Stewart: The long and winding road. Opportunities and challenges facing insurance companies. That's the topic of today. My name is Stewart Foley. This is the insurance AUM Podcast. We are joined by Ruth Farrugia, global head of insurance asset management for MetLife investment management, otherwise known as MIM. Welcome Ruth.
Ruth Farrugia: Thanks Stewart and thanks for having me today. It's great to be here. What I thought might be helpful for our audience today is to walk you through our macro outlook and potential risks that we are seeing on the horizon, but also looking to how we're navigating these markets as well, where we're finding relative value, good risk adjusted returns for our life insurance portfolio clients, but also looking at the different opportunities as well across interest rate environments. And finally, I thought I'd touch upon ESG considerations in our investment strategy.
Stewart: That's great. Obviously, everybody knows MetLife massive general account portfolio management effort, MIM managing money on a third-party basis. And so, your views are very important on both sides of that. So, can you set the stage for what MIM's macro outlook for the US economy is? And within that answer, what are some key risks that you're watching closely?
Ruth Farrugia: That's a great Stewart. I would say as a starting point, we do not know what the new normal is going to look like. Once we're past COVID, recovery could actually be bumpy. On the demand side, it's unclear at this juncture what's post COVID consumption patterns are going to look like. We don't know how this pandemic has changed people's preferences as a starting point. We do not know where this consumption will take place. It's important to almost define that and provide some context there.
Ruth Farrugia: There's a lot of demands, which may be for services, which is unlikely to create a sustainable boost to overall activity. And perhaps conversely, further demand for goods may stress available production of goods as well. Our view is that even with strong outputs, growth will not return to the pre-COVID trends until 2023.
Ruth Farrugia: And I think I would say finally as well, and this is very topical, it's been very discussed as well. We do not know whether an aging population will consider holding onto the savings that they've generated during this pandemic, rather than immediately returning to what I would call the higher level of consumption. On the supply side, firms have difficulty returning to a normal level of production in an efficient and timely way as well. The demand estimates here, I think word of caution demand estimates might be faulty. As you think now through the implications, what are the implications here? The implications are that I would say investment products that are consumer based are likely to have stable to fall in credit risk. But I think when it comes to stand alone companies on a name by name basis, that's where I think there's going to be a bit more of a shift to idiosyncratic risks.
Ruth Farrugia: You have to look at risk almost on a name by name basis, as opposed to I would say systematically. I think when we focus on areas like real estate, for example, real estate performance, it will differ across type and location. But maybe Boyd as well by rising inflation concerns. I think touching upon the word inflation here, I think the key concern that comes out in every discussion in every room is inflation. I think we do see a higher level of inflation over the next year as low inflation readings heading into the crisis emerge on the other side with what can be defined as commensurately higher inflation. But this is likely to pull up the average inflation over a 10-year period. But we believe that this is not likely to be sustained enough to prompt a response from the Fed.
Ruth Farrugia: That said, ongoing supply disruptions and the rising number of commodities in short supply do raise the possibility that inflation remains above the Fed's target for a longer period of time. But we believe that the Fed will tolerate inflation, that they see as transitory. And I think that's key. The risk for the Fed is not so much about realized inflation, but rather surging inflation expectations, as the Fed can overlook a brief period of inflation that appears to be high relative to recent past. But then what happens with yields? This is where when we think about it, the rise in yields that could come out of this scenario, coupled with sustained shortages, may be difficult for the Fed to restrain without hiking rates. This would further add, I would say to the tail risk of a distribution across different outcomes.
Stewart: It's a really interesting idea about a Fed tolerating or having a more flexible, if you will, policy for this transitory inflation period. I think it's anecdotally something that I've seen even in the availability of, there are certain shortages that you just don't think of. Automobile production due to chips and things that you just don't think of and it's really interesting to think about that in terms of a transitory inflation risk and how the Fed might just accept that for a period of time. I've never considered that. I think that's really interesting. Given the macro backdrop, insurance companies think about not only strategic, but also tactical allocations in the current environment if you have continued low interest rates.
Ruth Farrugia: That's a great segue as well when it comes to thinking about investment strategy for insurance portfolios. Strategic asset allocation is applied I would say to determine portfolio positioning overall. For us, it's based on an asset liability management process. So broadly speaking, we're relying on the maturity structure of our liabilities or predefined liabilities because our investors are liability driven at the end of it. We're generally focused on risk adjusted returns over a longer-term horizon. It's important to set the scene I would say at the outset because that is the starting premise. To that end and on this point, we work closely with our insurance clients to understand their objectives and constraints and there's no one size fits all here.
