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.