(Bloomberg) — U.S. life insurers are piling into the shadows of the corporate-bond market to boost income, even as rising demand reduces the extra yield they get paid to hold the debt.
About $728 billion of debt known as private placements were held by insurers at the end of 2013, up from $678 billion two years earlier, according to Fitch Ratings. Insurers are shifting into harder-to-trade assets that generally offer higher yields than publicly registered and actively traded securities, causing those premiums to evaporate, according to Goldman Sachs Group Inc.
“In the investment-grade world today, that liquidity premium is virtually gone,” John Melvin, who oversees fixed- income investments for insurers at Goldman Sachs Asset Management, said by phone. Insurers “really have almost an insatiable demand for investment product on the long end of the yield curve,” he said.
With hundreds of billions of dollars to reinvest annually and interest rates held near record lows by the Federal Reserve, insurers are looking beyond public, investment-grade bonds, according to BlackRock Inc. In addition to private placements, they’re weighing infrastructure bets and real estate, said BlackRock’s David Lomas.
“Insurance companies are a natural holder” of less liquid assets, said Lomas, who runs BlackRock’s global financial institutions group. “They’ve got great cash flow, and they can afford to extend their strategy into some of these areas.” Insurers can hold premiums on life policies for decades before paying death benefits.
Borrowers may choose private loans and bonds to limit financial disclosures and save administrative costs. While that contributes to the higher yields, it makes the debt harder to sell should an insurer need to exit a holding to pay claims or cut credit risk.
“To the extent that you need to sell a security and liquidate it, there’s less ability to do that without impacting the price,” said Shachar Gonen, an analyst at Moody’s Investors Service.
At New York Life Insurance Co., the extra yield from less liquid investment-grade debt has dropped by about half over the last two years, to a range of 20 to 25 basis points, according to Tony Malloy, who oversees a portfolio that was valued at more than $185 billion at the end of 2013. A basis point is 0.01 percentage point. Malloy’s company, the largest policyholder-owned U.S. life insurer, allocates about 30 percent of its portfolio to private placements and mortgage loans, up from about 25 percent five years ago, he said. Since 2008, New York Life has built a business to make its own loans, reducing its reliance on other firms that originate the debt. That’s helped maintain spreads, Malloy said.
“The competition for assets amongst insurance companies is fierce, and so we had demand that was greater than the supply,” Malloy said. “A way of meeting the demand that New York Life had was to essentially open up the regional offices and go knocking on the doors of corporations.”
When Goldman Sachs surveyed chief investment officers in February and March, it found that insurers saw holding less- liquid assets as among the best strategies for increasing returns. Insurers planned to boost allocations to private equity, commercial mortgages, real estate equity and mezzanine debt, Goldman Sachs said.
“While the interest in investment-grade traditional private placements has been quite strong for the last several years, that’s probably waning,” Melvin said. Insurers are “moving down the credit curve.”
American International Group Inc. said in June that it had committed $1.5 billion to a venture with Oak Hill Capital Management that will lend to mid-sized companies. The business, called Varagon Capital Partners, will lend to companies with earnings of as much as $75 million before interest, tax, depreciation and amortization.
Yields on investment-grade company bonds have dropped to 3.11 percent, less than 0.5 percentage point from the record-low reached last year, according to Bank of America Merrill Lynch index data. That compares with an average of 4.77 percent over the past decade.
The Financial Industry Regulatory Authority began disseminating prices for the first time in June on debt issued privately under a rule known as 144a, the latest step in the agency’s effort to make over-the-counter debt markets more transparent.
With spreads declining for private bonds, the increase in demand is probably nearer to the end than the beginning, said Robert Derrick, co-head of the North American corporate finance group at insurer Prudential Financial Inc.’s private-lending unit. The challenge is that the extra yield for taking on risk is dropping across asset classes, said Alton Cogert, whose Strategic Asset Alliance advises insurers.
“You don’t get a whole heck of a lot,” Cogert said. “Nowadays, it’s so hard to get compensated for taking risk, it’s crazy.”
–With assistance from Lisa Abramowicz in New York.