Stewart: You have got to be kidding me that we're talking about core fixed income today. Welcome to the Insurance AUM Journal Podcast. I am joined by Wesley Pate of Income Research and Management, commonly known as IR&M. Wesley, welcome.
Wesly: Thank you. It's a pleasure to be here. Yes, and always happy to talk about core fixed incomes.
Stewart: I love it.
Wesly: Nice to see it getting the interest back again recently.
Stewart: Absolutely. Listen, this is the greatest thing because I am a fixed income geek and I think people who run core bonds refer to themselves as geeks. I don't mean no disrespect to anybody else who thinks they're a geek, but I'm for sure a fixed income geek. And I find it amazing the changes that have gone on, what constitutes core bonds. When I started in this business, it was triple B or better, thanks for playing. And a crazy allocation was 10% high yield. Way different world today. We're in a situation where rates are rising and inflation is up and bonds hate that environment. How are you positioning insurance company portfolios given high inflation and rising rates?
Wesly: Yeah, that's a great question. And I'd actually first say that as a bond portfolio manager and as a fellow core fixed income geek, if you will, it's something we hang our hats on with great pride is that rising rates are not necessarily bad. The classic rule in fixed income is if your time horizon exceeds your duration, you will benefit from rising rates. And if we think about an insurance company is an ongoing entity, a going concern. So really arguably long term, they should ultimately benefit from rising rates as they get to incrementally reinvest the coupons and maturities at these incrementally higher yields.
Stewart: Okay, so you and I fixed income geek extraordinaires, but, you use the term duration. Not everybody who listens to this podcast knows what that means. As you and I both know, that is not a passage of time.
Wesly: Correct.
Stewart: That is a number that measures interest rate sensitivity of an individual bond or a bond portfolio. So when you say duration, when you say your time horizon is longer than your duration, I'm just trying to put that in context and break it down for folks who may not be as familiar with core bond asset class as others.
Wesly: Yeah, and it's a great point because time, maturity is an input to duration, but it's certainly not the only thing. It's a great caveat there. That duration is measuring the bond or the overall portfolio, most importantly, its sensitivity to changes in interest rates.
Stewart: And we're going to derive the formula for convexity in just a moment. I didn't mean to stop you there in the middle of this so the question was, how do you position insurance company portfolios given higher levels of inflation and rising interest rates, and you were talking about if the time horizon is longer than the duration, then you should benefit from rising rates. So please continue. I'm sorry, I didn't mean to stop there.
Wesly: No, no, it's great to dive ever deeper. So, the first thing we would say is we're having an increasing communication with our partners, with our clients, with consultants, with the actuarial partners that we work with, to really hone in on exactly where they need to be positioned in this sort of rising rate environment. It's important that we talk about how we manage portfolios. For starters, we're duration neutral. So in other words, we seek to keep the duration of the portfolio roughly in line with that of the set index that's chosen by our clients. And we work with those clients in order to make sure or that that index has a duration that's reflected of the amount of interest rate risk that they're seeking to take. Really what we're doing now is having a lot of dialogue that also really make sure that we're capturing the welcomeness of potentially having to take some realized losses in this environment as rates go higher and bond prices have fallen.
That's created some losses in the portfolio. So, one of the things that we're doing is incrementally turning over the portfolio a little bit, but the advantage there is we're adding book yield. It's amazing to think if we go back just a couple years ago, the complaints weren't that rates are rising, the real issues were, oh my gosh, my book yields are so low, they're so depressed. What do I do? And what did that do? That really pushed a lot of insurers, insurance companies to go more into private debt, go more into other private asset classes, go incrementally more out on the esoteric spectrum. Now, today, what we're seeing in the way we're positioning those portfolios is core bonds are back in. They're back incrementally more in favor. And so that is certainly advantageous because you're not having to stretch quite as much today to get the exact same yields that you were just only a year or two ago. So, incrementally, we're seeing some of that shift away from privates and starting to see a little bit more of a core fixed income come back into favor.
Stewart: Okay. So, Wesley, we're going to go back to a term you used in your last answer, book yield. That's an insurance only concept. So just if someone is on this platform and they're not an insurance investment professional, which I don't think that... The chances are small, but nevertheless, what's book yield for an insurance company and why does it matter?
