Peter Miller, CFA®, FSA, Insurance Research Strategist, Invesco Investment Solutions
While the U.S. presidential election is understandably the most anticipated and most discussed decision for this year, Invesco believes there is another critically important decision facing insurance investors in 2020: how best to diversify corporate credit risk as they grapple with increasing leverage, historically low spreads, an economic expansion that is in its 11th year, and ever increasing concentration in BBB exposure. Many insurance CIOs are struggling to maintain yield in the continued low-rate environment, especially as they worry about increasing credit risk and risk-based capital considerations. We see two clear opportunities that may benefit insurers across these dimensions – emerging market debt1 and structured credit.
Before delving into detailed insurance considerations, it is instructive to see the economic impact of expanding one’s investment universe at a high level. Here we utilize Invesco’s Vision2 platform to examine how the efficient frontier improves when adding emerging market debt and structured credit to a representative Life investment portfolio3. The frontier results would look similar for representative P&C portfolios as well.
Figure 1: EM Debt Frontier Analysis – Life
1 This article focuses on U.S. Dollar-denominated emerging market debt.
2 Invesco Vision assumptions as of 12/31/2019 for this frontier analysis: returns are based on fixed income yields and Invesco Capital Market Assumptions (CMA) for growth assets. Risk framework leverages MSCI BarraOne. These estimates are forward-looking, are not guarantees, and they involve risks, uncertainties, and assumptions. For information on our CMA assumptions please see page 13 of our 2020 Long-term Capital Market Assumptions Q1 update here: Invesco’s 2020 Long-Term Capital Market Assumptions Q1 Update. These estimates reflect the views of Invesco Investment Solutions, the views of other investment teams at Invesco may differ from those presented here.
3 Representative allocation consists of 57% Bloomberg Barclays US Corporate Index, 10% Bloomberg Barclays US MBS Fixed Rate Index, 10% Commercial Mortgage Loan Proxy, 5% Bloomberg Barclays US Treasury Index, 5% Bloomberg Barclays Taxable Municipal Index, 3% Bloomberg Barclays US High Yield Index, 5% S&P 500 Index, and 5% US Private Equity Buyout Proxy. The proxy for EM Debt is the JP Morgan EMBIG Diversified Investment Grade Index and the proxy for Structured Credit is the JP Morgan CEMBI Broad Diversified Investment Grade Index. The commercial mortgage loan proxy is informed by the Giliberto-Levy Commercial Mortgage Performance Index and Invesco Solutions. The private equity proxy is informed by Burgiss and Invesco Solutions.
Figure 2: Structured Credit Frontier Analysis – Life
When either EM debt or structured credit are incorporated, the efficient frontier moves up and/or to the left, meaning lower risk for a similar return (or higher return for the same risk) is achievable. Notably, this is an economic perspective based on mark-to-market volatility; as we’ll discuss shortly, these asset classes are even more compelling when considering default risk and risk-based capital.
Beginning our deeper dive with emerging market debt, it’s important to address the most common concern we hear – EM debt is too risky. It’s true that there is seemingly always one developing country or another in the news for the wrong reasons: financial mismanagement, corruption, fears of pandemic outbreaks, political upheaval – the list goes on. However, investors should not swear off investments in emerging markets – a cohort that accounts for 60% of global GDP and 85% of the world’s population — over idiosyncratic headlines. Just as in corporate bond portfolios, diversification across issuer EM countries and companies reduces the exposure to one-off events. It’s also true that EM debt has historically experienced bouts of considerable spread volatility — but in our view, this is mark-to-market risk that overstates the real risk for investors who have the ability to hold over the long term — such as insurers.
Long-term risk-adjusted returns for EM debt are in-line, and in the case of EM corporates, have even exceeded those of U.S. corporate debt over the past 10 years:
Source: JP Morgan as of 12/31/2019. Past performance is not indicative of future results. Volatility is measured by annualized standard deviation. The assets classes are based on the following; the JPM EMBI Global Diversified Index, the JPM CEMBI Broad Diversified Index and the Bloomberg Barclays US Aggregate Bond Index.
Furthermore, actual default losses for EM debt have been more muted than spread volatility would suggest. The following table contrasts total return volatility with realized default losses:
Source: JP Morgan, 10-year period ending 12/31/2019.
Investors who understand these dynamics have an opportunity to enhance yield without taking on more credit risk, and at the same time, maintain risk-based capital requirements. The following exhibit highlights yields across the investment grade US corporate and EM debt spectrum:
*Assumes 12% cost of capital.
