Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name is Stewart Foley, I'll be your host. Welcome back. It's great to have you. Today's topic is a good one. It's why emerging markets for insurance companies and we're joined by Pramol Dhawan, managing director and head of the EM portfolio management team and member of the investment committee at PIMCO. Pramol, thanks for being on. Thanks for taking the time and we're very happy to have you.
Pramol: Thanks for having me, Stewart.
Stewart: So we're going to do the same icebreakers that we're going to drag you through that process, like we do everybody else, right? What's the town that you grew up in, what was your first job, not the fancy one, and what makes insurance asset management so cool?
Pramol: Great. Well, again, thanks for having me. My hometown is a place called Coventry in England. It's bang smack in the middle of England. I say middle of England, it sounds like a Lord of the Rings reference, in Middle Earth or something, but it is, literally, in the middle of the UK.
My first job was at a golf course in Coventry. I was a caddy at a golf course. I love playing golf. Of course, I don't get too much time to do that anymore with two young kids, but I'd love to do that a little bit more.
What makes insurance asset management so cool, well, I think I've had the pleasure of meeting various insurance practitioners in Bermuda and in Connecticut and I think insurance asset management's really at the forefront of innovation between public and private sectors, searching for yield, high-quality assets, thinking about how to match assets and liabilities. It's been a great eyeopening experience for me, lots of really smart, interesting folks thinking about how to attract value for their portfolios. Of course, a lot of that lends itself to discussions in emerging markets of which I'm sort of predisposed towards. But really smart people, interesting area, are very, very much innovative in their nature and great fun to go out with drinks after work, Stewart, if I may say so.
Stewart: Absolutely. That's consistent with my experience with this group as well. So let's start it off with why EM for insurance companies and more specifically, why now?
Pramol: Really four reasons. Diversification at the forefront are high yields, correlation, benefits, and high-quality long-duration assets. So we start with the first one, diversification. Emerging markets is an effective way for insurance companies to deconcentrate away from US corporate credit risk. By deconcentrating, I'm not talking about giving up on yield. In fact, you get higher yields in emerging markets than you do in US corporates. Even when you match for just the ratings perspective, EM gives you a superior yield up. So that diversification benefit is very important and it's certainly important against the backdrop of the regional bank defaults that we saw earlier this year.
The second is yields. Emerging market yields are higher than that of US corporates, and that's primarily due to embedded risk premium and that risk premium, you can break that out to lower liquidity, higher mark-to-market volatility and less stable technical flows. I think insurance clients, Stewart, are able to benefit and withstand some of that mark-to-market volatility and they can harvest that yield compensation over the long term. The third point is on correlation. It's a really good way to get spread risk, but also to think about getting spread risk in a way which is less correlated to generic spread and equity risk. In fact, the correlation to US IG spread is about 0.6 over the long term, which is quite low and quite low when you think about it in context of broader sort of fixed income assets.
The final point I would mention is, is just high-quality long-duration assets. And when you think about life insurance balance sheets, one of the questions we get asked all the time is, is how do I get high-quality long-duration assets? Well, my answer is emerging markets and issuers in emerging markets, whether it's Israel or in the Philippines or in Chile, they're more predisposed to issue investment-grade century bonds or long-duration assets, both at the sovereign level and at the quasi-sovereign level. So I think we can sort of easily get nine to 15 years of duration for our clients whilst maintaining investment grade-rated portfolios.
Stewart: You kind of went down a place where I wanted to go, which was has the definition of EM changed? I mean, I think that some folks have an antiquated view of what EM actually is, right? So you mentioned a few countries there. Is there any change in the way that EM is defined today?
Pramol: Yeah, it really has changed a lot, Stewart, and I would agree with you. The initial reactions from clients is met with one of, I think, a healthy degree of skepticism. These countries are often front page of Financial Times and you've got headline risks and internal liability risks, et cetera, et cetera. But that's not really the subset of countries we're talking about. We're not talking about the single Bs and the triple Cs. We're really focused on the higher quality emerging market countries where balance sheets are relatively healthy. In general, these subset of countries were not able to quantitatively ease so they don't have the massive pickup in debt metrics that you've seen in the US and in the euros. On top of that, they didn't do a large amount of fiscal stimulus post-COVID as well because the market didn't allow them to be able to get away with it.
