Key takeaways:
- Credit assets offer a growing insurance market quality investments, liquidity and diversification
- Longer maturities are key to insurers as they seek to match their liabilities. Emerging market debt may offer high-quality duration
- The asset class is complementary to developed market debt, but investors should be mindful of the illiquidity risk and issuer concentration
The global insurance market is in line for a steady expansion of 5.5% annual growth over the next decade.1 Simultaneously, credit assets now offer a significant yield premium after over a decade of ‘lower for longer’ interest rates, positioning the asset class as a natural home for some of this new investor demand.
Given the evolution of the asset class and several attractive characteristics, we think EMD should play a bigger role in the insurance fixed income portfolio.
With their focus on quality investment income, liquidity and diversification, insurers are natural credit investors. Public fixed income plays a critical role in an insurer’s asset-liability management (ALM) process. Investing in the space allows insurance clients to match their portfolio’s duration (its sensitivity to changes in interest rates) and cash flows to their liabilities, in order to generate an investment spread while remaining sufficiently tradable to meet unexpected liquidity demand.
Despite the tremendous growth in the size and maturity of emerging market debt (EMD), most insurers would still consider it a ‘core plus’ strategy and allocate on a tactical basis. Smaller insurers are often missing out on the opportunity set, due to a lack of resources and specialist expertise in house.
Given the evolution of the asset class and several attractive characteristics, we think EMD should play a bigger role in the insurance fixed income portfolio.
A diversified and growing market
The EMD universe has grown tremendously, both in terms of diversification and asset size. In 2010, there were 38 countries in the most-widely-followed family of indices (JP Morgan EMBIG); today, there are over 70 countries. The countries are dispersed throughout the world – 34% of the index weight is in Latin America, 25% Middle East, 19% Asia, 14% Eastern Europe and 8% Africa.
Figure 1 shows the evolution of the market capitalisation of the aforementioned index. It has grown almost sixfold since the Global Financial Crisis and is now of a similar size to the US high yield corporate bond index. EMD as a whole represents 26% of all global debt (compared to 6% in 2000), at more than US$1.2 trillion.
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Compelling valuations
The EMD universe offers a large pool of high-quality assets.
More importantly, the EMD universe offers a large pool of high-quality assets. The majority of the index is investment grade (IG): 58% of the EMBIG. There is also a sizeable portion in high-quality non-IG issuers (17% BB-rated) that are at the cusp of reaching IG status. This provides a fertile hunting ground for insurance investors with different risk/return objectives to diversify issuer-specific and sector risks within the rest of their fixed income portfolio.
For duration-focused life insurers seeking to obtain high-quality duration (AA-A rated) in hard currency (USD-denominated assets), EMD offers ample opportunity as there is a structural tilt towards longer maturity issuance when compared to the US IG universe.
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Emerging market debt offers compelling spreads to US Treasuries, with similar (and sometimes better) fundamentals compared to developed market (DM) fixed income. The chart below shows the historical distribution of the “EMD premia” relative to US corporate issuers with the same rating.
As Figure 3 shows, the size of the “EMD premia” varies throughout the cycle. Having an EMD allocation positions the insurer to take advantage of future relative-value opportunities between EM and DM fixed income arising from asynchronous economic cycles.
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With a potential spread premium over comparable DM corporate credit risk, EMD may offer a more attractive return on regulatory capital.
There also appears to be a ‘rating premia’ embedded into the relationship – that is, the further down the credit spectrum you go, the larger the pick-up in spread you can harness. An investor could construct an EMD portfolio that invests in both the highest-rated bonds (AA and A-rated) and complement it with BBB-rated and select high-quality BB-rated issuers (if permitted by their mandate’s guidelines) to optimise their yield per unit of regulatory capital consumption.
With a potential spread premium over comparable DM corporate credit risk, EMD may offer a more attractive return on regulatory capital. This is because EM hard-currency bonds are typically treated in a similar manner to corporate credit risk under most risk-based insurance regulatory regimes.
Emerging market corporate debt: buyer beware
Like its government counterpart, EMD corporates has also experienced a surge in growth over the past several decades, as the chart below illustrates.
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Corporates also offers a similar level of diversification as the government index, with 700+ of issuers representing 59 countries.
However, there is one rather large and important difference between EMD government bonds and corporate bonds – liquidity. TRACE (corporate trading data compiled by FINRA) tracks trading data for over 720 EMD corporate issuers. Out of those 720+ issuers, only 13 have daily trading volume that exceeds USD 10 million (and bear in mind that this is at the issuer level, not the bond level).
Clients may be asking, “Is liquidity really that important for a buy-and-maintain mandate?” And it would be a fair question to ask – after all, while liquidity may be challenged, a portfolio manager could patiently buy a particular corporate bond gradually over time until they reach their target allocation.
The issue however is not with the entry but rather the exit. There are several instances where a portfolio manager may need to liquidate a particular holding. The key reasons are a downgrade from IG to HY, and structural liquidity demand coming from the liability side of the insurance balance sheet – as demonstrated from the recent lapse experienced when higher rates incentivised policyholders to surrender their lower yielding policies in favour of more compelling opportunities.
In such events, the portfolio manager would be selling an illiquid asset at the most inopportune time, exacerbating the mark-to-market losses and crystallising the adverse impact on their balance sheets and solvency positions.
Recent examples of where such events happened were in Chinese property names and Russian corporates. The figure below shows this phenomenon at a broad level – the aqua blue line shows the rolling three-month realised volatility of US Treasuries (the world’s risk-free asset) and the navy blue line shows the same for EMD high-yield corporates (the riskiest segment of the EMD universe). The reader will notice that there are times where EMD high-yield asset volatility is lower than the risk-free asset – either this means that we are living in a new world where EMD high yield is the new risk-free asset, or this reflects the illiquid nature of the asset class. We can see it is the latter when we see what happens in moments of stress – in 2020, during the pandemic-induced selloff, EMD high-yield corporate volatility spiked from 1% (not a typo!) to 33% (also not a typo!) as investors were forced to sell illiquid assets into a stressed market.
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Conclusion: moving to the core
We believe insurance investors should concentrate in quasi-sovereigns and select large corporate issuers with strong fundamentals that provide liquidity on par with government bonds.
So, does this mean insurance investors should completely avoid EMD corporates in a buy-and-maintain portfolio? By no means – EMD corporates offer a rich vein of high-quality assets for yield-seeking investors to tap into.
One simple point to be mindful of is the liquidity risk. To mitigate this risk, we believe insurance investors should concentrate in quasi-sovereigns (i.e. government-owned corporates) and select large corporate issuers with strong fundamentals that provide liquidity on par with government bonds.
The figure below shows just how concentrated liquidity is in the top handful of issuers. These are the types of corporate issuers that one should target – high-quality names that offer a similar pickup in spreads to other issuers but offer higher liquidity premiums. An insurance investor can create a compelling buy-and-maintain portfolio by overlaying a select number of corporate issuers with a core holding of EMD government bonds that may offer an attractive yield pick-up relative to developed market assets with a similar risk profile.
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In our view, EMD assets may offer attractive investment opportunities for insurers, including attractive spread pick-up potential, diversification and liquidity. For life insurers seeking high-quality duration, EMD may complement DM fixed income in portfolios. As the asset class continues to grow and mature, we believe EMD should be considered a ‘core’ part of insurer’s public fixed income strategy.
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