Wesly: It's a great question because to your point, book yield is not something that's necessarily discussed in every fixed income curriculum. It really has to be well understood by managers of assets on behalf of insurance entities. So, book yield really reflects the yield at which you purchase the security. Now, there is a little bit of a fallacy in the calculation because it assumes a constant state of reinvestment. However, really what it does, it reflects the purchase yield. And so, book yield really holds static throughout the life of the holding of the security. And because insurance companies don't always have to mark their every single security to market on an ongoing basis, if those securities, for example, are held to maturity instead, you're not going to have that constant mark to market. And so the book yield is ultimately the income that's going to flow to the income statement from the purchase of those securities.
Stewart: Thank you. That was a great, perfect textbook definition and so important for folks who, when you're talking about insurance companies and reinvestment, to hear you say that you are getting book yield increases really is a testament to how much this market has changed in the recent past.
Wesly: Absolutely. And it's changing in both dynamics, both in terms of the risk free rate, that of treasuries, and also spreads. So, here we are today and say intermediate corporates are now yielding well north of 3%, and it's the first time in a long time we've seen yields that way. So, core fixed income is starting to offer those yields that are really starting to bring investors back. And, that really highlights that rising rates long term are going to be beneficial for investors and general insurance entities in particular.
Stewart: And I don't mean to re-cover this ground that you're covering, but you're making the case that insurance investors should not be as concerned about rising rates as just a flash of ‘rates up, prices down’ because we're not marking to market on a statutory basis, we should be focusing on reinvesting at high rates. Is that fair?
Wesly: Yeah, I think it's definitely important. We have to make sure as a manager that we do still have empathy and we understand that it can still result in some near term pain because maybe some of those incremental sales of the portfolio could realize losses at this point because rates are higher. So we don't want to pretend that it's completely immune. However, again, we're taking that long term view.
The way we think about portfolio is the same way we think about every investment, we're not buying a bond on a Tuesday expecting to sell it on a Wednesday. We take a long term view, and we really partner with the insurance companies that we manage money on behalf of and make sure that they understand that long term view and that it's consistent with their desires as well. So, insurance companies are not bond flippers. And so that's important to recognize. They take a long term view. They're not looking to have that level of volatility in their portfolio all the time. So taking a view of ‘how is this bond going to perform over a longer period of time’, maybe over a rate cycle is very important in making sure that we put forward and are able to achieve the objectives that are set forth.
Stewart: Yeah. And I think that's consistent with the way insurance companies operate. Insurance companies make promises, that's what they get paid for. And those promises go out sometimes many years. And they're buying investments to offset those liabilities and to make sure that when there's a loss that they can pay those claims. I think your point is very well taken and that insurance companies have those long term horizons in all facets of their business. Inflation. Inflation reached a 40 year high in February. Treasury rates are pretty up pretty significantly. What does the Fed need to do to get inflation under control?
Now this is bond geek 101. Yesterday, I see on one of the financial shows, bond market flashes recession signal, and there's an inversion of the yield curve and immediately makes headlines. So can you talk a little bit about what you think the Fed needs to do and what the curve shape implications are?
Wesly: Yeah, absolutely. And it's a great question because the shape of the curve is not necessarily the perfect signal always. It's not the perfect harbinger of predicting everything that's going to occur. And there's a couple of things that we would talk about here. One is the Fed has effectively labeled inflation public enemy number one, and they are incrementally getting more and more aggressive, more hawkish, if you will, in terms of fighting the inflation that we're seeing in this environment.
I'd like to think back a year plus ago, everything was mentioned to be transitory. Now whenever you hear about the Fed, you're hearing the term Volkeresque or Volkerism. So really starting to think about Paul Volker and his moves to fight inflation back in the 70s and 80s. And we're starting to see incrementally a much more hawkish stance in terms of addressing inflation, looking at where the Federal Reserve expectations are going forward throughout the rest of the year.
