Insurers’ Conundrum: Higher Book Yields at the
Cost of Shrinking Unrealized Gains
by Laura Lake, CFA
Senior Portfolio Manager,
Insurance Client Strategies Group
“There’s no such thing as a free
lunch.”
– Milton Friedman
The federal funds rate is on the move after
nearly a decade at the lower bound. For
eight years, insurance companies waited
for a higher rate to stem the erosion of
book yields and the end looks to be in
sight. While higher reinvestment rates
may be welcome, it comes at the cost of
dwindling unrealized gains.
At Standish, we are discussing long-only
strategies with insurance clients to seek
to monetize portfolio gains and minimize
the impact of rising interest rates. At
the extreme, significantly shortening
duration or moving to all cash can lock-in
gains, but it comes at the cost of reduced
income. While there is not a magic
bullet to preserve both gains and income
simultaneously, gains can be harvested
and reinvested in strategies that may help
mitigate unrealized losses going forward.
Potential approaches include:
Isolating Credit Spreads
Investment-Grade Credit
Floating-rate notes (FRNs) have coupons
comprised of two components: an
adjustable component that moves with
a short-term interest rate index, typically
based off of LIBOR, and a fixed component
based on the credit spread of the issuer
at the time of issuance (Exhibit 1). The
adjustable component minimizes interestrate risk or Treasury duration in these
instruments, leaving the price sensitivity
almost entirely a function of changes in
the credit risk of the issuer. This is often
referred to as ‘spread duration’. While
floaters have little interest-rate risk, it is
important not to view them as a cash
substitute; they have both credit risk and
liquidity risk in the event that they are sold
prior to maturity.
When adding a strategic allocation to
FRNs, we recommend that clients consider
owning them in a separate account,
funded from a vertical slice of their core
portfolio. This allows clients to maintain
the appropriate duration profile of their
core holdings. If the FRN component is
integrated directly into the core portfolio,
the increased short duration allocation
could be offset by a greater allocation to
longer bonds in order to maintain portfolio
duration. This barbell-curve position does
little to mitigate the impact of higher
rates in the overall portfolio. Within a
separate account, the FRN exposure can
be managed independently and serve as a
diversifier to the core portfolio.
Exhibit 1
Floating Rate Note Example
Citigroup Inc.
Issue Date:
8/19/2016
Maturity Date:
9/1/2023
Coupon Rate:
2.48%
Coupon Formula:
3M LIBOR +143bps
Rating:
BBB+/Baa1/A
ff Reducing interest-rate beta via taxexempt municipals and TIPS; and
Duration:
0.20 Years
Spread Duration:
4.93 Years
ff Modifying accounting classifications—
held-to-maturity versus available-forsale
Source: Bloomberg as of March 15, 2017
ff Isolating credit spreads through
floating rate investment-grade bonds
and bank loans;
Coupon Rate
Fixed:
143bps
Adjustable:
3M LIBOR
page 424
Bank Loans
Exhibit 2
Bank loans are sub-investment-gradecorporate debt instruments with floatingrate coupon structures, secured by the
assets of the borrower. Therefore, bank
loans are expected to offer a higher recovery
rate in the event of default than unsecured
obligations, such as high-yield bonds. Due
to their position in the capital structure,
as well as the short duration nature of the
floating-rate coupon, loans may display
lower market price volatility than high-yield
bonds. For insurers that can incorporate
a National Association of Insurance
Commissioners (NAIC) designation of three
or four into their portfolios and handle a
higher capital charge, higher spreads on
bank loans make them more attractive than
investment- grade debt.
Muni Treasury Yields Beta: 10-year Maturity
to help mitigate the negative price impact
of rising interest rates, particularly versus
other liquid fixed-income asset classes.
3-year rolling
1.00
0.50
-
Jan-17
Jan-16
Jan-15
Jan-14
Jan-13
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
(0.50)
Rolling Muni-Treasury Beta
Beta computed on nominal monthly charges - rolling daily
Source: JP Morgan, Standish as of March 20, 2017
at higher book yields to lessen the loss of
book income.
TIPS
TIPS are Treasury securities indexed to
With the Fed looking to move interest
inflation in order to protect investors from
rates higher, companies should revisit the
inflation risk. Given the reversal of the US
merits of using the HTM designation for a
Federal Reserve’s unprecedented balance
portion of their fixed-income assets. Bonds
sheet
ultra-accommodative
Yieldexpansion
Volatilityand
of Muni
vs. Treasury: 10categorized
Year Maturity
Bonds
as HTM
do not require markmonetary
policy, the
markets’ inflation
Rolling monthly
period:
6 Month
3 Year interim
to-market adjustments because
expectations
may
not fully reflect the future 109%
As of current
date
volatility is not expected to86%
be realized,
reality.
