In today’s low yield environment, an efficient way for life insurers to enhance portfolio returns may be through investing in less liquid assets. Life insurers may be cautious of increasing credit risk as credit assets are expensive and credit underwriting standards are deteriorating.
Increasing duration can be challenging when the path of interest rates remains uncertain as “normalization” draws closer, and can be particularly difficult for life insurers focused on asset-liability matching. Allocating to less liquid or illiquid assets can provide an incremental return and enables life insurers to capitalize on a longer-term structural advantage to provide liquidity where patient capital is increasingly scarce.
Some life insurers may be holding more liquidity than needed. Life insurers typically have liabilities with highly predictable cash flows and can use less liquid assets to back these liabilities, as the need to liquidate assets to support liability demand is limited.
Life insurers typically have a “buy and hold” orientation, which means accepting a lower level of secondary liquidity can add incremental yield without significantly increasing portfolio risk.
For life insurers seeking illiquidity premium in investment grade credit, emerging market corporates offer a spread premium relative to comparable developed market corporates. Life insurers comfortable with below investment grade credit should consider allocations to middle market loans, which offer an illiquidity premium relative to large market loans. Life insurers seeking equity risk premium for either long-duration liabilities or surplus capital can earn an illiquidity premium by investing in private equity assets.
Lower levels of liquidity due to regulatory change
After years of unprecedented global monetary stimulus, markets are ostensibly flooded with liquidity. Accommodative monetary policies have reduced market volatility and risk premium, resulting in exceptionally low nominal interest rates. Amidst this easy money environment, there are structural changes taking place that are having a long-term impact on liquidity.
Bank regulators are focused on strengthening capital and liquidity under the Basel III framework. As a result, banks face higher capital requirements, particularly for riskier assets.
Further, U.S. banks are facing greater restrictions on proprietary trading and tighter risk limits under the Dodd-Frank Volcker rules. This has led to diminished capacity for dealers to hold inventory and warehouse risk which reduces the availability of liquidity.
Measuring illiquidity premium
Life insurers should evaluate whether they believe the asset class offers adequate compensation for lower levels of liquidity. Illiquidity premium can be difficult to isolate, not easily observable, and can vary over time.
Illiquidity premium can be approximated by comparing assets of similar quality and tenor and measuring the excess spread over the more liquid benchmark assets. Credit assets that offer an illiquidity premium include emerging market corporate debt and middle market senior secured loans.
Emerging market debt
External emerging market corporates offer higher yields than developed market counterparts, yet have maintained strong fundamentals. EM investment grade corporates currently offer a spread premium of approximately 100 bps relative to U.S. investment grade corporates and approximately 150 bps relative to European investment grade corporates.
In the early stage of the EM corporate debt market, the spread premium could be attributed to differences in credit risk, but EM corporates have evolved from a speculative grade asset class to a predominantly investment grade asset class. Approximately 70 percent of the JP Morgan Corporate Emerging Market Bond Index (CEMBI) is rated investment grade.
(Click or touch the images to enlarge.)
Market value of J.P. Morgan emerging market debt indices
Source: GSAM, J.P. Morgan. As of November 2014. EM External Sovereign Debt is J.P. Morgan EMBI Global Index, EM External Corporate Debt is J.P. Morgan CEMBI Broad Index, EM Local Sovereign Debt is J.P. Morgan GBI-EM Broad Index.
Investment grade corporate spread comparison
Source: BofA Merrill Lynch Global Research, Bloomberg. Spread data is spread to worst. As of December 31, 2014. U.S. IG Corporate is BofA Merrill Lynch U.S. Corporate Index, EM IG Corporate is J.P. Morgan CEMBI Broad Diversified High Grade Index, and Europe IG Corporate is BofA Merrill Lynch Euro Corporate Index.
EM corporate debt liquidity
Despite strong credit quality, perceptions of political risk and less liquidity contribute to greater volatility and wider spreads for EM corporates. While EM corporate liquidity has improved, EM corporates have fewer secondary market liquidity providers, as evident in wider quoted bid-ask spreads.
EM corporate trading volume also comprises a significantly smaller percentage of overall EMD trading volume relative to the sovereign market.
Source: BofA Merrill Lynch Global Research, Bloomberg. As of September 30, 2014.
Impact of Fed tapering and current market environment
Given the impact of central bank driven liquidity on emerging market inflows, it is likely that volatility in EMD will increase as central banks withdraw liquidity. As market volatility increases, illiquidity premium is likely to increase.
Life insurers that can withstand short-term volatility and have a longer-term investment horizon stand to benefit from the illiquidity premium offered by EM corporates.
EM vs U.S. corporate return comparison
Source: Bloomberg. As of December 31, 2014. EM Corporate is the J.P. Morgan CEMBI Broad Diversified Index and U.S. Corporate is the Barclays U.S. Aggregate Corporate Index.
Middle market senior secured loans
Middle market senior secured loans (middle market loans) offer investors the potential opportunity to capture a spread premium relative to large market syndicated bank loans (large market loans) due, in part, to lower levels of liquidity.
The middle market is defined as companies with less than $50 million in EBITDA. Lending involves a concentrated and aligned debtor community that directly structures loans with borrowers. The smaller size and private ownership of these companies makes it difficult for banks to trade the debt which results in lower liquidity, and subsequently buyers tend to hold the assets to maturity.