Now the market expects upwards of eight additional rate hikes. So that would be nine for the year. Nine, 25 basis point hikes. The market's expecting a 50 basis point hike at the upcoming meetings. So first time in a long time that we've been in a rate hiking cycle. I think it's really interesting though to think of the last time we went into a rate hiking cycle. Twos, tens was over a hundred basis points. Today it's basically zero. So, we are certainly in some interesting times, but there's a couple of things we would note here. One is the Fed does have another lever they can pull and that's really the balance sheet. So as they lean on the Fed funds rate, as they push that higher, that's really going to impact the front end of the curve. However, given the large amount of treasuries and mortgages the Fed owns, what we are expecting to see is more of an active approach of reducing that balance sheet.
And that'll start to really move long end rates potentially higher. So you have a dynamic here where they have multiple levers and each lever affects a different part of the yield curve. We're not expecting to see necessarily these parallel shifts all the time because really what's going to matter is which lever do they pull in more aggressiveness. And one other thing that we would really want to talk about is inflation in terms of not just how it's impacting the assets for insurers, but also how's it impacting the liabilities?
Stewart: Amen.
Wesly: Think about a property and casualty insurer especially. So, given the large increase in prices we've seen in homes and automobiles, that means the claims are going to be incrementally higher. So, what we're definitely seeing as insurers really lean on the pricing power that they do have, and that's going to be ever more important because as rates are going higher, they're going to be able to get better book yields that'll ultimately be beneficial, but ultimately the pricing lever is going to have to be utilized as far as getting through this cycle.
Stewart: Yeah, it's interesting, if you think about a homeowner's policy that was sold five years ago, the home construction costs that were built into that pricing are substantially different than they are today. So let me just go back and just touch on one thing because I think it's important. So, we're talking about yield curve shape and rising rates and blah, blah, blah, blah. And you said “we run a duration neutral portfolio,” which means that you are trying to, the interest rate sensitivity of your portfolio is designed to be consistent with the benchmark and that implies that you are not making directional bets on interest rates. Is that a fair assessment of your philosophy there?
Wesly: Yes, that's correct. And we actually take it one step further and say we're also not looking to take bets on the shape of the yield curve. So not only do we look to keep the portfolio duration neutral, but we also look to keep the overall key rate distribution or the certain points along the curve roughly neutral to the benchmark. Now we do allow for a little bit of movement and oscillations therein because we don't want to excessively trade in order to get to the very last sort of 0.01. So, one thing we're seeing right now is shifts in duration. You brought up, we'll probably dive into convexity at some point, as any bond geek would say, it's always going to be a topic near and dear to all of our hearts, but that convexity factor or which really is highlighting how much duration changes.
What we're seeing now is that's weighing on the overall durations of indices and also the assets that they represent. So we've definitely seen a little bit of an extension for example on a lot of extension in the mortgage market, which has a lot of negative convexity. And then at the same time, in, say corporates and long treasuries, we've actually seen the positive come convexity kick in and so we're actually seeing duration shorten there. So you do have some offsetting factors. But it's important to make sure that just as much as we don't want to have a duration that's matched, we want to make sure we have a convexity advantage in the portfolios because that allows us to take advantage of some of the volatility that we're seeing.
Stewart: If you think about convexity in terms of measuring the callability or the cash flow, the variability in the cash flow in the portfolio. So the more negative convexity is that it kind of works against you and the more positive it is, it works for you. And there's a yield cost to that convexity, but, you're managing that convexity across, you're aware of what that might be. When you talk about duration extending in resi mortgages, for example, the way that I would kind of think about that is: that means that it's not financially viable to refinance my mortgage on my house, and consequently then I'm going to just keep paying my mortgage, which reduces the amount of prepayments. Is that fair? And is that why the duration or the interest rate sensitivity of some of those securities is increasing?
Wesly: Yes. You're spot on. In fact, the percentage of the mortgage market that is currently in the money to be refinanced. In other words, the rate that they're paying is higher than today's newly issued mortgages is at or near an all time low. It's the lowest we've seen in a long time. It truly speaks to just how quickly rates shot up. And so, the overall prepayments are certainly going to slow in such an environment and that's what's going to incrementally push those durations longer. And one of the things that we would say that's important to be mindful of there is, if you have a convexity advantage in your portfolio, making sure you also have liquidity in your portfolio. Because one of the things we'll always talk about is the need to monetize convexity. In other words, when volatility kicks in, if the index is experiencing greater volatility than the portfolio, that's a great thing.