Stewart: Absolutely not.
Ruth Farrugia: The aim here is to come up with an optimal asset allocation and an effective ALM program, if you will, to manage through varying interest rate environments. And then ultimately make tactical asset allocations to basically pivots along with changing markets. That's I would say sort of the starting premise and the overall context here. But now bring that to looking at the current backdrop, which as we just said is complexity. We're definitely at an interesting juncture here. But strong central bank support globally pretty much, further stimulus, these are all positive headwinds for credit. We've seen this translating in public markets with spreads tightening for their across asset classes, will close or ads, cycle tights at the moment. And in essence, I would say this has really shifted the opportunity set. Valuations are generally rich in category. If you look at IG spreads, they're particularly rich, especially when you measure them on a duration adjusted basis.
Ruth Farrugia: There are some pockets of relative value across some of the public markets, which we'll discuss as well later on. But I think as I think through strategic asset location and just generally asset allocation teams, which we believe will continue to be a focus for life insurance companies, I think the main team will still very much revolvearound the investment in private markets. I think for life insurers, although there are regional differences and I stress that from the outset, we feel that the outlook for long-term emetic drivers for investing in private markets remains positive at this point in time. Especially as investors adapt to a series of structural shifts as we just spoke about, but also increased focus on responsible investing, which we're going to touch upon later on as well. It's important to bear in mind that as long-term investors, life insurers have the benefit to look beyond the short term and deploy capital and what I can sometimes describe as perhaps, a patient way of looking at long-term horizons and long-term returns.
Ruth Farrugia: So, to that end, we believe that private assets form an integral part of strategic asset location and that discussion. And we have seen increasingly shifts in tactical asset allocation towards these markets accelerated perhaps last year. In Q2 2020, we saw a dramatic spread contraction following the highs of spreads volatility in March. We saw the spread contraction at the back of Fed announcements. And basically, essentially what we saw was a shift towards private assets that were benefiting from a bit of a lag in healthier spread premiums, if you will. I think if I think of the current environment, a yield-based strategy continues to tilt that shift towards these asset classes.
Ruth Farrugia: With the focus I would say for life insurance clients on the investment grade side. Where we've seen increased demands for investment grade private credit, residential and commercial loans, but also in private structured credit where we're seeing very healthy spread premium to publics. And as I said up till the end of last year, the opportunities in the private markets continue to reflect that legged effect of the public market dislocation we saw earlier in the year. They've come back since then. And there's been that contraction that we saw in spreads and the strong global technicals that we've seen in public markets has resulted in contraction in private markets as well, but we can still find very good relative value in private markets across some of the asset classes. I would expect this trend to carry on.
Stewart: It's interesting when you bring up the duration adjusted risk in some of those public markets. I'm a certified bond geek, the lower rates go, the longer those durations get. And it's not the same, a hundred basis points spread when the basis is 5%, is a whole lot different than a hundred basis point spread when the basis is 150 basis points. It's a different animal. I think it's really interesting and insightful that you're looking at those risks on a duration adjusted basis in particular. As we emerge into a post-COVID world where, and this is a tough question, I'm sorry, but where do you see pockets of opportunity for both ALM and total rate of return-oriented investors?
Ruth Farrugia: That's such a great question. And I'm glad that you're making that differentiation as well in terms of the different return profiles and different return requirements across the different balance sheets because obviously the objectives will differ. Return profiles, risk profiles, risk appetite as well are very important considerations always as we think of different insurance portfolios. I would say, to add to the previous point and to our notes, at current spreads within public markets, I think there are some pockets of value within emerging market debt. Although I would say within the investment grade space, emerging markets spreads for sovereigns, I think hovering around 150 basis points on corporates, slightly higher, slightly around 170 or thereabouts. One could argue that they are rich on a standalone basis, but then relative to USIG, we feel that they still offer good spread pick up and actually are fairly cheap compared to some of the historical averages. In general, corporate credit quality, much better than sovereigns and this latest stage of the pandemic.
