If innovation is the key to unlocking higher fixed income returns, what does that innovation look like?
If innovation is the key to unlocking higher fixed income returns, what does that innovation look like? As noted earlier, in the current environment, it means an allencompassing rethink of investment strategy, approaches to risk and capital management, and the internal culture across an organisation. This isn’t a challenge for the timid. As spreads have tightened in recent years, insurers have moved from domestic markets to international markets, first developed and then emerging. They have moved further down the credit curve from investment grade fixed income towards high yield bonds. Structured credit in its different flavours (ABS and MBS) has become a mainstream allocation. But according to some insurers, the trouble is that these usual suspects, so often trotted out as the first alternatives for the fixed income portfolio, are now looking tired and squeezed of value. Given the massive compression in yields post 2008, finding new value here will be a challenge, though some are battling to find as yet under-exploited pockets. There are also new macro uncertainties to consider given the proliferation of oil and gas companies in the high yield space, and the rapid growth in dollar-denominated emerging market debt. Both face increased risks given the fall in commodity prices and the strong US dollar. More recently, interest has grown in alternative credit – a wide heterogeneous field encompassing direct lending, infrastructure debt, commercial real estate lending, distressed debt, mezzanine, insurance-linked securities, trade finance, leverage loans and liquid hedged credit strategies to name but a few. Ninety-three per cent of 25 22 7 13 33 Increasing yield Understanding the future direction of policy Finding new fixed income substitutes (eg private debt) Reducing economic tail risk Crafting capital ecient solutions Figure 1: The key fixed income challenges for insurers today Source: Insurance Investment Exchange survey, March 2015 Figure 2: The growing innovation gap for insurers Growing economic uncertainty, regulatory complexity, data etc Ability to distil, model, allocate, design solutions etc Innovation gap Source: Camdor Global Cultural change Risk and capital management Investment strategy Figure 3: The spectrum of innovation for insurance companies Source: Camdor Global 4 insurers see this wide space as the recipient of their fixed income flows in the coming two years. But as insurers take their first steps, the need to think carefully about asset allocation vis à vis their own requirements, and understand the new dynamics of these asset classes is becoming clear. Equally, they require a wholly different due diligence approach, both in choosing managers as well as on the underlying assets. For example, property debt such as commercial real estate lending has seen a rapid compression of yields when it comes to prime areas and senior debt, as the flows of money and competition from other institutional investors, such as pension funds, have overwhelmed limited capacity. Areas such as infrastructure debt and social housing are popular from an allocation perspective, but spreads are tight in segments of the market and origination is a growing concern. There are also dislocations between supply and demand, with insurers unwilling to take developmental risk, despite the bulk of deal flow emerging in new infrastructure. Bridging that gap requires both deal bespoking and structuring. And there are large segments of the market for which these are wholly inappropriate. Typically, infrastructure assets are illiquid and it is unclear whether there will be a ready secondary market if investors need to sell – a particular concern for property and casualty insurers who could be forced to realise assets at short notice if faced with large catastrophe claims. Where pockets of value are emerging, they are often in complex areas such as direct lending, mezzanine financing, esoteric credit, bespoke hedging strategies and so on. Two key and inter-related themes emerging in our discussions with the industry are the need to think carefully about portfolio construction and the need to penetrate this greater complexity. Alternatives by themselves are not a de facto better choice. They are a set of new tools that properly used could provide significant benefits to insurance portfolios and returns on capital. That requires a carefully thought through and judged approach as to their place within the portfolio, an understanding of their proclivities and dynamics, and a careful management of the new risks acquired. Otherwise, a knee-jerk and scattergun approach is likely only to prove a hindrance, converting the greener grass on the other side of the fence into a minefield. Different strategies will also develop in the life and P&C markets, given their differing liability profiles, and especially as Solvency II is bedded down. With eyes now wandering towards areas outside fixed income and considering a wider range of allocations from multi-asset solutions to smart beta to real assets, it is clear that: a) insurers are thinking harder about how to construct portfolios and manage their risks; and b) that these challenges are not going to diminish anytime soon.