However, what you need to do is be able to monetize that. And so, one of the things that we've been able to do is that when spreads were tighter, we've built up a lot of dry powder in our portfolio, mainly in the way of treasuries. And that gave us the ability to monetize or take advantage of some of those convexity advantages that we've seen. So, I think it also in an environment like today where spreads are wider and volatility is higher, it's also allowing us to reinvest and put that dry powder to work at ever more attractive spreads.
Stewart: Is it fair to say that given, and you talked about this a little bit, there's a shift to private assets (or has been a shift to private assets) for the yield advantage and that with the interest rate increases, it'll be interesting to see, I don't know, I think the jury's out on whether that flow continues or not. But, I think the one thing we you can agree on is that private assets have less liquidity than public assets and the liquidity in the investment grade or the core bond portfolio does become a bigger issue when other parts of the portfolio become less liquid. Is that fair? I'm sure you're having that conversation too.
Wesly: Absolutely. And what we would say is don't forget about your core. It's important. Core is just as important today and it's growing in terms of its importance. So, if you're giving up liquidity and the other more esoteric parts of your portfolio, maintaining liquidity within the core is going to be just as important as it ever has been because ultimately you're seeking to add that incremental yield elsewhere. Well, we all know we see these once in a hundred year events a lot more often than once in a hundred years. And so maintaining liquidity in your portfolio and making sure that you look at the portfolio in whole, in its entirety, is going to be exceptionally important.
Stewart: So are you seeing insurers change their fixed income allocation with the implementation of the new NAIC RBC rules and S&Ps proposed capital model?
Wesly: Yeah. So it's a great question and especially timely. One thing we would note given the timeliness is we're seeing the scheduled holdings come out for insurance companies and we have seen a modest shift so far in holdings that are incrementally more or less favorable from an NAIC treatment. So, incrementally we're seeing less exposure in some of the triple B categories and also low single A where NAIC treatments were more adverse. And so we are starting to see that cycle and we think it's going to be important. Whenever we think about capital efficiency and making sure that the returns are optimal into the context of the capital required on the other side, incorporating this in NAIC treatment is important, and we're starting to see that come across more of the industry.
As far as the S&P most recent releases, they're important. It's definitely not going to be to the same degree and same margin as that of the NAIC treatment. However, definitely has to bear in mind and I think it's important because of the timeliness of this conversation. As more insurers have gone further out the curve in terms of the esoteric nature of their holdings, they're going into more holdings that oftentimes are not rated by one of the big three or not rated by S&P. And so, it's an environment where it's important that insurers are aware that there could be upcoming changes to S&P's rating methodology, but ultimately we think it's going to be much smaller, mainly because S&P and the big three as a whole still rate the overwhelming majority of the market. Even as you go more esoteric, they're still actively involved.
Stewart: Is my understanding correct that the NAIC RBC model is going to affect all insurers, the S&P capital model change is going to be more of a focus for stock companies versus mutual companies. Is that accurate?
Wesly: Yes, that's a hundred percent accurate.
Stewart: Okay. Here's a topic I can't remember the last time came out of my mouth, municipal bonds. Back when the earth was cooling, Wesley, I was the treasurer of the city of Columbia, Missouri. We were a standalone double A, and we owned all the utilities in town in addition to having taxing power, except for the gas company. We didn't own that, but we owned everything else. Trash collection, parking, you name it. It was just a great, fun, fun gig. Muni treasury ratios have been at historic lows. Can you talk about the relative value between taxable and tax advantage sectors?
Wesly: Yeah, so it's been great to see that change. And for the first time in a while, municipals are starting to make sense once again, including especially for insurers. So the muni treasury ratio is oftentimes sort of the guiding light for valuations within munis. Looking at the 10 year, it had gotten down into an all time low of in the 60s. And here we are this afternoon and it's in the mid 90s. So it really highlights just how much valuations are more compelling today than where they were a very short time period ago.
