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David L. Braun
Perhaps no investor base wants interest rates to rise more than the life insurance industry. After all, low rates are unhelpful to an industry with legacy long-term liabilities containing rigid embedded credited rates; they exacerbate asset-liability mismatches and pressure earnings margins. Similarly, low rates make some life and annuity products less marketable – or worse, marketable yet difficult to hedge! So insurance investors may welcome higher, more traditional, interest rate levels for both their inforce block and for potential new business … but will it happen?
PIMCO’s New Neutral thesis suggests rates will remain low over the secular horizon of three to five years. The New Neutral is an extension of the New Normal, the moniker for our 2009 secular forecast of modest, below-potential growth. In The New Neutral we expect growth to remain modest and well below potential, deleveraging to continue (from all-time high global debt levels), and inflation to remain muted and generally below central bank targets. This “Triple Crown” of too little growth, too much debt and too little inflation gives central banks the incentive and air cover to remain accommodative.
As such, The New Neutral puts a greater focus on policy rates. Specifically, PIMCO expects neutral policy rates in the U.S. to be close to 2% nominal and 0% real in the years ahead. These rates are lower than historical levels, lower than current Fed estimates (the nominal 3.75% median blue dots) and lower than many forward rates embedded in today’s yield curve. Over the secular horizon, PIMCO sees 10-year Treasury rates ranging from 2.5% to 4.0%. We believe rates will rise, but not as much as most investors fear (hope?) they will rise. What should insurers do in this environment? Here are six things to consider.
Design and price products for The New Neutral world Consider creating products that can weather several years of low interest rates and lower asset returns. The dark days of products designed and priced with wishful hopes of mean reversion to historical yields and 10% equity returns – recall the infamous “arms race” in variable annuity guarantees – are long gone. Still, while today’s products seem much more reasonably designed and priced, as competition heats up it may become tempting to factor in a rise in rates, spreads and equity risk premiums. PIMCO anticipates bond returns to be in the 3%–4% range and equity returns to be in the 5%–6% range over the secular horizon – something to consider in new product design.
Reevaluate your asset-liability management (ALM) strategies Some insurers are likely tolerating duration mismatches (i.e., asset duration less than liability duration) in the hope that rates will rise, creating a better entry point to cover the mismatch. However, a sustained low-rate environment, coupled with risk-based capital rules that increasingly penalize ALM mismatches, means it may be wise to begin covering this mismatch sooner rather than later. A prudent thing to do may be to establish a rate-based glide path, as rates could occasionally overshoot New Neutral rates over the secular horizon as the market romances the idea of “old neutral” rates. Insurers may be able to exploit this volatility to cover some of their duration shortfall.
Maintain credit overweights Spreads have narrowed in the past few years, but value still exists. We believe a low, but stable, growth world with engaged policymakers lowers the risk of left-tail events. Combine this with a corporate universe that has low-rate, termed-out debt maturities and you have a decent environment for credit. That said, with most spread product fairly priced (and some fully priced), the margin for error may be small. Investors need to combine rigorous bottom-up credit research with top-down macroeconomic views to identify attractively priced securities and separate the likely winners from the potential losers. Look to focus on “rising star” high yield companies that are on the march to investment grade; NAIC 1 and 2 non-agency mortgage-backed securities; taxable municipal bonds with attractive relative value versus similarly rated corporate bonds; securities of certain financial and nonfinancial issuers that are lower in the capital structure, as their credit spread ratios versus those of senior securities look attractive; and select investment grade corporates with superior asset quality, growth potential and pricing power.
Given your liability structure, do not overpay for liquidity Levered investors with restrictive margin requirements and retail funds with volatile investor flows need to be mindful of liquidity, especially given the lack of depth in the secondary markets due to reregulation of the banking industry. Insurers, however, are different because their liabilities are generally long-term, and unlike mutual funds or hedge funds they are generally not subject to redemptions or withdrawals. At PIMCO’s Insurance CIO Forum in 2013, a common theme was that insurers had realized that they have more liquidity than they’ll ever likely need. Therefore, do not pay up for unneeded liquidity; instead, focus on enhancing yield by selling liquidity. Look to do so in off-the-run, non-benchmark-eligible public securities, private debt lending and reverse-inquiry deals that fit your liability, risk and yield targets. Be prudent: Liquidity spreads, like credit spreads, are not what they used to be.
Avoid home-country U.S. bias With rates and spreads in the U.S. relatively constrained, go global and expand your investment opportunity set. Look for high quality investments outside the U.S. in markets offering wider credit spreads, larger liquidity premiums and/or higher real rates of interest. Focus on select emerging markets (e.g., Brazil and Mexico for both rates and credit) and select European credits that have decent growth prospects and continue to delever. Lobby your local insurance department to begin relaxing antiquated aggregate non-U.S. issuer exposure limits (e.g., 10%–15% in many states); the global economy and capital markets have expanded significantly since such rules were established. These rules forcing you to own more concentrated, U.S.-centric portfolios may increase risk and reduce return potential.
Active management In The New Neutral, with beta from stocks and bonds likely to be relatively low, insurers should look to enhance buy-and-hold return potential via active management. In addition to alpha opportunities from robust bottom-up credit work, we believe attractive opportunities from overshoots in rates and credit spreads will emerge as markets react to noise and as investors dream of the Old Normal, Old Neutral world. This may create invaluable alpha opportunities for the active manager. Active management, by the way, is not just for those focused on total return. Even if your focus is on book yield, active management may be a key ingredient to delivering added value (see “Can You Have Your Cake and Eat It Too?” April 2014).
Adding it all up So what does it all mean? Insurers may want to recalibrate their expectations of future interest rates, as well as broad bond and equity market returns. Rates will likely rise, but probably not to historical averages, nor even to levels embedded in today’s forward curves. Insurers should play defense and ensure that their business and product mix is well positioned for The New Neutral. At the same time, the stability and continued healing of the global economy coupled with accommodative central banks can provide opportunities to play offense in your general account. Life insurers may never love low rates, but they can find opportunities in The New Neutral.
Past performance is not a guarantee or a reliable indicator of future results . All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.Equities may decline in value due to both real and perceived general market, economic and industry conditions. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Investors should consult their investment professional prior to making an investment decision.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United States and throughout the world.
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