Insurance companies – like many investors – are not immune to the challenges posed by the current market environment. Global rates are at historical lows, and compensation for risk has decreased. Insurers’ portfolio requirements may be unique, but we believe that certain investment opportunities can address them. Specifically, securitized and taxable municipal bonds may help insurers moderate late cycle dynamics, maintain income, and increase capital efficiency.
BBBs Are Here to Stay
- The credit cycle is in the late stages, and the BBB segment of the investment-grade corporate bond market is on the rise. Corporate issuers, taking advantage of historically low interest rates and yield-starved investors, have leveraged their balance sheets.
- Many investors – insurance companies included – are sacrificing credit quality for higher yields. Overall, insurers have increased their exposure to NAIC Class 2 securities in order to maintain portfolio income.
- An economic recession could trigger a wave of downgrades. To mitigate the potential impact, insurers may want to consider less traditional securitized bonds, as well as taxable municipals.
Opportunities Abound in Securitized Assets
- The role that securitized bonds played in the Great Financial Crisis (GFC) continues to shape investors’ perception of these securities. While some insurers have long invested in this sector, the broader market has been more reluctant to do so.
- We believe this presents an opportunity. Since the GFC, the underwriting standards and regulation of securitized bonds have improved significantly. These bonds now often have stronger credit profiles, which may not be factored into pricing.
- Within asset-backed securities (ABS), a wider scope of ABS issuance has resulted in an expanded opportunity set. We believe that there is value in the senior tranches of on-the-run sectors such as prime auto, credit card, and equipment, as well as more niche sectors.
- One example of a niche ABS subsector we invest in is handset receivables. With handset receivables, cellular carriers securitize customers’ smartphone payments. This structure is insulated from carriers’ idiosyncratic risk, and more correlated with consumers’ strength.
- These bonds are often shorter in duration (five years and in), and offer a spread of 40bps to 50bps over Treasuries for AAA senior tranche risk.
- Last-cash-flow commercial mortgage-backed securities (CMBS) may also offer attractive relative value.
- CMBS fundamentals remain robust, driven by elevated commercial real estate values and low delinquency rates. Many seasoned bonds have appealing loan-to-value ratios due to higher valuations and strong loan performance. Additionally, senior tranches often have over 30% credit enhancement.
- Despite these attributes, CMBS spreads lagged the rally in corporates in the second half of 2019. This resulted in a spread concession for AAA rated CMBS relative to A rated corporate bonds.
Municipal Issuers Pivot to The Taxable Sector
- In 2017, the Tax Cut & Jobs Act (TCJA) lowered the corporate tax rate from 35% to 21%, rendering tax-exempt municipals less attractive for numerous investors. In response, many insurers reduced their allocation to tax-exempt municipal bonds.
- Since TCJA, municipal issuers have increasingly relied on taxable municipal bonds to refinance existing tax-exempt debt. As a result, taxable municipal bond issuance has risen 150% year-over-year.
- Recent taxable deals have been shorter in duration as compared to previous trends, and offer investors with intermediate-dated liabilities a viable and attractive alternative to intermediate corporates.
- This wave of taxable issuance may allow insurers to maintain exposure to the sector, or further diversify their fixed income holdings.
Improvements to Quality, Income, & Downside Risk
- Within municipals, taxable bonds have a sizable yield advantage over similarly-rated corporate bonds, stemming from modest liquidity differences. However, insurers may benefit from owning taxable municipals, given the potential for increased compensation without the need to sacrifice credit quality.
- In 2019, a AA- healthcare system issued 30-year bonds at a spread of 100bps over Treasuries. That same week, an A-rated corporation issued 30-year bonds at a spread of 80bps.
- Historically, taxable municipal bonds have been less sensitive to corporate earnings, have had lower default rates than similarly-rated corporates, and have exhibited less spread volatility during market corrections.
- The correlation of excess returns between taxable municipals and corporates has been trending downward.
- On the contrary, the correlation of rolling 52-week excess returns between corporate sectors, such as Financials and Industrials, has remained near a 10-year high.
- In the current environment, insurance companies may want to consider taxable municipals, which can help maintain or enhance portfolio income and credit quality.
At IR+M, we recognize that insurance companies have specific investment needs, objectives, and risk tolerances. Current market conditions, which are characterized by low interest rates and tight spreads, are challenging – but they are not insurmountable. We believe that, for insurance companies, securitized and taxable municipal bonds may provide excellent relative value. Select securities within these sectors can help mitigate exposure to the credit cycle, while preserving portfolio income and capital efficiency.