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.
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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.