Indicies used: Bloomberg Barclays US Corpoarte Investment Grade Index, JP Morgan CEMBI Broad Diversified Investment Grade Index, JP Morgan EMBIG Diversified Investment Grade Index as of 1/31/2020.
4 Source: S&P Twenty Years Strong, a look back at US CLO Ratings Performance as of 12/21/2019.
In an environment where interest rates remain stubbornly low, and insurers are working harder to preserve capital for underwriting and alternative investment opportunities, EM debt may offer a unique opportunity to enhance portfolio yield without consuming additional RBC.
Many of the same dynamics apply to structured credit – low realized default losses despite historical bouts of high mark-to-market volatility, with investor aversion often stemming from headline risk rather than true economic risk4. One of the clearest examples of this is in the AAA CLO space, which has never experienced a default, not even during the financial crisis. Risk in the structured credit space has arguably diminished since the crisis; namely, via improving consumer balance sheets and more conservative underwriting standards at the bond structure level.
Starting with consumers, it’s important to recognize the improvement in consumer household fundamentals: improved mortgage affordability via lower mortgage rates, solid wage growth near 3% annually, historically low household debt service ratios, higher-than-average savings as a percentage of disposable income, and very low mortgage default rates. This improvement matters because consumers comprise the collateral pools underneath many structured bonds – it is their auto loans and credit cards that collateralize asset-backed securities, it is their home loans that collateralize residential mortgage-backed securities. As the collateral within these types of bonds improves, the risk to the bonds themselves diminishes.
An additional driver of risk improvement in structured credit is underwriting at the bond level and structuring terms of the bonds themselves. Since the financial crisis, loan underwriting standards have become more conservative, with increased income and asset documentation, higher credit scores, higher down payments, and stricter property valuation requirements. Additionally, enhanced protections have been built-in to bond structures themselves to safeguard investors. Perhaps the most significant among these is increased subordination levels in most non-agency RMBS, CMBS, and ABS. Taking just one example, many recent securitizations feature subordination at the BBB level that is more than twice the pre-crisis average. Rating agency actions attest to this improvement in bond structures; for example, in non-prime auto ABS deals, in the past 3 years Moody’s has upgraded 472 deals and downgraded only 3.5
In the RMBS market, agency CRT (Credit Risk Transfer) have seen 149 deals (out of a possible 189) upgraded since 2013. While risk-taking has arguably increased in other corners of the market – particularly corporate bonds, where leverage has increased and terms have tilted in the favor of borrowers at the expense of lenders / investors – the shift toward more conservative underwriting in the structured credit space is a notable advantage that should not be overlooked by investors.
Given the improved risk considerations above, investors might expect structured credit to offer lower yields than corporate bonds. Yet the opposite is actually the case – shifting from corporates to structured credit can improve credit quality without sacrificing yield. This affords insurers an opportunity to maintain or enhance returns without sacrificing precious risk-based capital:
*Assumes 12% cost of capital.
Indicies used: Bloomberg Barclays US Corporate 3-5 year Index, Bloomberg Barclays US ABS (Fixed & Floating) Index, Bloomberg Barclays CMBS Investment Grade Index, Bloomberg BArclays US MBS Fixed Rate Index, JP Morgan CLOIE AAA Index as of 1/31/2020.
Notably, the RMBS data is focused on agency bonds; for investors with the ability to expand their universe to non-agency mortgages, additional spread opportunities exist as well. With structured credit broadly, as with EM debt, insurers with the willingness and ability to look through short-term risk have an opportunity to improve portfolio returns without significantly increasing long-term credit risk.
It is important to recognize that taking advantage of opportunities in EM debt and structured credit requires significant resources. At Invesco, we have over 230 fixed income investment professionals across 14 locations, including 22 dedicated structured investments professionals and 18 dedicated EM debt professionals. Truly understanding and analyzing credit risk of developing countries often requires a local presence on the ground, where credit analysts can regularly meet with government leaders, central bankers, and other policymakers. Similarly, proper structured credit analysis requires a thorough understanding of the underlying collateral, structural details of the various bonds and their varying credit tranches, and modeling resources to synthesize all of these factors and inform a view as to where true risk is present and where there are genuine opportunities.
While many market participants, including Invesco, do not foresee a recession or wave of corporate bond defaults in the near-term, we believe – as many of our insurance clients do – that now is the right time to explore diversifying opportunities. In an era of persistently low rates, for insurers seeking complementary exposures to their corporate bond exposure that maintain yield without sacrificing capital, the decision is clear: emerging market debt and structured credit are two strategies worthy of serious consideration.