Credit markets entered 2020 following a strong bull market rally. Investors had, for a short while, been grappling with low investment yields, whilst spreads in the credit segment continued to reach all-time lows.
As a consequence of the coronavirus pandemic (COVID-19) and only four months into the crisis, the investment landscape has changed materially. Investors will need to pay greater attention to their credit allocation going forward, taking into account, for example, the already structural shifts in ratings migration and the subsequent surge in “fallen angels”. As the pandemic persists, one of the biggest challenges facing corporate credit investors is the magnitude of credit deterioration and whether it subsequently leads to an increase in defaults. Just as challenging is ratings migration risk, which could lead to the upheaval of credit allocations as investors are forced to sell securities that no longer meet their mandate requirements.
In a 14 May 2020 report (‘Credit Trends: Potential Fallen Angles Hit A Record-High 111’), S&P Global Ratings assessed the risk to credit investors from potential fallen angels, using data as at 30 April 2020.
Reflecting data covering issuers and bonds only rated by S&P Global Ratings the report highlighted:
- 24 fallen angels YTD with over USD 300bn highest volume since 2015;
- The number of potential fallen angels has risen to 111 issuers globally, a record;
- 26 have ratings on credit watch negative,
- The negative bias for all investment grade issuers has risen to a post-financial crisis high of 25%.
This rapid structural change will alter the composition and structure of the high yield market in the near future and will strongly influence how investors will make allocations across the credit spectrum.
How do Insurance Bonds fit into an institutional portfolio?
For investors seeking an alternative allocation within investment grade and high yield, Insurance Bonds provide attractive returns coupled with robust fundamentals. Insurance also has within it significant industry diversification, in part due to the many facets within the sector itself, from P&C to Life , and vs high yield, offering investors higher security through ratings, whereby more than 95% of the insurance sector carries an investment grade rating. More importantly, insurance companies derive profitability from strict underwriting and are less dependent on the short term direction of markets.
One distinctive feature of Insurance Bonds has always been its attractive premium compared to Corporate Bonds. Twelve Capital believes that this sector premium remains unwarranted, given the strong industry fundamentals and that it can be attributed to the perceived complexity of the insurance sector.
Furthermore, sector complexity lends itself to partnership with a specialist manager, covering the entire balance sheet of an insurance company, from Insurance Debt, Private ILS, Catastrophe Bonds, and Insurance Equity. Twelve Capital believes that it is in a far more informed position, and able to capture the nuances that drive sector profitability, bringing the complex jigsaw puzzle of the insurance sector together and at the same time exploit sector specific opportunities.
The parameters of the insurance business model is by nature defined by an efficient management of risks and as such is affected by the merits of the industry, which demonstrates strong enterprise risk management capabilities, including the ability to reliably communicate on mark to market solvency positions;
- Access to well diversified, strong performing sources of earnings and cash generation;
- An emphasis on fee or underwriting driven earnings, with less focus on investment spread businesses;
- Liquidity positions, especially in relation to holding companies, built to withstand extended periods of financial market stress;
- Robust and effective market risk hedging programs, where applicable;
- Generally lower investment leverage; and
- Lower debt leverage, with well laddered debt maturities
When considering COVID-19, Twelve Capital expects that in aggregate, direct impacts from the disease outbreak in terms of insurance losses, whilst painful, will be manageable (i.e. higher cases of life mortality, disability, business interruption, travel insurance etc. claims).
In addition, a more significant impact is expected from second order effects linked primarily to the performance of investment markets. These have been extremely volatile, providing at different times over recent weeks headwinds and even on occasion tailwinds to sector solvency.
One potential source of risk faced by insurers relates to their credit investing activity, however given that Investment grade credit is a prominent feature of the balance sheet of insurers’ investments, risk remains muted. Part of the reason is that insurance companies invest mainly in high quality investment grade, which currently benefits from central bank programs keeping spreads compressed, this is positive for insurance groups solvency and by extension investors in Insurance Bonds.
Yet despite the strong fundamentals and robust credit ratings, subordinated bonds still sit only second in terms of spread to airlines and wider to banks.
Default probability once again matters
The global economic environment is certainly challenging many industries, such as airlines, retail and tourism, that are typically sensitive in traditional recessions but more so in the current context, given the direct negative effects the COVID-19 related lockdowns have had on their business models.
As a surge in global default rates is expected, Twelve Capital highlights the defensive nature of the insurance sector evidenced by historically low default rates. In part, it is driven not only by the highly regulated insurance environment but also in part by the nature of the businesses, which rely less on short term funding.
How have Insurance Bonds have demonstrated resilience through the COVID-19 pandemic?
In Twelve Capital’s view, the pandemic led volatility within global credit markets, has created an attractive entry point to the Insurance Bond asset class. Currently, Twelve notes that since pre-pandemic, Tier 2 (T2) bonds issued by European insurers are down, on average, by around 7 points, with Restricted Tier 1 (RT1) instruments down even more by, on average, 16 points. Although there has been a further recovery the average ratio between the spread of RT1:T2 still remains elevated at just over 1.7x.
Insurance spreads are sitting well inside the financial crisis wide point and have tightened from the recent mid-March wides of 400bps. Yet, spreads of around 300bps mean that Insurance Bonds remain one of the widest when compared to global and European investment grade credit and just slightly inside of European high yield (see next illustration).
Meanwhile, throughout the global financial and peripheral European sovereign crises of 2007 and 2012, only one coupon payment was missed to investors in Europe, and one was suspended but subsequently accrued for and paid at a later date. Since 2013 the average issuer rating of insurance groups monitored remains at a solid “A”.
How large is the attractive part of the universe?
The growth of the subordinated Insurance Bond market exhibits issuance at a steady rate and has become an integral part of European insurers own funds. In particular T2 and T3 have been the dominant preferred issuance, due to the fact that combined they are permitted to constitute 50% of solvency capital requirements for an insurer. Recently, the emergence of RT1 has caught many investors attention. The first deal was in 2017 and the market continues to grow, currently with 14 available instruments totalling approximately just over EUR 7bn. It is important to highlight that these are the most junior forms of debt instrument, and in order to qualify as RT1 compliant the instruments need to be perpetual with a minimum of five year non-call. In addition, coupons have to be fully optional with a trigger mechanism allowing for equity conversion of principal write down.
Where’s the ‘sweet spot’ in this asset class?
In the main, Twelve Capital focuses on Solvency II Tier 2 debt instruments, issued by European insurance companies. It believes that the Insurance Bond sector is highly attractive, combined with the new forms of RT1.
T2 dominates the investors’ landscape, as for insurance companies there is very little need for them to issue senior debt funding, given that the nature of their business is less reliant on short term funding.
As a consequence, Twelve Capital’s core focus means that funds typically warrant a BBB rating, and should appeal to those investors who still require investment grade credit and yet benefit from higher yields. Despite being long only in nature, there are active ways to extract alpha from the sector, which should appeal to those investors seeking an alternative allocation, whilst balancing risk and return.