Ruth Farrugia: What's interesting about an emerging market allocation, it can be used across multiple strategies depending on the risk appetite and portfolio requirements. Dynamically managed portfolio, alpha generation for total rate of return, fits very well within that investment strategy. For more liability driven, longer term requirements in portfolios, then generally there would be perhaps a bit more of a long-term orientation mindset because investors here would be predominantly income driven. I think to that end, one may be rewarded by holding, actually even adding emerging markets, selectively and opportunistically to market volatility. I think it's important to be cognizant of risks across both environments and being able to differentiate risk. I think with life insurance investors as well, managing downgrade risks is extremely important because of capital implications.
Stewart: Absolutely. And to your point around risk tolerance and risk appetite, my experience in running money is that there's no benchmark language that gets spoken. I've never met an insurance CEO that didn't say, we have a conservative investment philosophy. But what that means to each company, that's a conversation. That is a, “what are your objectives?” conversation.
Ruth Farrugia: That's right.
Stewart: You covered emerging market debt. Can we talk a little bit about bank loans and high yield?
Ruth Farrugia: Sure. Again, very topical. And again, I would say at a very interesting juncture there as well. I think I would say, start with leverage loans. We like the relative value on the bank loan side at this point in time. I think there's also here, the floating rate structure can help mitigate as well as some of the duration risk in a rising rate environment. And act as a hedge as well for inflation. The liable floors as well, which provides some structural protections. But we've also seen some good, I would say, attractive risk adjusted returns across both investment grade loans and below investment grade. I think within the investment grade space it's interesting because you can get 50 to 60 basis points of extra spread versus your triple B investment grade bonds on a three-year and five-year juncture. Right now, it's a good spot to be.
Ruth Farrugia: Overall, I would say valuations in the high yield space, think the market continues to price in strong economic growth and a strong recovery and improving fundamentals. That was validated by Q1 earnings as well, which are showing strong year on year growth and a good recovery there. What we've seen with high yield spreads, and I think they've tightened around 70 basis points since the start of the year. I think high yield remains at or near record lows of overall oil in yields of around 4%. I think there's another interesting dynamic at play here when it comes to high yield bonds.
Ruth Farrugia: If you look at the secondary market, roughly 70% of the high-yield market is trading to coal. So it's quite tight. It's not a new dynamic, but it's an interesting dynamic. The new issue market continues to offer as a result some opportunities in some of the segments where you can buy some good quality credits at some discounts to secondaries. But I think in terms of, if you think about a rising rate environment, we could see double B spreads widen if rates tick up because of rate sensitivity there. That presents again, an interesting dynamic. And again, I would say higher rates, that signals stronger economic growth. There would be a positive, as we said, for overall credit, for underlying credit fundamentals and would also benefit the high-yield asset class. We would expect here some tactical shifts along the way.
Stewart: Okay. Moving on to real estate, how do you see commercial mortgage loans, those impacted most by COVID-19, what's your view of that asset class?
Ruth Farrugia: That's such an interesting question. As we think of emerging opportunities in private markets, when it comes to commercial mortgage loans in particular, especially areas that were mostly impacted by COVID-19, when we think of originations as a starting point, we've seen origination activity starting to gain more momentum across the different lender times. And we expect origination activity to continually improve in the coming months. Those sectors, such as office, where there's some lingering post-COVID I would say uncertainty might not reach pre COVID origination levels in the very near term. The market dislocation created by the pandemic may produce some short-term opportunities here to acquire assets at discounts to long-term values whilst also obtaining I would say good, attractive lending spreads in underserved parts of the hospitality market. I think just to take a step back here as well, the hotel sector has been the most directly and severely impacted by COVID-19.
Ruth Farrugia: Perhaps this is a more, I would say, complicated asset class. A more complex sub sector to land on, compared to the more core property times with long-term leases, such as office and retail and warehouse. Capital market conditions here remain, I would say strained and stressed. This is despite the quickly recovering occupancy and room rates that we've seen in recent months. Currently I would say there still remains limited liquidity and investment capital available to the sector. But given the steady progress with vaccine distribution in the U.S. especially, we believe hotel occupancies have likely troughed at this juncture and will steadily recover. Until reaching pre COVID demands, we estimate 2022 and 2023 in terms of time horizon. But that said, the recovery will likely be uneven across the hotel subtypes. And ultimately, we believe that this will create pockets of investment opportunities for a real estate lending platform.
