The Big Idea

The rise of annuities and the demand for credit

| 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. This material does not constitute research.

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

Note: Annualized YTD sales numbers based on sales through 3Q2023.
Source: CreditSights, Santander US Capital Markets

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

Note: *PE-owned. + Relationship with outside money manager. Other notable insurers with PE ownership include Fortitude Re (Carlyle), Talcott (Sixth Street), Resolution Life (Blackstone), Martello Re (Centerbridge/BBH), Somerset Re (Aquarian), Prismic Re (Warburg Pincus, others), Ohio National (Constellation), NSM Insurance (Carlyle), Resolution Life (Blackstone), Argo (Brookfield). As of July 2023, PE firms owned 137 US insurers.
Source: CreditSights, NAIC
here and here, Santander US Capital Markets

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

Source: NAIC here, Santander US Capital Markets

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.

* * *

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.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

Important disclaimers for clients in the EU and UK

This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.

This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.

This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.

This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.

The Library

Search Articles