Life insurers can strengthen portfolios by adhering to strategies that have served savvy investment managers well.

For life insurance professionals who have long had difficulty selling interest rate-sensitive products because of abysmally low yields, 2014 should bring welcome relief. Interest rates are due to rise — and stay on an upward path through 2018.

This forecast, part of a wide-ranging industry outlook, was one prediction unveiled by AllianceBernstein executives at the asset management company’s recent Insurance Symposium held in New York City. The all-day gathering, attended by life insurers’ home office investment professionals, examined the opportunities and challenges that carriers will face as they seek to implement long-term investment decisions and optimize risk-adjusted returns.

The following is a recap of key developments to look for in the year ahead.

The effect of the Fed’s tapering

A major factor underpinning the rise in interest rates, according to AllianceBernstein Chief Investment Officer Doug Peebles, are market expectations over the Federal Reserve’s plans, announced by former Fed Chairman Ben Bernanke earlier this year, to “taper” or pull back from the monetary policy known as “quantitative easing.” The easing aims to stimulate the economy by having the Fed purchase assets with maturity dates longer than short-term government bonds, thereby lowering longer-term interest rates.

A third round of quantitative easing, “QE3,” was announced in September of 2012. Then in June 2013, the Fed disclosed plans to reduce its monthly bond purchases to $65 billion from $85 billion. But on Sept. 18 of that year, the central bank postponed the reductions.

Peebles noted the market’s concerns about tapering are already having an impact, draining money from bond funds, and boosting interest rates. This year, the five-year forward rate on five-year Treasury notes increased to 4.5 percent from three.

Peebles forecasted yields on five-year Treasury notes rising to between 5 and 6 percent through year-end 2018. Tapering is also expected to impact the federal funds rate — the interest rate at which depository institutions actively trade balances held at the Fed — as yields rise from below 1 percent to a forecasted 4 percent by year-end 2018.

As rates rise, insurers can look forward to continuing positive returns on U.S. Treasuries, including five-year notes (a projected 1.54 percent total return at year-end 2018), 10-year notes (1.36 percent) and 30-year notes (0.27 percent). Peebles expressed concern, however, about the impact of rising rates on asset prices.

The three previous rounds of quantitative easing, which pumps more money into the economy, resulted in increased asset prices. Should the Fed make good on its tapering plans, asset prices could fall, thereby reducing growth.

Peebles observed that key drivers of the asset prices are reflected in the U.S. Broad Price Index, an inflation benchmark that integrates the consumer price index, several producer price indices, the S&P 500, along with prices of new homes and existing homes. These last two measures, which have risen by 12.7 and 10.2 percent, respectively, during the year past, could be significantly impacted by the Fed’s tapering.

Also of concern to market participants is the pending implementation of the Volker rule. The rule’s final wording, approved by five federal agencies on Dec. 10, would ban proprietary trading or speculative investments that do not benefit the banks’ customers. Though not part of the original proposal, the rule also requires bank CEOs to annually attest to regulators that their financial institution “has in place processes to establish, maintain, enforce, review, test and modify” a program to monitor compliance with the rule. Peebles cautioned the rule’s rollout will result in less liquidity, making banks more vulnerable and less able to fund the capital requirements of the real economy. For life insurers, however, the Volker rule has a silver lining for they can fill the liquidity gap and make a tidy profit in the bargain. “You all have big balance sheets — be prepared to use them,” said Peebles. “In times of illiquidity, [life insurers] should be able to make oodles of money by providing liquidity when and where it’s needed and by taking a longer-term time horizon when investing.”

Insurers’ sunny prospect will be buoyed by an expanding American economy and continuing low inflation. Peebles said that AllianceBernstein remains bullish on the U.S. and anticipates that GDP will increase by 3.6 percent through 2014, a rate that will outpace that of other developed economies. Underpinning the expansion will be a continuing recovery in the U.S. housing market, healthy corporate profits and household interest payments, plus continued growth of the private sector and stable prices.

Asset allocation for life insurers

Given these positive outlooks, what is the trend-line in investing? According to Dan Loewy, a CIO and co-head of multi-asset solutions at AllianceBernstein, investments are flowing into vehicles that will generate current (as opposed to future) income. During the year past, between 15 and 20 percent of investments have been directed at income-oriented assets (such as high-yield corporate bonds and real estate investment trusts), as opposed to equities. The enhanced focus on current income, he added, has contributed to a re-pricing of assets. The result: A “compressing” of yields, causing lower than average returns on investments, most notably corporate bonds.

AllianceBernstein forecasts 10-year returns of 2.5 percent and 3.1 percent, respectively, for portfolios comprising 100 percent bonds and 90 percent bonds/10 percent equities. This compares with historic yields of 6.1 percent and 6.5 percent, respectively, for these portfolios. The 10-year yield gap is comparable when one increases the proportion of equities in a portfolio to 20 percent (3.6 percent currently vs. 6.9 percent normally); and 30 percent (4.1 percent vs. 7.2 percent).

Given the lower yields, what investment mix makes sense for life insurers looking to boost returns? The answer, said Loewy, is to expose portfolios to riskier assets that are likely to produce higher yields over the long term.

It’s a good time to do so. The results of 10,000 investment simulations conducted by AllianceBernstein shows, for example, that seven-year U.S. Treasuries now have an 85 percent chance (as compared to 58 percent historically) of outperforming two-year T-bills. Other asset classes in the trials also saw improved performance odds, including seven-year investment grade corporate bonds when compared to seven-year Treasury notes (61 percent vs. 56 percent normally); real estate versus high-yield bonds (68 percent vs. 52 percent); and U.S. stocks vs. seven-year investment grade bonds (73 percent vs. 64 percent).