Ruth Farrugia: We'd expect the leisure hotel assets to recover faster than hotels more dependent on group and business travel. That's due in part to both pent up demands for leisure travel, but also equally the opposite is true for increased, I would say adoption of virtual meetings. To that end I think, where are we right now in terms of from an RV perspective, hotels are attractively priced in our view at this point in time. In the commercial mortgage sector, hotels are pricing at roughly 300 basis points spread premium over publics. Just to provide some perspective there in some contexts, this is generally normal times around 100 basis points. There's very good relative value there. And I think shifting gears a bit to the equity space, we estimate that hotels are pricing at roughly, I would say, 15% in terms of discount when compared to pre-COVID levels.
Ruth Farrugia: I think to move maybe more to your earlier points in terms of the total rate of return space and sticking perhaps to the equity side of things, we do like the attractive total returns of real estate equity. I think that's from a kind of total rate of return perspective, it's a good asset class. I think once again, given the complexity and bearing in mind the origination time to completion of a transaction, there's an illiquidity consideration here to keep in mind. But we do think about this as an illiquid asset class, which carries a yield premium, attractive on a total rate of return basis. Perhaps, not so much from an NII or income perspective because your returns come to appreciation and capital gains. But we believe that the asset class as well, adds diversification. There's this additional benefit, if you will, at the asset class level, but also with time if you have the right origination platform, you can create diversified portfolios as well.
Stewart: No discussion of opportunities is complete without private credit, in particular infrastructure. Infrastructure requires, not just everybody can play an infrastructure. You've got to be of a certain size in order to be effective there. I know that this is an area that MetLife investment management has a substantial effort. Could you just hone in on the private credit infrastructure opportunity set as you see it?
Ruth Farrugia: That's such a great point because at the end of the day, I think to operate effectively and efficiently in these markets, you do need to have deep origination platforms. You do need to have these market relationships, but I think when it comes to private credit, I think we've seen some very good relative value overall when it comes to private credit. I think as we mentioned earlier as well, they're a good match for long duration portfolios as well. They check the ALM bucket as well in terms of the additional incremental benefits I would say for life portfolios. With infrastructure I think it's been I would say a very interesting start to the year because once again, we've seen origination picking up, the market has picked up, especially when it comes to certain segments. The production, as we said, tends to be longer dated. In terms of weighted average life, we're talking about the 15, 16 years.
Ruth Farrugia: So as I said, sort of a very good fit for a long duration portfolio needs and very healthy spread premium to publics. We're talking ninety to one hundred basis points. And I think in terms of the pipeline, we see the pipeline continues to be very strong across different geographies as well. In Europe we've seen good origination and a good pipeline in housing, in utilities, in sports and in power. And we're seeing good ramp up activity in the U.S. as well, especially as we're heading into May, June in the U.S. as well with renewables, with energy savings, utilities, but also in digital infrastructure. So again, there’s tangential points as well, which is extremely important as we talk, to sustainable and responsible investing. As you think through relative value as well for these asset classes, the relative value and the spread premium to publics is very reflective of the complexity of the underlying assets, the region, the issuers themselves.
Stewart: You mentioned private asset classes for insurance companies. I think the data bears out that there has been a lot of flows to private asset classes for the reasons that you've pointed out about the relative value. But are there other considerations that should be factored in when talking about private placements above and beyond just what's the yield.
Ruth Farrugia: When you think about these asset classes and their characteristics, incremental yield potential, they're efficient from a capital point of view as well. If you think about U.S. regime, both from an RBC perspective, as well as economic capital, you've got downside protection, structural protections as well. And ultimately, they expand the investible universe. So, these are all benefits, but ultimately I think one of the primary considerations that we touched upon earlier is you need to have a broad and deep origination platform with specific relationships, direct marketing, to effectively operate in these markets. There might be barriers to entry here as well. For some investors, this might not be cost effective.
Ruth Farrugia: You'd need to look at third party asset managers that are heavily involved within these asset classes. I would say to that end, the outsourcing dynamic has been a key point of discussions over the last few years for investors who do not have direct access to these platforms. And also, because there is an appreciation of the potential benefits that these asset classes provide, and that they might add significant value to insurance portfolios. But it’simportant I would say, always to bear in mind that you need to have a strong origination platform to be able to operate and originator effectively these asset classes.
Stewart: I totally get that. It has a tremendous impact on your deal flow which is the name of the game. The thing that everybody talks about is liquidity. What we can refer to as the illiquidity factor. How much is too much in private asset classes?