Also, not only are they more compelling, rates are higher. As rates have gone higher, the value of that tax exemption has also grown. And so for the first time in a while, we're incrementally starting to add tax exempts to portfolios at a much more accelerated pace because today's valuations are certainly more attractive and munis, I should note munis are near dear to my heart, it's actually where I started my fixed income career as a municipal credit analyst, so it's something I always will talk about it, but the muni treasury ratio in many ways had actually lost its relevancy. When muni rates had gotten so exceptionally compressed, especially in the front end, say two year muni treasury ratios had got, or munis had gotten down to 20 basis points. And one basis point move moves the ratio by 5% in that environment. So, it was sort of the wall of small of numbers. Here we are today with rates closer to about two and a half. The relevancy is coming back. And just as much as the relevancy is coming back, the attractiveness of the asset class is coming back. And one other thing we would note with munis is sort of the immunity in many ways to the supply side relative to rate changes.
As a former treasurer, I think you could definitely speak to this. If you think about munis, they don't take their cues in terms of issuance from the overall rate environment. So for example, if you need to build a new school, you're not looking at, did rates move by 25 or 30 basis points? You're saying, our current school's overcrowded, do we need this to be built? And so muni supply is a little bit more disconnected from the overall rate environment. So, as we see rates go higher, we don't actually expect to see it materially weigh one way or the other on the supply of tax exempt securities.
Stewart: Oh, the issuance process, don't get me started. The vote, you got to get a voter approval. The thing I always said when I was running money is like, look, the city of Dallas is not going to lever up and take over the city of Fort Worth. That's not how munis work.
Wesly: The M&A activity is not present in municipal bonds.
Stewart: It is not. And we had a parking garage, the first hour was free and the second hour was like a quarter. I'm like, how in the world are we going to pay back these bucks? Sure enough, everything's fine. You know, I love the muni market, good stuff. We have 72 pieces the last time I checked. 72 articles and podcast on ESG investing. There's been a lot of focus on it this year for sure. It seems as though there's been an increase in insurer's focus on ESG. Why do you think that's the case?
Wesly: There's a couple of reasons that we would note. Really, I would identify three different parties if you will, that are really raising this up, starting with regulatory factors. We're actually seeing the state of New York, for example, recently held some ongoing discussions around ESG that both gathering information, also sharing their thoughts. As regulatory bodies are starting to account for it more, that's going to push insurance companies to in incrementally making sure they're aware. We do expect to see an uptick in the amount of reporting for ESG on behalf of insurance companies. So I think they're trying to get ahead of some of that as well because it's going to be important for their ongoing operations.
Secondly, it's just stakeholders and shareholders as well, many are really wanting to be cognizant of what does an insurance company hold. And really in many ways, ESG and SRI have been part of an insurance entity’s investments for a long time. Health insurance companies will rarely buy tobacco, for example, as a good example. So I think there's been an element of ESG within their investing profile for a long time, but we're certainly seeing it uptick as well.
And then the third element is just general risk management. We have been doing ESG for a very long time at our firm. And the way we think about it is, how is it protecting against the downside? And we think that's extremely important. So, I think as generally speaking, as more and more insurers start to view ESG as a risk management exercise as well, protecting to the downside, that's only going to further bolster the amount of utilization and the importance of it within the investment community.
Stewart: I want to ask about the federal home loan bank borrowing program. First of all, what is it? We were talking about this when I was running money. That's a really terrific program for insurers, particularly for what they naturally own. But first of all, what is it? And are you seeing insurance companies utilizing it? And if so, how?
Wesly: Yeah, we continue to see an uptick in utilization. And it's something that we're excited about, not just from an asset management perspective, but we're all ultimately clients of insurance entities as well. And the FHLV program really allows them to do several things. So the way it works is ultimately an insurance entity is able to pledge collateral and receive a line of credit from the FHLV. And from there, there's a lot of flexibility on what they can do. A lot of insurance companies use it as a liquidity factor to help smooth out some of their operations throughout the year. That also allows them to not necessarily have to sell securities all the time in order to make claim payments. So it overall improves the general level of liquidity for an insurance entity. And so there's a lot of benefits there.
But one thing we do want to note is it's not an arbitrage investment, if you will. I think back to every finance class, arbitrage always comes up. It's not risk free. There's ultimately no real duration in that liability, but there is duration if you're utilizing the proceeds to go out and buy securities on the other side. So one of the things that we're really having a lot of conversations around right now is not creating an asset liability mismatch by buying longer and longer securities on the other side of a near zero duration liability. So it's important. We think it's an exceptional tool that really just about every insurer should look to utilize, but it's important to put the risk management hat on, on the follow, and making sure that you're not ultimately creating more risk in the portfolio by its utilization.
