Insurance companies stand poised to combat the challenges of persistently low interest rates, tight investment grade credit spreads, and economic uncertainty by taking advantage of opportunities in public and private credit markets. Mary Anne Guediguian, account manager in the financial institutions group, Chitrang Purani, portfolio manager in the financial institutions group, and Christian Stracke, global head of credit research, discuss trends identified by PIMCO’s Secular Outlook, “Escalating Disruption,” and their investment implications for insurance companies. PIMCO’s base-case outlook for low rates and more volatility, coupled with tight current valuations, requires insurers to be nimble and ready to diversify their credit exposures in the pursuit of stable risk-adjusted income to support policyholder liabilities.
Q: Persistently low interest rates have created significant challenges for insurance companies. How has this affected insurance company risk-taking?
Purani: After the 2008 financial crisis pushed rates toward historical lows, we saw broad shifts in the way insurance companies invested. One shift was reduced liquidity driven by the large increase in private debt investment (high quality corporate private placements and commercial mortgage loans). Another was a move lower in credit quality.
We expect continued appetite for private commercial and corporate debt – accepting reduced liquidity in exchange for additional spread, which we believe is sensible for yield-focused investors like insurers. However, we don’t anticipate that firms will continue moving lower in aggregate credit quality given economic uncertainty and stressed corporate balance sheets against tight valuations.
We would advocate a more barbelled approach: On one end are opportunistic vehicles in stressed or distressed debt. At the other is higher-quality public debt – but with less of a tilt toward generic, index-like credit in lieu of profiles that offer a premium for complexity or reduced liquidity. We believe this balanced approach enables insurers to preserve dry powder in terms of credit risk and risk-based capital to deploy when bouts of volatility may create attractive opportunities, while also allowing them to take advantage of the more compelling areas of today’s credit markets.
Q: What are PIMCO’s views on the current tightness of investment grade credit spreads, and on default risk?
Stracke: To offer a longer-term perspective, U.S. investment grade spreads are now around the 40th percentile of their range during the past 20 years. In other words, spreads have been wider 60% of that time. The main reason for this has been the Fed’s unprecedented support for corporate bonds, which has eroded the liquidity premium.
Default expectations in high yield markets have also played a significant role. Though we do not expect the default rate for high yield bonds to rise into the mid-teens as some ratings agencies predict, we believe it will move to high single digits from its year-to-date level of around 6%. A resurgence of the pandemic or a hard double dip in the economy could make that considerably worse. Investment grade credit would not be immune, but the risks are far greater in high yield. So, our bias is toward higher aggregate credit quality.
Q: With considerable economic risks and tight spreads, how should insurance companies think about managing downside risk?
Guediguian: The low-rate environment on the asset side and pressure on the underwriting side present considerable challenges for insurance companies’ profitability. At the same time, capital and surplus across life, property and casualty, and health insurers is stronger than it was before the financial crisis. We’ve seen a significant volume of fallen angels (investment grade debt downgraded to high yield), and we expect more. The impact of these downgrades on valuations has been amplified by recent growth in passive ETFs, which often become forced sellers when ratings change. Though this does not warrant a run for the exits, insurers must consider ratings migration to ensure optimal capital allocation, have an ability to hold positions through price volatility, and be opportunistic when market dislocations occur.
Q: Are insurance companies getting paid for taking extra risk by going down in credit quality?
Purani: In the most basic sense, realized defaults almost never exceed the spread compensation earned on a broad portfolio of investment grade credit over a period of three to five years. Much of the spread earned is a function of liquidity, volatility, and other sources of risk premium. However, the level of this excess spread is currently compressed relative to history thanks to central bank actions and the general reach for yield – despite the increase in corporate leverage. While this dynamic may persist for some time, our focus remains on buying credits with more resilient balance sheets and selectively stepping into lower-quality/dislocated credits when the added spread becomes more attractive.
Q: Income-focused investors are seeing more volatility in net investment income results. How can CIOs create more resiliency on the balance sheet?
Guediguian: When we talk about resiliency of portfolios, diversification is the term that typically comes to mind. Through our lens, diversification happens through risk factors – for example, rates are indeed low, but duration still serves as one of the more effective hedges to credit spread volatility. Corporate credit dominates many insurance company portfolios, and adding higher-quality sources of securitized credit, as well as opportunistic exposures in emerging market or high yield debt, could reduce concentration while enhancing yield. Similarly, private credit could provide an opportunity to further diversify and potentially increase yield. In looking to balance risk across the investment portfolio within alternatives, we think it makes sense to lean into broad-based strategies versus doubling down on corporate risk through traditional private equity or direct lending.
Q: What are some of the more compelling investments you see in the private credit space?
Stracke: We remain constructive on public credit. However, we believe there are once-in-a-decade potential opportunities in stressed and distressed credit. These include stressed borrowers, as well as those looking to raise liquidity, which spans corporate, real estate, and consumer debt. The economic disruption caused by the pandemic has distributed stress widely. There is a significant opportunity to lend to these distressed borrowers, but it is highly differentiated and requires the capability to conduct detailed analysis for each.
We also believe there will be considerable opportunities to purchase risk assets from motivated sellers. Banks, for example, have been slow in disposing capital-intensive assets but will likely accelerate the process as they clean up their balance sheets to support depressed equity valuations and brace against any further economic weakness. In recent months, banks have sold pools of student loans, consumer receivables, reperforming mortgages, and other types of debt with attractive risk/return characteristics. Additional motivated selling could come via direct lenders and collateralized loan obligations, which can be triggered by downgrades and an inability to properly handle stress in credits.
A third area of opportunity is distressed debt. Despite greater risks, we feel we are in the early stages of an extended wave of distressed opportunities. Many companies entered this pandemic-driven recession with high levels of debt after building balance sheets predicated on growth outlooks that are now more uncertain. Many have limited access to liquidity, and will need to restructure.
Q: There has been some concern about whether the opportunity set in the private market can absorb the large amount of investment capital that has been raised. Does PIMCO have confidence in its ability to source attractive investment opportunities?
Stracke: The leveraged finance market – U.S. and European high yield bank loans and some emerging market corporate credit – has roughly $4 trillion outstanding following explosive growth over the past decade. If we hypothetically apply a 10% default rate, that’s $400 billion of claims that could potentially go through some form of restructuring. That doesn’t include the significant cohort of stressed borrowers that desperately need funding, or other areas such as real estate debt or consumer receivables.
It’s true that multi-billion-dollar funds are being formed to pursue these opportunities, and there ultimately might not be enough for everyone. But it largely depends on which asset managers can take advantage of the opportunities. This is a complex area of investment, and we believe that PIMCO’s size and breadth helps us to source investments that might not be accessible to investors with less robust platforms. It’s not just about credit risk, but also structures, funding profiles, securitizations, and a range of other specialized skills, including rigorous credit research and analysis. We believe that PIMCO’s resources, presence in the market, and technical expertise give us a considerable edge.
The continued long term impact of COVID-19 on credit markets and global economic activity remains uncertain as events such as development of treatments, government actions, and other economic factors evolve. The views expressed are as of the date recorded, and may not reflect recent market developments.
All investments contain risk and may lose value. Alternative investments involve a high degree of risk and can be illiquid due to restrictions on transfer and lack of a secondary trading market. They can be highly leveraged, speculative and volatile, and an investor could lose all or a substantial amount of an investment. Alternative investments may lack transparency as to share price, valuation and portfolio holdings. Complex tax structures often result in delayed tax reporting. Private credit involves an investment in non-publically traded securities which are subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investments in Private Credit may also be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond a manager’s control.
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