Over 1995
the last 10 years, TIPS’ 3-month 65%
Avg. since
as these bonds are held to62%
maturity and
beta has averaged around 0.6 compared
therefore carried at amortized cost on the
to that of nominal Treasury yields (Exhibit
balance sheet. One should note that while
3). We expect TIPS to outperform nominal
there are circumstances in which HTM bonds
Treasury bonds in a rising rate environment.
may be sold, auditors closely scrutinize
Exhibit 3
sales so excessive activity may cause the
securities to lose their designation.
TIPS Beta
Given the desire of most insurance
companies for income stability, turnover
6-Month Rolling Average
is generally modest in high-grade bond
2.0
allocations. Therefore, in a portfolio that
1.5
already experiences limited turnover, it
1.0
is possible that designating a portion as
0.5
HTM may have little impact on an overall
0.0
investment strategy. The challenge is
-0.5
6 month average of each days prior months
beta the bonds for which HTM is
identifying
-1.0
3 year average of each days prior months
betaappropriate. Allocations to higher
most
volatility sectors, such as emerging markets
and high yield, are typically not candidates
6 month
of 2017
each days prior months
since designation
1995
for beta
the HTM
as managers
Source
Barclaysaverage
as of March 15,
require
flexibility
to capitalize on relative
3 year average of each days prior months
beta since
1995
Determining Appropriate
value opportunities.
Therefore, higher
Accounting Classification
quality securities with some duration risk
Insurance companies generally classify are generally most appropriate for HTM
their fixed-income assets as available-for- portfolios.
Aug-16
Aug-15
Aug-14
Aug-13
Aug-12
Aug-11
Aug-10
Aug-09
Aug-08
3-Month Beta
Aug-07
Reducing Interest Rate Beta
3-Month Betang Average
Investing in asset classes with lower rate
0.526
0.755
sensitivity may help hedge against rising
0.720
0.524
interest rates. Holding all else equal, a
0.693
0.523
lower beta means that as nominal rates
0.690
0.523 typically
move higher, yields
in these sectors
0.690
0.522 portfolio
rise at a slower rate. Implicitly,
0.682
0.521 without
interest-rate sensitivity is reduced
explicitly lowering
duration. 0.519
A beta of less
0.642
than 1.0 suggests0.621
that the sector
will be less
0.519
volatile than nominal
0.598Treasuries,
0.518whereas a
beta of greater than
0.5801.0 indicates
0.517 that the
sector will be more volatile.
0.574
0.517
Historically, tax-exempt
0.573 municipals
0.516 and TIPS
(Treasury inflation-protected
0.573
0.515securities)
have been positively
correlated
0.572
0.515with—but
less volatile than—nominal yields, which
0.570
0.514
signifies a beta of less than 1.0. However,
0.572
0.513
the beta relationship between movements
0.512
in nominal yields 0.571
compared with
municipals
0.568
0.511
and TIPS are not always stable
over time.
0.565
0.510
Tax-Exempt Municipals
0.565
0.509
Tax-exempt municipal
bonds
have proven
0.566
0.508
to be defensive in periods of rising interest
0.566
0.507
rates. While the relative relationship can
0.566
0.506
change over shorter time periods, our
0.565
0.505
research has shown that intermediate0.562
0.504
duration municipal bonds have
a long-term
0.560
beta of approximately 0.65 0.504
relative to the
0.503 rolling
10-year Treasury0.558
over a 6-month
0.557
0.502the lower
period (Exhibit 2).
We expect
volatility characteristics
0.556 of municipal
0.501 bonds
6-month rolling
1.50
sale (AFS) under the Statement of Financial
Accounting Standards No. 115. Relative to
the held-to-maturity (HTM) designation,
the AFS designation provides more
flexibility to sell bonds before maturity. The
AFS designation served companies well
as interest rates fell over the past three
decades. It provided firms with the option
to either harvest gains or to hold positions
The hiking cycle of the US Federal Reserve
is underway with the path of interest rates
expected to move higher. While the balance
between preserving gains and income
simultaneously is a challenge, there are
strategies that can help mitigate unrealized
losses as rates move higher.
Use
Use
Use
Use
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WP/Ins/4-27-17/BR
Standish Mellon Asset Management Company LLC
Boston • Pittsburgh • San Francisco
Standish Mellon Asset Management (UK) Limited
London
www.standish.com • [email protected]