Ruth Farrugia: That's such a great question and I like how you've defined it as the illiquidity factor because I think when it comes to many of these asset classes, as we alluded to before, they're a good match against longer dated liabilities. They have spread duration, contribution and good ALM benefits there. But private assets operate in different markets. In some instances, you are able to find some pockets of liquidity, but this is very asset class dependent. I think in reality here, the question goes back to asset allocation. To the point that you made, which is the most important point. And how much should we and can we allocate to these asset classes within a portfolio? The answer here will vary by insurance company. Largely dictated by the underlying business mix and by the nature of the underlying liabilities and the actual liquidity requirements for portfolios.
Ruth Farrugia: This will vary materially across insurance balance sheets. I would say when it comes to insurance companies, our experience has been here that most insurance companies will have very defined liquidity limits. This is based on the underlying business mix, as we said, the underlying liabilities, but will also be based on stress testing their balance sheets. Looking at historical experiences, which they will review very regularly. Ultimately this will also determine the asset allocation mix and the amount of allocation that you have to private assets. Ultimately, I mentioned earlier on, ALM discipline. We would view this as an integral part of management of, part of the ALM process, management of liquidity. It ties into a strong ALM philosophy and management of ALM.
Stewart: No investment discussion is complete without including ESG. We are partners with PRI. We're also signatories. It's a big topic, big topic today. Major focus for insurers, asset managers, regulators, and so forth. How does ESG factor into an insurance company's investment strategy?
Ruth Farrugia: This is a strong team. To your point, we've seen an acceleration of focus across the boards. But I think it's probably safe to say that a strong ESG platform is critical for any issuer to effectively perform through time. But let's just take a step back. When it comes to an investment process, it's founded on discipline fundamentals, research and underwriting. There's a rigorous security selection process and this would also include a specific evaluation of each and every issuer's ESG philosophy. That would include environmental issuers, labor practices, as well as the governing structure. To that end as well, we're also seeing increased focus on ESG reporting. I would say as an asset manager, I feel that our role is critical in supporting our clients with their ESG objectives. It starts with research integration and engagement with our issuers. Analysts seek to fully understand company objectives and ensure they consider material ESG factors when identifying business risks and opportunities.
Ruth Farrugia: One other point, which I think is, we're seeing again an acceleration and increasingly ESG considerations are becoming an integral part of portfolio construction. Part of the decision-making process when building and managing portfolios. So, the expectation here is that ESG factors will become a key part of strategic asset allocation. Ultimately, this ties in with the long-term top-down asset allocation as well that is strategic asset location. I think here perhaps it's also important to bear in mind that factor in risk management into this discussion, given that ESG risks have systematic long-term implications as well as an asset class. The market and at the sector levels as well, and they fit into wide global teams. I think perhaps the best example is sizing up exposures to climate transition risks. Which is extremely topical as well. These risks are structural long-term in nature. A natural consideration as well here when it comes to the long-term horizons that underpin and define strategic asset location. Remain very actively focused here on ESG as a team, at the different levels of the investment process. I would expect this heightened focus is here to stay.
Stewart: That's fantastic. So, here's the portion of the program that you probably didn't prepare for. It's called the ask me anything portion. Part of my real core is to be the loudest white male voice in America for diversity and inclusion in the insurance asset management space, in the insurance industry and the asset management business in general. I want to take you back to a particular day in your life that I have a feeling you'll remember well. This is your graduation to getting your undergraduate degree in college. Now, no matter what happened the evening before, whatever celebrations there may have been, there you are bright eyed, and bushy tailed in your robe and cap and gown and everything else and it's all good. Now you like me, your last name starts with F so it's not too long of a wait and they read your name and across the stage you go, you get a quick handshake, you get your diploma, a quick photo op and you go across, you're waving to the crowd. And as you walk down the stairs, you run into yourself today. What do you tell your 21-year-old self?
Ruth Farrugia: That's such a great question. I love that question. I would tell my 21-year-old self to stay focused, to work hard and be committed always to her work. I would tell her to manage her career very closely. It's extremely important and to be fearless in her decisions because ultimately, I think it's extremely important to take constructive and well-informed risks in your career. Same as I would say, investment philosophy.
Stewart: That is such great advice and it is obvious to me that you've taken it because you are Ruth Farrugia. the global head of insurance asset management for MetLife. Thank you very much for a great global market overview, for some very good advice and for taking time out of your day. Thanks for being on Ruth.
Ruth Farrugia: Thanks, Stewart.
Stewart: Thanks very much for listening to another edition of the insurance AUM journal podcast. If you have ideas for podcasts, please email us at firstname.lastname@example.org. My name is Stewart Foley and this is the insurance AUM journal podcast.
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