@M&G.
As we move into the later stages of the credit cycle, effective risk management within core fixed income portfolios is an increasingly pertinent issue for insurance companies. With corporate balance sheets under increasing pressure, traditional buy and maintain credit management strategies are being tested for the first time, placing increased focus on the benefits of a more active approach to long-term credit allocations.
The buy and maintain model typically serves insurers well, given that investments in corporate bonds provide regular payments and the return of capital at a known date, potentially offering predictable income streams. With specific cash flow requirements, insurers are therefore able to match future liabilities. The benefit of a portfolio approach provides active credit selection, alongside diversification.
Since buy and maintain investments typically provide exposure to investment grade credit market beta, bonds’ stability is often prioritised over value. Portfolio management strategies that match durations and target problem avoidance have therefore proven adequate in stable bond markets over the last ten years.
The buy and maintain model evolved in relatively benign credit conditions post the Global Financial Crisis (GFC), which means investors have not needed to be hypervigilant to risk. Equally, the justification for credit analysis spend has been less apparent, set against increased pressure on asset management fees with the introduction of MIFID II. As a result, cost-efficient, quantitative driven strategies and reliance on external ratings agencies has taken precedence over rigorous fundamental credit analysis.
However, with geopolitical tensions and growing concerns around the credit market and economic environment, fixed income markets are facing increasingly uncertain conditions, and traditional buy and maintain strategies are being tested for the first time. It is also important to note that the average credit quality in the investment grade (IG) market has deteriorated markedly since the GFC, given the increase in corporates using bond markets for funding (rather than banks). With around 50% of corporates rated BBB, this in turn has increased the risk of rating downgrades from investment grade to high yield, along with the possibility of defaults.
In this macroeconomic landscape, the role of active portfolio management and rigorous credit analysis cannot be underestimated, in our view – not only as part of the initial credit selection process, but on an ongoing basis as economic conditions change, given the potential impact on underlying issuer credit risks.