So from a starting conditions perspective, you've got a bunch of sort of triple B plus, single A minus-rated countries that whose starting balance sheet metrics are much more favorable than that of developed markets and whose yields, or starting levels of yields, give you an uplift of that of US corporates as well. So really the value proposition is there and we think that when clients think about emerging markets as an asset class, this is an asset class, Stewart, that generates countries of which generate around two-thirds of global economic output.
But when we look at US insurance companies, they have about 3% of their portfolio allocations or low single-digit allocations within emerging markets. And I think it's fair to say over time, folks, as they get more and more comfortable with emerging markets and these types of portfolios, will look to raise their allocations and probably one can expect that these yield premiums that are endemic in the asset class will get ironed out over time. But that's not for now. For now, those yield premiums are there and we're encouraging our client bases to start really thinking about EM, not necessarily as a tactical trade, but really as a long-term investment proposition, which is how we think about it.
Stewart: I think that makes a ton of sense. So when you look at this market, what is the influence of technicals or flows on performance versus the fundamentals that you just discussed?
Pramol: So I'm going to get a little bit technical here, Stewart, and I'm going to reference some long-term empirical data because I think the best way to ground this is in facts and in empirical evidence.
Stewart: The good news is that our crowd loves it, loves the weeds. They want to get in the weeds so this is perfect.
Pramol: Wonderful. So if you think EM, if you knew nothing about the asset class and if you just looked at emerging markets against US corporates, the first thing that you would say at a high-level perspective is that the fundamentals are nearly identical to that of US corporates. We have nearly identical default rates, nearly identical recovery values and nearly identical ratings migrations. In fact, some of the statistics if you factor in the recent regional bank defaults are actually more favorable in emerging markets than that of US corporates. So when you look at the empirical evidence, if you go back to 1983, and that was a very volatile phase and, quite frankly, a different phase for emerging markets, but if you take the longest time series you can, emerging markets are statistically insignificant in terms of ratings migration, loss given defaults than that of US corporate credit.
However, unlike US corporate credit, emerging markets has a significant yield uplift and for about a single A minus portfolio on average you get around about a 70 basis point yield to worst uplift in emerging markets than that of US corporate credit for, again, similar fundamental risks. But what you do give up is you have to give up a little bit of liquidity risk and it's about one-third less liquid than that of US corporate credit, in fact, quite similar to that of European IG corporate credit as well.
So for those that can withstand the lower liquidity, I won't call it illiquidity, it's less liquidity, but want to take a long-term investment horizon to capture that 70 basis point yield to worst uplift for the same loss given defaults, the same ratings migrations and the same recovery values and default rates, well, then EM sovereigns and quasi-sovereigns represent a real really attractive alternative to that of US corporates. And, of course, when we talk about those that can withstand that liquidity and the volatility and the mark-to-market, well, that sort of squarely puts us into that insurance bracket of clients.
Stewart: That's terrific. So let me just go back and work on the numbers that you just laid out because I think this is really important. You said it is that IG is a third less liquid than US corporates, but on par with IG European credit. That's a really helpful metric.
Pramol: That's right.
Stewart: Okay, good deal. One of the things I think that when investors are looking at managers, they're trying to figure out how to differentiate one from the other and I think particularly if there's a multi-manager situation, whatever. So what is PIMCO's philosophy, if you will, for managing insurance EM assets?
Pramol: For us, insurance investments in emerging markets and emerging markets investments, in general, is like a game of tennis. You win by making the fewest mistakes possible and that's really our philosophy. Stay high-quality. We really try to bifurcate between risk and uncertainty. We're in the business of pricing risk. We're not in the business of trying to price uncertainty. In fact, by definition, it's highly difficult to get a competitive advantage on political and geopolitical risks. But emerging markets, that philosophy is squarely in line with what the best risk-adjusted returns are for emerging markets. So, again, if you knew nothing about this asset class and if you just looked at returns by ratings cohorts, you would find that the best risk-adjusted returns are in that triple B/single A part of the asset class, risk-adjusted for volatility of each of the ratings cohorts. So, for us, it's clear. We follow the empirical evidence, we go for the best risk-adjusted returns and we stay high-quality.