Middle market loan fundamentals
Although middle market loans are less liquid, they are often higher quality and offer better structural protection relative to large market loans. A simple capital structure with fewer stakeholders enables faster resolution of credit issues, typically resulting in lower defaults and higher recovery rates.
While leverage ratios in the middle market have increased, they remain below those in the large market. Fewer capital providers have resulted in higher yields and more disciplined underwriting. Covenant-lite deal volume has picked up in the middle market, but is still well below the large market.
Middle market loan fundamental comparison to large market loans and high yield bonds
1 Represents average new issue yields for the twelve months ending September 30, 2014. Based on middle market and large corporate loan indices per S&P LCD and based on Bank of America/Merrill Lynch Global High-Yield Strategy Index (H0A0).
2 Based on middle market, high-yield, and large market LBO transactions per S&P LCD for Q3 2014 YTD.
3 Covenant-light percentage represents percentage of volume as of September 2014.
4 Average LTM default rates (by count) per S&P LCD from September 2004 to September 2014.
5 Middle markets loss given default data per GS estimates. Large market losses from S&P based on $-weighted ultimate recoveries for all loans from 1987 to 2013.
6 Loss rate calculated by multiplying LTM default rates (by count) and loss given default rates cited above.
For illustrative purposes only. This information discusses general market activity, industry or sector trends, or other broad based economic, market or political conditions and should not be construed as research or investment advice. There is no guarantee these objectives will be met. Past performance does not guarantee future results, which may vary.
The spread premium in middle market loans can in part be attributed to supply/demand fundamentals. Middle market companies do not have the same access to financing as large market companies, reflective of a structural change in the middle market.
Prior to the credit crisis, mid-size companies were served by national and regional banks, specialty finance companies, CLOs, and hedge funds. Post-crisis, these funding sources have returned to the large market but not to the middle market.
Illiquidity premium in middle market loans
The illiquidity premium in middle market loans is evident when compared to large market loans of similar credit quality. Over the last five years, middle market B-rated loans have offered on average 130 bps of additional spread over large market B-rated loans. Middle market loans also offer LIBOR floors similar to large market loans.
Middle market lending and insurance portfolios
Insurance companies with appetite for credit assets with lower liquidity have an opportunity to become capital providers where banks are increasingly leaving a void. The cash flows from middle market loans can be used to back intermediate-dated liabilities that do not require a high degree of current liquidity, though insurers would need to manage the duration mismatch due to the floating rate nature of the loans. Loans can be capital efficient for life insurers when rated and held directly on a balance sheet as opposed to in a fund vehicle.
Middle market vs large market Single B loans average discounted spread
Source: S&P LCD. As of September 30, 2014.
Life insurers can capture illiquidity premium by allocating to smaller, less efficient credit markets or they can increase allocations to assets that are inherently less liquid such as private equity. Private equity investments require a long-term commitment from investors, sometimes 10-12 years, which by definition makes the investment illiquid. A long lock-up on capital is crucial for private equity managers to generate returns, and investors’ willingness to accept this lock-up reflects an expectation to receive higher returns.
Private equity sources of return
Manager selection is one of the most crucial aspects of private equity investing. Top quartile managers are often successful because of a proven investment philosophy, a unique skill set, or a repeatable investment process, which can result in consistent performance. Private equity manager return dispersion is therefore significantly wider than that of public equity or fixed income managers.
Private equity vs public equity and fixed income return dispersion
Source: Private asset data: Thomson Reuters; Morningstar Principia (public data) as of June 30, 2014.
Note: Private equity fund returns are compared with four-year annualized average returns of public funds, realized over a period starting one year after the private equity fund vintage year. This lag and time-averaging is done in order to take into account the private equity investment period and long time-horizon over which private returns are realized. Private equity data is for funds raised between 1990 and 2013, with returns as of June 30, 2014. The data for public fund returns over the years 1990 through 2013 and are chosen by matching the MorningStar category to the market designations listed in the chart (i.e. they are not necessarily benchmarked to an index which covers the respective market).
Private equity in an insurance portfolio
Private equity allows insurers to capitalize on a structural advantage to provide liquidity where individuals, banks and other institutional investors are less willing or able.
Life insurers have relatively small equity allocations and generally have the capacity to take more equity risk. High capital charges under U.S. risk based capital guidelines can deter insurers from investments as the post-tax capital charge for private equity investments is 19.5 percent.
However, if we assume a U.S. life insurer holds the industry average equity allocation of 3.3 percent, adding incremental equity exposure can result in a lower risk based capital charge due to a co-variance adjustment in the RBC formula for diversifying investment risk.
Essentially, life insurance companies have an opportunity to earn an illiquidity premium in a market environment where liquidity is increasingly scarce and where the compensation for interest rate and credit risk is limited. Depending upon risk tolerance, there are various asset classes that can offer compensation for taking liquidity risk.
Investment grade emerging market corporates offer an excess spread over comparable developed market corporates. Middle market loans enable life insurers to take advantage of a dislocation in the supply of capital to earn a premium over larger, more liquid loans.
In exchange for long-term patient capital, private equity provides equity risk premium, diversification from fixed income risk, and the potential to earn excess return over liquid assets.