Insurers: The Smart Debt Money

Insurers are returning to bonds, finding opportunities in liquid credit
 

By: Greg Obenshain

The rise of the endowment model has generally correlated with the decline in fixed-income investing, as the vanguard of institutional investors have shifted their debt investments into alternatives. But one group, whom we believe to be smart institutional investors by virtue of both prudence and regulation, has maintained a very large allocation to fixed income: insurance companies. Insurance companies tend to have 60–70% of their portfolios in bonds.

But even within this group, led by a few innovators, insurers have shifted from bonds into common equity and alternatives to the extent allowed within their constraints.

Figure 1: Cumulative Percent Change in Share of Insurance Company Balance Sheets

Source: naic.org. “Alternatives” represents Schedule BA assets in NAIC reports.

And this has made sense, given a low-rate environment. The yield on BBB debt, the average yield of issuers in the S&P 500, was barely above the S&P 500 dividend yield throughout the 2010s.

Figure 2: BBB Bond Yield Minus S&P 500 Dividend Yield

Source: Bloomberg

But this is changing. Debt yields relative to equity are as high as they have been in over a decade. And the investors who most focus on debt, insurance companies, have reacted. For the first time in years, the bond share of investments on insurance company balance sheets increased in 2022. This is also evident from the earnings calls of large insurance companies. Insurers are once again embracing debt and locking in higher rates over longer periods. For example, Allstate is extending duration. In their own words, “this duration extension locks in higher yields and income for longer, while positioning the portfolio to benefit from potential future reductions in interest rates.”

The longer rates stay high, the more we would expect this shift to continue. The traditional purview of insurance companies (rated, high quality credit) becomes more attractive relative to the alternatives when rates are higher. This is particularly true because insurance companies are penalized for unrated or low rated investments like common equity or many alternatives. In our opinion, insurance companies no longer need to venture far afield to increase return. Beyond investment-grade yields that are now over 5%, BB credit, the step below investment grade, now yields around 7% according to the Bloomberg BB index. We have long argued that BB credit provides the highest return opportunities in corporate credit and for insurance companies, the BB rating is not nearly as punitive to company balance sheets as illiquid alternatives.

And yet, even as we start to see some shift in insurance company behavior, surveys of insurance companies suggest that alternatives continue to occupy attention. According to a survey from Conning, “83% of insurers intend to allocate 10% or more of their assets to private assets, up from 61% today,” and “Nearly one in four expects more than 25% of their portfolio to be invested in private assets in two years.”

A Mercer survey paints this picture in more detail. Below we show the percent of Mercer respondents increasing allocations to private versus public assets over the next twelve months.

Figure 3: Expected Allocations to Private vs Public Assets

Source: Mercer, Public investment grade is core fixed income. Public high yield is high yield and bank loans. Public equity is domestic equity.

We understand why investors would be enamored of private assets in a low-rate environment, but why now? We believe higher rates are bad for private equity firms, which rely on floating-rate debt to fund their investments, and bad for highly levered borrowers, mostly private equity buyouts, which make up much of the high-yield private credit universe. In this context, we are skeptical that insurance companies will shift as aggressively as suggested into private high-yield credit and private equity.

Let’s focus on high-yield private credit. The long history of debt investing provides terrific data with which to evaluate the current choice between higher rated liquid credit and lower rated private credit. While liquid high-yield credit tends to skew higher quality, with over 50% of the high-yield market rated BB, we have shown in earlier work that private credit tends to map to lower credit ratings, mostly single B ratings. We’d argue that with increasing private equity buyout prices and debt levels in recent years, private credit may even be at the low end of that credit range.

We do not have credit stats for private credit, which makes it hard to evaluate. But we do have a long history of performance by credit rating in the public high-yield markets and current credit stats for the public high-yield markets, which we show below.

Figure 4: Credit Statistics, Default Experience and Historic Return by Rating

Source: Bloomberg, Moody’s, Verdad Bond Database. EBITDA is not adjusted.

Single B credit has lower returns than BB credit. Our long-standing opinion is that the incremental yield available from lower-rated credit is erased by higher default and down-grade losses. Perhaps the greatest innovation of private credit is that it is not rated. We suspect that if we could get aggregate credit stats for private credit, investors would be concerned by what they found.

We expect that insurance companies will come to the same conclusion and that the small shift we have seen back into bonds will continue as the shift to private assets dissipates. In our opinion, insurers will find more traditional assets attractive and the survey data that continues to predict the inexorable rise of private assets, especially in credit, will not come true. We believe that there are much better opportunities for insurance companies to move into higher rated high-yield credit, which works well on their balance sheets and has the advantage of being liquid and much more transparent. We are perhaps in the early innings of a shift back to bonds.