And then just the very last note there, we talked about core fixed income coming back in vogue, and you're starting to see a little bit move away from private to as general rates have come up, that's going to ultimately potentially weigh on some of the utilization, because core is going to be more liquid than more of the esoteric nature of what was held previously. So we might see a little bit of a reduction in utilization. That's not something we would encourage. We would say, continue to utilize that line, keep it open, whether it be for buying short securities or just ensuring you're not having to sell securities in order to fund claims on an ongoing basis.
Stewart: Yeah, you definitely don't want to be a forced seller into any market. So the one thing you said at the beginning was that insurers can pledge collateral. It has to be a certain collateral. Is it agency resi mortgages? Is that what they primarily accept?
Wesly: The acceptances across various different asset classes. One of the key differences though, is what is the “haircut” across different asset classes? So, agency residential mortgages and treasuries tend to receive the best haircuts as well as agency commercial mortgages as well. So agency backed securitized product and treasuries are the primary collateral that's utilized. And that's really a reflection of the lower levels of haircuts that are experienced for them.
Stewart: All right. Last question. Here we go. Where do you see the value in today's environment? Where do you think there's opportunity out there right now?
Wesly: I think the opportunities today are so much more exciting than what they were six, nine months ago. So I answer this question with a lot of enthusiasm because of the fact that the markets are so much more attractive today. So spreads are wider. Really what we've seen is widening spreads creates the divergence across assets and divergence creates opportunities. So several parts of the market we would talk about within securitized, incrementally looking at some of the slightly more off-the-run parts within the ABS sector, potentially rail car, container. One area we don't see value in is aircraft ABS. It's an area of the market that we've shied away from for a long time. And given the ongoing conflict in Russia and Ukraine now, that's proving to be quite beneficial. Within corporates, we would definitely say we're seeing a lot of interest and value in high quality high yield.
So the change in the NAIC treatments made the purchasing of double Bs far more attractive than what it was previously on a capital efficiency perspective. So that's an area of the market, especially for insurers that we're looking to add more where allowed. It's important to make sure you're aware of the regulatory factors there. And also munis. We talked about some of the attractiveness in munis.
I think it's also important to sort of bring it back and circle back a little bit. You're hearing a lot of discussions about the inversion of the treasury curve, as you noted at the onset. We're not seeing that in munis. The relative steepness of the muni curve is far steeper than out of the treasury curve, flatter than historical averages by itself, but certainly still more attractive than what we're seeing in treasuries. And so not only are we able to pick up, in some instances, more after tax yield, you also have a little bit of a price tailwind in buying 10, 12, 14 year type municipals because you're actually rolling down a meaningfully steep curve. And so, that really proves itself to be an additional level of benefit going forward for that asset class.
Stewart: That's awesome. All right. I kind of lied to you, but this is the last question. Do you remember the day you graduated from college?
Wesly: I do. It's been a little while, but I do recall it.
Stewart: What would you tell your 21 year old self today?
Wesly: It's a great question. There's been so many things I've been learning across the career, and I'd say my answer's probably a little different than the way most people would answer it. I think back to my childhood, and my mom and dad and grandmother would always say the golden rule, treat other people how you want to be treated. And I would tweak that. I would say in my career, the best advice I could have given myself is treat other people how they want to be treated. As you grow up, you spend time with most people very similar to you, even in high school and in college. But once you enter your career, people are going to be much more different.
So, I think it's important to take a step back, show empathy, and try to see the world and their careers through the way they're thinking about it. So, I would say tweak the golden rule a little bit and make sure you treat other people how they want to be treated. I think it'll benefit your career, but also it'll make for much greater working relationships with those people that you're going to spend a lot of time with.
Stewart: Great advice, Wesley Pate, Income Research and Management. We're talking core fixed income. Wesley, thanks for being on.
Wesly: Thank you. It was my pleasure.
Stewart: Thanks for listening. If you have ideas for podcasts, please email us at podcast@insuranceaum.com. My name's Stewart Foley, and this is the Insurance AUM Journal Podcast.
The InsuranceAUM.com podcast is available on
