clear Politics capped off the day with an incisive and hilarious outlook on the midterm elections. The prognosticators at RCP are not projecting a Democratic tsunami overtaking the House and the Senate, though there is still time for momentum to develop in either direction. Their base case is for Democrats to pick up enough seats to have a slight majority in the House but lose two seats in the Senate. The divided Congress would once again struggle to advance any significant legislative proposals on either side of the aisle, beyond broadly bipartisan efforts such as the recently passed bill aimed at curbing the opioid epidemic. One potential consequence of Democrats taking a majority in the House could be a groundswell movement to impeach the President. The populist optics of such a decision could be appealing, but it could also present a much needed focus issue for President Trump to mount a campaign against in 2020.