Erinn R King CFA, Managing Director, Payden & Rygel writes that bond markets have repriced dramatically this year and short duration credit appear to offer a much better risk-reward profile today as a result.
On a twelve-month horizon, it would take a second consecutive year of extreme market moves for investors to experience negative returns in short duration investment grade corporate bonds. This is possible but unlikely. Furthermore, in a highly uncertain world, maintaining an allocation to safe and liquid assets will help take advantage of market opportunities as they arise. Now that investors can meet their return targets with time-tested assets, they no longer need to venture into less liquid and less transparent private credit investments.
The 2022 inflation surprise has brought a sudden halt to the low yield environment of the post-Global Financial Crisis (GFC) world. It is too early to assess whether these inflationary pressures are a short-term phenomenon or a longer lasting regime shift away from the disinflationary environment of the last four decades. In any event, we believe this recent experience will lead insurance CIOs to reconsider some of the investment strategies born out of the post-GFC ‘forever low yield’ world.
The GFC has had many long-term implications. For instance, the most significant changes to financial regulation in the last fifteen years have been shaped by the crisis. Securitised assets’ punitive capital treatment under Solvency II is just one of many examples. Conversely, private credit barely existed as an asset class during the GFC. Unlike securitised, private credit was not ‘part of the problem’ and therefore received favourable capital charges under Solvency II. In the extraordinarily low yield environment of the post-GFC world, giving up liquidity (and transparency) to enhance returns in capital efficient private assets has been a popular strategy.
Now that bond yields are normalising, many investors are reconsidering the approach. Specifically, when return targets can be met with time-tested liquid assets, why give up liquidity and transparency in an untested asset class? Private credit will undoubtedly remain an important part of the strategic asset allocation for investors with long duration liabilities who can genuinely afford to give up liquidity for parts of their portfolio but there has also been a number of newer investors in these markets who are not as well positioned to give up liquidity. In addition, liquidity is very difficult to measure, forecast and plan for in practice. The LDI strategies used by defined benefit pension plans in the UK have been a prime example of this challenge: the cash calls have been coming a lot sooner than many had anticipated leading to reports of fire sales of private credit portfolios to meet cash calls.
Given the sharp monetary policy tightening and outsized market moves this year, second order effects are likely to impact some corner of global financial markets. In Warren Buffett’s words: ‘Only when the tide goes out do you discover who has been swimming naked’.
It is always difficult to identify trouble spots in markets ahead of time but holding liquid assets today will help take advantage of the attractive opportunities future disruptions will likely bring. Whilst most fixed income portfolios have experienced significant losses so far this year, maintaining an allocation to liquid fixed income assets will help take advantage of tomorrow’s opportunities. Importantly, we believe the risk-reward profile of short fixed income investments has improved dramatically in recent months. The much higher starting yields on short corporate bonds will better cushion against future volatility.
In such an uncertain environment, geopolitical risks and policy responses diverge across countries: diversification is therefore paramount. The ongoing volatility in Sterling assets since September shows that macro risks are rising and are not impacting markets uniformly. The time-tested principle of diversification is more than ever critical to managing risks. For property and casualty insurers with less interest rate sensitive liabilities, global fixed income portfolios hedged back to the desired currency can help mitigate part of the interest rate risk. For instance, in the third quarter of 2022, a one-to-three-year global corporate bond index hedged back to Sterling returned -1.5 per cent versus -4.2 per cent for a Sterling corporate bond index of a similar maturity profile.
Whilst diversifying interest rate exposure can help better manage risks, a more uncertain growth trajectory going forward argues for building well-diversified credit allocations across sectors. Some parts of private credit markets such as infrastructure debt bring genuine diversification of corporate credit risk. It is however worth noting that securitised assets offer a liquid alternative to achieve similar diversification benefits. For non-life insurers with relatively short liabilities, securitised assets would be an ideal asset if it was not for prohibitive Solvency II capital charges. In practice, securitised is really only a practical diversifying option for entities with comfortable capital positions or those able to take the capital charge in more favourable jurisdictions such as Bermuda or the US.
Securitised has been severely tested as an asset class during the GFC. Whilst certain structures and practices have thankfully disappeared, the overall securitised market has reformed and is today a lot more resilient. When it comes to securitised allocations, the CLO market is often the first port of call for insurers. With spreads of approximately 220-230bp on AAA-rated tranches and 280- 300bp on AA-rated tranches, they currently offer good value relative to competing alternatives. Beyond their yield pick-up, CLO 2.0’s improved structures and their extremely low default history strengthen the case. In addition to CLOs, securitised markets offer a wide range of collaterals: Consumer Asset-Backed (ABS) and Commercial MBS (CMBS) have grown significantly, and relatively new markets in the U.S. for Single Family Rental (SFR) and Agency RMBS Credit Risk Transfer (CRT) bonds continue to grow. Taking advantage of this wide range of collaterals beyond CLOs can strongly diversify an insurer’s credit exposure, and allows for a range of durations, maturities, and credit risks. The loan level data of many structures also provides an interesting opportunity for ESG and impact investment screens with more details than provided by vague corporate commitments.
In today’s testing times, investors are reconsidering some of the investment strategies born out of the post-GFC ‘forever low yield’ world. Time-tested liquid corporate bonds are once again offering an attractive risk-reward profile. For many investors, getting close to 6 per cent on high quality short duration investment grade corporate bonds will be ‘good enough’. Furthermore, in an uncertain environment, holding liquid assets to take advantage of opportunities as they arise is critical. Private credit made sense in the ‘forever low yield’ world but why give up flexibility and transparency now that return targets can be achieved with straightforward short corporate bonds? Simplicity, transparency and liquidity are back in fashion.
