Changes in asset allocation due to increased interest rates and commercial mortgage-backed security (CMBS) changes are major areas of interest for insurers. There is also the question of how investors should be navigating these conditions.
The topic was discussed in the Insurance Investor Live | North America event in December last year in New York, which is now featured in the Insurance Asset Management North America 2024 report.
In the chat, Amit Agrawal, Head of Fixed Income, AXA XL, and Sean Barnes, VP of Finance, Chief Financial Officer & Chief Investment Officer, United Educators, shared their thoughts, alongside moderator Victor Palacios, Senior Manager, Investments & Treasury, EY, on current risks in the market.
Barnes and Agrawal both offered their views with respect to their organisations' different sectors and portfolio make-ups. One of the aspects both focused on was how their asset risks have changed in the inflationary event and subsequent interest rate rises, and how this has in turn impacted investment strategies. They also discussed what it will mean over the short-to-mid-term.
Read more to see their views below.
Sean Barnes: From a factor point of view, when looking at where our risks are compared to our peers, it would be real estate. If you look at the risk assets and some of the underlying investment grade portfolio, we have more real estate exposure than most. Our duration profile is another area, because if you look at our ALM for our peer group, our liabilities are a bit longer, so we have more of a duration risk in our book comparatively.
Amit Agrawal: Our portfolio is high quality, and we run a four-and-a-half-year duration because, for P&C assets, the liability profile is shorter than a life insurance company. This is a blessing in disguise in the current environment where rates have gone up so much. With a smaller division portfolio, you have lower market-to-market so are less worried about liquidity risk. 20% of the portfolio rolls over every year, which helps lock in a better rate environment as the rates go up.
In terms of the biggest risks, there isn’t a major asset class within our portfolio that we worry about. The biggest risk is around the concept of ‘higher-for-longer’. If the US Federal Reserve (Fed) continues to keep the rates higher for longer, it will create ills and a cascading impact where a lot of borrowers in the lower part of the capital structure face hardships in refinancing their debt. As a result, you will see downgrades from rating agencies that could result in fore-selling and other liquidity events, which would affect all asset classes and our holdings.
"The Fed may start to cut rates next year. If this pans out, we are in great shape; but if the rates stay higher for longer, many markets could be in trouble."
If you had asked me this question in early October 2023, I would have said that this was a risk, but if we look back at what has transpired from mid-October to the beginning of December 2023, the rates have dropped about 60 basis points (bps) so the narrative has shifted from higher-for-longer.
Now, the Fed may start to cut rates next year. If this pans out, we are in great shape; but if the rates stay higher for longer, many markets could be in trouble, starting with real estate, particularly in the Commercial Real Estate (CRE) space. Everyone has their fingers crossed that we will continue on a path of lower rates, which would cure a lot of ills and risks within the portfolios.
Amit: For the five-plus years that I have been in this role, this year has been the most proactive in terms of turning the portfolio. This is firstly because the thematic trade we have been doing is to get out of a lot of floating assets and lock in current yields.
"It’s a good time to build liquidity and buy treasury bonds at 5% yields. At the same time, we still want to be exposed to risk assets."
We have a lot of Collateralised Loan Obligations (CLOs) and other floating rate instruments, so it makes sense as this is a one-in-eighteen-year opportunity. The last time we saw these kinds of rates was back in 2006. We have consciously been reducing our floating rate assets in favour of fixed rate assets. We have been turning our portfolio to maturities that are due next year, maybe pre-funded this year, where you might take small losses, but at the same time lock in these yields for longer. Extending duration is one of the big asset allocation shifts we’ve done. We view duration risk as less intense going forward, but it was the major concern this year.
Another shift is around quality. It’s a good time to build liquidity and buy treasury bonds at 5% yields. At the same time, we still want to be exposed to risk assets – but, at least in the investment grade (IG) space, we have been upgrading the portfolio from BBB to A because you are not getting paid for that yield premium going from BBB to A.
Sean: Before, there was an opportunity cost of holding up cash within the operating company – so, you tried to get as much of this out there as possible. From an investment standpoint as well as a Chief Financial Officer (CFO) point of view, almost the entire portfolio is now in an unrealised loss position. So, in trying not to harvest those losses to impact our net investment income, we have tried to say that if the asset is money good, let us minimise the losses with the exception of some of the tactical ones you have mentioned.
Amit: What has changed is that insurance companies have better IG credit – for example, A and BBB. This is the part of the market that looks extremely rich now, with IG spreads at 100 and below the long-term averages.
We are taking a barbell approach; we are not shying away from taking risks. The private credit market looks extremely interesting right now, so you can get 10-12% returns, load up on your liquidity through your treasury portfolio, and own a lot of treasuries. In other words, you are not introducing risk but reshaping the portfolio into more of a barbell shape and adding a bit more private credit illiquid risk. But, you’re then making up for the liquidity by owning a lot of treasury bonds that are more liquid. So, you’re not sacrificing liquidity on the overall basis, but at the same time, you’re not shying away from risk-taking. You’re also noticing where the value is within the credit spectrum, which seems to be a little bit better in underwritten credit in the private space as opposed to public markets, which don’t have all the necessary protection.
"The commercial mortgage-backed security (CMBS) market is an interesting one. If people can play, there has never been a better opportunity there."
Sean: If you consider the types of assets you were investing in within the core book – particularly the corporate credit allocation – the credit quality has drifted upwards because, for a while, BBB names were the only place you could get yield. Now, every time you are adding, it is either there or, because of the rising interest rate environment, we have added more agency mortgages this year because of structural dynamics.
You’re then taking more risk in your risk bucket; whereas, before, you needed to take more risk in your IG portfolio to get yield. So, we are now taking an opportunity to dial this back while rates are high.
Amit: The commercial mortgage-backed security (CMBS) market is an interesting one. If people can play, there has never been a better opportunity there. It’s a market that stands out. This is largely driven by the fact that banks no longer own the asset class, and also they have been selling or not buying. Also, the Fed is going to be a better seller.
There had to be a lower clearing level – and now total return players and insurance companies see value, so they’re picking up the slack. This is one of those adjustments that you can take advantage of.
Sean: We had room in our policy statement, too, because we didn’t buy any of it whilst the Fed was buying. So, our mortgage position had declined but is now picking back up.