But many of the other managers don't do that. They tend to venture down to the lower quality, the single Bs and the triple Cs. And unlike US corporate credit, emerging markets, there's no statistical evidence that the single Bs and the triple Cs add incremental value. In fact, it's exactly the opposite. Your risk-adjusted returns actually go down once you pass that triple B inflection point. So I think it's, literally, the opposite approach when you try to bottom-fish in the low-quality assets.
So we sort of swim the other way. We stay high-quality and we really try to focus on making sure that we can bifurcate between risk and uncertainty, making sure that we're avoiding what we call black hole risks. That's capital impairment risks, which we know is front and center of our insurance client's hands and we really try to make sure the portfolios are adequately diversified such that the clients are capturing that bottom-up idiosyncratic value in this asset class, which lends itself to that risk premium we spoke about earlier about the 70 basis point yield to worst uplift versus corporate credit.
Stewart: That makes a lot of sense, too. I mean to paraphrase that, what I'm hearing is you're not getting adequately compensated to go down in credit an EM, which I think is an important takeaway for the podcast. I think that geopolitical and domestic political risk always or enter the discussion whenever we're talking about EM. So how does PIMCO price these kinds of risks and how do you think about managing them in the context of an EM mandate?
Pramol: The first thing I would say is it's not an EM-only factor. Political risks, geopolitical risks, are creeping their way into developed markets as well. If you just take a step back and think about the UK LDI crisis, we're on the precipice of a government shutdown or potential government shutdown in the US after significant challenges earlier in the year. They are endemic within a global ecosystem that's facing challenges around demographics, around climate change, around growth, quite frankly.
Now in emerging markets, we've had more experience about being able to deal with them, therefore, we've learned a few key lessons. Firstly, we simply focus on what risk we can price so we don't want to take binary election risks. We're not in the business of trying to call elections in emerging markets. That is not our edge and I would argue that that, in fact, is not anyone's edge. So if we park that uncertainty to one side and try to extract the risk elements of it, well, that's something we feel very comfortable in in terms of pricing, especially across emerging markets, and I'll go back to a previous point that I made.
Emerging market balance sheets are very healthy right now, whether on the corporate side, the quasi-sovereign side or on the sovereign side. If you look in a post-COVID world, well, we've really sort of amplified the debt levels in developed market countries, yet we've tapered off or flat-lined the debt levels in emerging market countries. So starting conditions matter and starting conditions are healthier in emerging markets versus developed markets.
But that being said, let's not always think that geopolitical risks mean negativity. There are geopolitical risks which offer opportunities and create value. Think about when emerging market countries are at the forefront of geopolitical negotiations where the US will use certain emerging market countries to help strategic goals on the international stage. So think about a country like Turkey, which is at the front and center of negotiations between Ukraine and Russia, which the US are trying to develop and improve relationships with. It's at the precipice of trade between Europe and Africa and it's an important conduit to the Middle East, to the Arabic-speaking world at a point where oil prices are incredibly high. I think it's fair to say that Turkey is a geopolitical beneficiary of the current environment and it's one where you can think about geopolitical risks as being perhaps not a negative element, but a potential positive element for that particular country.
Stewart: So one of the things you mentioned was the balance sheet and you made some high-level comparisons, but you see an unprecedented amount of leverage on domestic market corporate balance sheets, which are a large component of an insurers' portfolios. Can you speak specifically on how emerging market corporates compare?
Pramol: Emerging market corporate balance sheets are far less levered than that of US corporate balance sheets. They can't use as much leverage and they must operate with more equity capital than that of their US comparables.
But I wouldn't make a ubiquitous statement about emerging market corporates. I think that there are certain niche industries which really warrant insurance clients digging a little bit deeper and fully understanding because you are shifting towards oligopolistic industries, ones where you can find favorable spread pickups and one that I would like to highlight is banks in emerging markets. So let's take a banking sector in a country like Brazil, for example. Unlike the US where we have many thousands, 4,000-plus banks across the US, you really only have five banks in Brazil and it is an oligopolistic market structure. Now typically, for historical reasons, the credit ratings for banks in emerging markets, they have a credit floor at the sovereign level. So the thought process is that that in a financial crisis, in a potential debt default, the financial system will get contaminated as well as the sovereign system and the correlation will trend towards one. So even though the bottom-up metrics of the banks are incredibly strong, there's limited competition, capital ratios are very adequate, and the delta between learning rates and deposit rates are incredibly favorable, these banks are floored at the sovereign ratings.