“Given today’s capital markets, it’s important to rethink what a bond-dominated portfolio is likely to achieve,” said Loewy. “Exposing your company’s portfolio to riskier assets further out on the yield curve is key to closing the gap between expected and actual returns.” U.S. high-yield market

Among the more chancy vehicles promoted during the symposium were high-yield bonds. Gershon Distenfeld, director of high-yield for AllianceBernstein, said the vehicles are up on average nearly 7 percent year to date, a level superior to that of many other fixed income assets. For investors, the most valuable are those carrying maturities of three to five years.

But with the higher yield comes greater risk — in particular, credit default risk. Distenfeld noted that par-weighted defaults on high-yields bonds averaged 3.8 percent over the prior 13 years. In August of 2013, the rate was just 1.3 percent. These default rates, however, vary by rating.

Over a 20-year period (1983-2012), the five-year cumulative default rate on BB-rated bonds was 11.1 percent. For B-rated, CCC-rated and C- to CC-rated bonds the five-year default rates are 24.9 percent, 47.9 percent and 75 percent, respectively.

“[High-yield bond] defaults were very low over the past few years since they peaked back in 2009,” said Distenfeld. “There’s a simple reason for this: The market got cleansed after the leveraged buyout-related defaults of the 2005-2007 period. But though the number of defaults have been low —and we expect them to remain so — they are exponentially higher in the lower ratings categories. This makes the higher quality bonds of the high-yield market particularly attractive today.”

Indeed, an AllianceBernstein analysis comparing average five-year losses on corporate bonds rated AA through CCC against the implied risk premium for each of these ratings (the excess return required to induce someone to hold a risky asset rather than a risk-free asset) reveals that investor “compensation” on all bonds except those rated C to CCC exceed expected losses.

Annual returns on high-yield bonds between 1994 and 2012 have been almost uniformly positive, ranging from the low single digits to a high of 61.2 percent (2009). Returns have been notably strong when the Federal Reserve hiked rates, including 1997 (12.6 percent), 2004 (13.2 percent) and 2006 (12.8 percent). Only during years of heightened default risk (as in 2008) were returns negative.

When accounting for market fluctuations, life insurers would do well to orient their portfolios towards low-volatility bonds (e.g., those rated B and BB). Why so? Because they produce, on average, superior risk-adjusted returns compared to the alternatives.

Since 2006, high volatility/high-yield bonds have achieved 8.9 percent annualized returns, besting the 9.2 percent returns of low volatility/high-yield bonds. But after factoring in annualized volatility for each of the vehicles (11.4 percent and 8.6 percent, respectively), the low-volatility bonds come out ahead. They produce 0.95 percent in risk-adjusted returns as opposed to 0.78 percent for the high-volatility bonds.

“By building a high quality portfolio of B- and BB-rated bonds, you can get the same returns with significantly less volatility,” said Distenfeld. “The high-yield market is not just one market. It can mean very different things from both a volatility and loss perspective.”

U.S. high-yield loan market

Positive returns are also possible in respect to another component of life insurers’ portfolios: High-yield loans, which are now experiencing increased market demand. The par amount of outstanding leveraged loans reached $640 billion in September 2013, according to AllianceBernstein. That’s up from $553 billion in 2012, $517 billion in 2011 and $504 billion in 2010. What are the loans being used for? A substantial portion of the institutional new issue volume ($380 billion as of October 2013) is directed at bond and dividend deals. By market segment, the deals encompass refinancing (47 percent), leveraged buyouts (16 percent), acquisitions (13 percent), recapitalization /dividends (12 percent), recapitalization/stock repurchases (2 percent), general recapitalizations (2 percent) and other (8 percent).

The market’s surge has been especially high in respect to “covenant-lite” loans (i.e., those that entail fewer restrictions on collateral, payment terms or income level). Volume surpassed $200 billion in October 2013, more than triple the volume of the year-ago period.

The market’s expansion, said Janegail Orringer, a portfolio manager of bank loans at AllianceBernstein, has been a boon to borrowers. “Borrowers are increasingly able to dictate the covenants or lack thereof to investors,” she said. “That’s led some of our clients to become concerned about the increased volume of covenant-lite loans.”

On the upside, the volatility of loans (as measured by the Credit Suisse Leveraged Loan Index) has abated to pre-credit crisis levels, resulting in just seven months of negative performance since the Great Recession ended in 2009. But as borrowers have gained leverage, loan yields have declined. AllianceBernstein expects that yields on B- and BB-rated loans will range from 4.5 to 5 percent next year — down from the 2011 highs of between 6 and 9 percent.

Though not outstanding, the 2014 rates, in Orringer’s view, are cause for optimism. “While it’s hard to get ecstatic about 4.5 percent to 5.0 percent returns, in an uncertain environment, we feel very comfortable with the collateral coverage and the quality of the loans in our loan portfolios,” she said.

A strategy to run with

Life insurers can be as comfortable with their own portfolio allocations in 2014 (loans or otherwise) so long as they adhere to strategies that have served savvy investment managers well to date. Chief among them: Diversify and strengthen the portfolio by investing in different asset classes that are likely to yield the highest risk-adjusted returns. These vehicles, ranging from real estate investment trusts to equities to high-yield corporate bonds, should also, to the extent possible, be “negatively correlated” — their prices moving in opposite directions as the market fluctuates — so as to minimize portfolio volatility.

A solid blueprint, indeed, for investing in 2014.