The Big Idea
The rise of annuities and the demand for credit
Steven Abrahams | January 19, 2024
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.
Corporate and structured credit have generally done well for debt investors since mid-2020, including the back half of last year. Part of the sparkle in credit has come from healthy demand from life insurers, and in structured credit especially from insurers owned by private equity. A surge in sales of fixed annuities is helping fuel this life insurer demand. And momentum from last year looks likely to carry over into this year and beyond.
Annuity sales rise with US rates
Overall annuity sales through September ran at an annualized rate of $361 billion, according to CreditSights tally of most recent regulatory filings, which would mark the biggest annual volume by far in the last decade (Exhibit 1). That pace would top the 2022 record annuity sales of $313 billion, and far exceed the average from 2013 through 2021 of $231 billion.
Exhibit 1: Annuity sales have surged in 2022 and 2023
The surge in annuity sales has come as US rates have moved to their highest levels since the Global Financial Crisis. And with 10-year rates still around 4%, LIMRA, an insurance trade group, forecasts annuity sales this year of $311 billion to $331 billion and in sales next year of $342 billion to $362 billion. If those forecasts pan out, insurer should see a continuing flood of investable cash in 2024 and 2025.
Funding well suited for debt with spread, duration and convexity
Fixed annuities usually guarantee a minimum interest rate for a certain period, including fixed payout annuities that guarantee the rate for a certain number of years and then return the annuity buyer’s principal. Fixed-index annuities allow the interest rate to vary depending on some reference index, such as the S&P 500 or similar, but also usually guarantee a minimum rate. Sales of variable annuities, which often make payments based on an equity index without a minimum rate and are not well suited to funding debt, have dropped.
Most annuities also include surrender charges that the buyer of the annuity pays to withdraw annuity principal. Those charges typically start high in early years and step down over time. Some contracts allow the owner to withdraw a minimum amount of principal, such as 10%, without a surrender charge. Declining or no surrender charges usually mean buyers tend to redeem annuities more often when interest rates rise and allow buyers to replace an old annuity with a new one paying a higher rate. As rates fall, however, buyers tend to hold onto their old annuities. That means the average life of a pool of annuities gets shorter as rates rise and longer as rates fall, making it a negatively convex source of funding for the insurer.
The relatively long expected average life and negative convexity of annuities as a funding source give insurers incentive to match them with assets that pay a spread to the guaranteed annuity rate, that match the annuity duration and that have positive convexity to offset the annuity’s negative convexity. That broadly describes corporate and structured credit, which is why annuity sales matter for investor demand in those sectors.
Attractive for insurers owned by private equity
Although a wide range of insurers issue annuities, the largest issuers notably include insurers owned by private equity firms (Exhibit 2). Athene, the largest issuer of fixed annuities in the first three quarters of 2023, is owned by Apollo. Global Atlantic, the seventh largest issuer, is owned by KKR. Security Benefit, the tenth largest, is owned by Eldridge. Other large PE-owned annuity issuers include American Equity and American National, both owned by Brookfield.
Exhibit 2: PE-owned insurers are among the largest issuers of annuities
PE-owned issuers of annuities often contract with the asset management arms of the PE owner to source assets. Those assets can include public and private securities as well as direct lending. Annuity sales become an important source of funding to different units of a diversified PE firm.
PE-owned insurers seem to lean toward structured credit
Insurers owned by PE show a roughly similar heavy allocation to corporate bonds as the average US insurer but much heavier allocation to structured credit. PE-owned insurers hold 52% in corporate bonds with the average insurer portfolio holding 56% (Exhibit 3). But PE shops hold 28% in ABS and structured securities compared to an average insurer’s 10%. PE shops also hold 6% in private CMBS compared to an average 4%, and 4% in private RMBS compared to an average 2%. PE shops show below-average exposure to municipal bonds and US and foreign government bonds.
Exhibit 3: PE-owned insurers show above-average allocation to structured credit
Even though PE-owned insurers controlled only $533.7 billion or 6.5% of total issuer asset as of mid-2023, they exert an influence on the investment styles of other insurers. To compete in the annuity market, other insurers have to offer competitive fixed rates. But the ability to offer those rates often depends on the assets available to match against the annuity funds. With the PE-owned insurers’ lean into structured credit, which often trades at a wider spread than corporate credit, other insurers come under pressure to add structured credit, too, or find some other way to enhance yield.
More fuel for credit demand
Relatively high US rates and consequent elevated sales of annuities creates a clearly identifiable source of demand for US corporate and structured credit. Credit has consistently outperformed other sectors of fixed income since mid-2020, and the surge in annuity sales is almost certainly part of the reason. That is a positive for credit performance going forward.
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The view in rates
Fed funds futures continue to price for 125 bp of cuts by December, although the implied chance of a cut in March has fallen back below 50%. A number of Fed speakers have countered market expectations of a March cut. And it seems unlikely the Fed will see enough data by March to firmly conclude that inflation is on its way to 2% with no chance of rebounding. With home prices rising and, at some delay, owners’ equivalent rent, too, Powell & Co. will likely take a little extra time to wait and make sure inflation is defeated.
Other key market levels:
- Fed RRP balances closed Friday at $625 billion, continuing a steady trend down since April. Treasury bills and Treasury and MBS repo all trade at yields above the RRP’s 5.30% rate. Money market funds continue to move cash out of the RRP and into these higher-yielding alternatives.
- Setting on 3-month term SOFR traded Friday at 532 bp, down 1 bp in the last two weeks and continuing a broad trend lower since September.
- Further out the curve, the 2-year note closed Friday near 4.38%, roughly flat to two weeks ago. The 10-year note closed at 4.13%, up 8 bp over the last two weeks
- The Treasury yield curve closed Friday afternoon with 2s10s at -26, steeper by 8 bp since early January. The 5s30s closed Friday at 29 bp, steeper by 10 bp over the same period.
- Breakeven 10-year inflation traded Friday at 234 bp, higher by 12 bp over the last two weeks. The 10-year real rate finished the week at 179 bp, down 3 bp from early January.
The view in spreads
The market continues to tighten spreads in credit, anticipating an eventual Fed rate cut and improvement in market liquidity. Liquidity is nevertheless likely to trend lower through 2024 as QT and relatively high rates in the front end of the curve continue. Lower liquidity is likely to keep volatility elevated, keeping pressure on spreads. Nevertheless, spreads should trade stable to tighter until at least March.
The Bloomberg US investment grade corporate bond index OAS closed lately at 95 bp, tighter by 9 bp over the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 146 bp, tighter by 2 bp in the last two weeks. Par 30-year MBS TOAS closed Friday at 42 bp, roughly unchanged over the last two weeks. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so a widening toward 70 bp looks reasonable.
The view in credit
Most investment grade corporate and most consumer balance sheets look relatively well protected against higher interest rates, and eventual Fed easing next year would relieve pressure from interest rate expense and falling liquidity. Fixed-rate funding has large blunted the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity. Less than 7% of investment grade debt matures in the next year, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.