If you were to take that bank, let's say an Itau or a Bradesco and you were to port it over to a US jurisdiction, you get about a two ratings, uplift, for being in an emerging markets bank versus a comparable US bank. And that, to me, is risk premium. That's risk premium that a long-term investor can underwrite, but you really have to understand which sectors you're looking to underwrite. And EM banks are one of the ones that we at PIMCO really like.
Stewart: That's really helpful. So what are some alternative sources of EM yield for insurers that have the flexibility to construct a mandate, including both public and private? And I think the basis for the question is that there's a lot of interest in private assets by insurance companies, right? So how would that work?
Pramol: Well, private things, Stewart, private assets mean many things to many different people. So let me start the conversation by saying that private in this context is not necessarily going down the quality spectrum. So it's lending to the same sovereign entities, the same quasi-sovereign entities, but rather than doing a public unsecured euro bond, you either do a reverse inquiry or you structure something directly with that particular issuer that might have better downside covenant protection benefit from superior lender status. And, indeed, you get paid for that illiquidity so, on average, about 125 basis points of additional spread premium over the comparable unsecured euro bond. So we've been doing a lot of this, which I call tentacle semi-liquid, rather than private, but it is lending directly to these issues. And I think this is a great expression for insurance clients, again, that are willing to give up a little bit of liquidity, but really want to have that high-quality additional spread premium.
Now emerging markets as an asset class is the largest pool of credit now, Stewart, in the world. It overtook the US in 2017 and it continues to grow. But it doesn't grow because of leverage. It's growing in a healthy way because of financial market depth creation, more countries coming online and we saw that with the announcement of India recently being added to market indices. So more countries coming along on online, more capital markets. So I think the idea for us is how do we, in a sensible manner, look to extract risk premium whilst trying to protect on the downside and I think this notion of private investing, whereby you can extract that additional 125 basis points or 150 basis points of illiquidity premium. But you can also work with lenders like the World Bank, like the EIB, some of the development agencies, and you can get this notion of credit uplift through partnerships with these multilateral agencies. I think that's a natural way to minimize a little bit of the embedded credit risk. It's a great area of development within emerging markets. It's something that PIMCO has been at the forefront of. We've deployed high single digits of billions of capitals within the last five years.
Stewart: That's fantastic. I have learned so much on this podcast, I really appreciate it. I mean, part of what we're doing is educating the industry and it's really helpful. I mean, I think you provided a couple of really metrics that are easy takeaways for our audience. I've just got one, potentially two, more fun questions on the way out the door. You can take either or both, which provides optionality. The question is, what's the best piece of advice you've ever gotten and/or who would you most like to have lunch with, alive or dead?
Pramol: I'll try and do both. The best piece of advice that I've ever gotten was from my father who said, dream big and work hard. It's something that I hold dear to me and it's something that we try and engender across the team within emerging markets. And, quite frankly, it's quite a similar philosophy for the insurance clients as well, especially when they've been starved of yield and challenging this notion of thinking big and thinking outside of the box has been something that sort of naturally lent to where we are today, where we're discussing emerging markets for insurance clients.
In terms of who would I like to have lunch with that never have, I'm a huge, I guess I have to call it soccer fan, but I would've called it a football fan. I'm a Liverpool football fan. I would love to have lunch or dinner with the manager of Liverpool Football Club, somebody that I think is an incredibly charismatic personality for those that know him. He's larger than life, a big football expert, but really a wonderful human being, at least who I can say from the outside. Somebody that's taken a team, really forges bonds across that team, creates a them-versus-us mentality and has really driven superior performance across this team through a cohesiveness and very tight bonding. So yeah, if I could ever have lunch with Jürgen Klopp, that'd be fantastic. I would love to do it, but I probably wouldn't let him go at lunch. I'd probably drag on until dinnertime, quite frankly.
Stewart: That's perfect. That's great. Listen, thanks for being on. I really appreciate it. Thanks for taking the time. We've been joined by Pramol Dhawan, who's a managing director and head of the EM portfolio management team, and a member of the investment committee at PIMCO. Pramol, thanks for being on. Thanks for taking the time.
Pramol: Thanks so much for having me, Stewart. It was great.
Stewart: If you like what we're doing, please rate us, review us on Apple Podcast, Spotify, or wherever you get your favorite shows. My name is Stewart Foley and this is the InsuranceAum.com podcast.
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