Investment grade corporate debt is yielding up to 7% compared to 1% for government bonds. William Rhode looks at fixed income instruments that are attracting re-insurers in a credit stricken world.
In his annual letter to shareholders in February, Warren Buffett wrote: “The investment world has gone from underpricing risk to overpricing it. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds, even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms.” For reinsurers, with their heavy emphasis on investment to bolster earnings, the words of the Sage of Omaha could not be more poignant.
Nick Johnson an analyst at Numis Securities, covering insurance and reinsurance companies in London, says investment returns usually contribute up to half the earnings profile for insurance and reinsurance companies. The quandary now, he says, is whether to continue with the same emphasis – and a higher risk profile - or accept lower earnings. “It’s not a pleasant choice to make.”
After AIG’s collapse, the largest ever loss in US corporate history, and a number of reinsurers’ earnings dragged into the red by poor investments, many are erring on the side of caution. In a fourth quarter earnings call in February, David Greenfield, CFO at Axis Capital Holdings, told analysts: “We continue to undertake actions to de-risk our investment portfolio. Specifically, we increased our cash and cash equivalents balance by more than $400m in the quarter while substantially reducing our exposure to municipal securities within our fixed maturity investment portfolio.”
But ultra conservative investment strategies can only take you so far. Buffett wrote: “Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear
commentators proclaim ‘cash is king’, even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.”
Which is why many reinsurers are finding appeal in the investment grade corporate bond market, where yields can reach between 6% to 8%.
Christophe Boizard, CFO at Paris Re, says that his company has been building up a large portfolio in corporate bonds since the beginning of last year, reducing its cash allocation reserves to their minimum of 5% out of a $5bn portfolio. Two years ago Paris Re sold out of equities and got out of structured investments at a 1% loss. Government & Agency bonds (representing half of the portfolio) and corporate bonds (37% of the portfolio) have since made up the mainstays of its investment strategy and, he says, will deliver a 4.5% return on its portfolio for 2008. “Corporate debt yields are a simple but brilliant solution to our problem of performance in a terrible credit environment.”
Johnson agrees that corporate debt is a good option – “the returns are very attractive to reinsurers”.
In the year end results announced in February, Andy Haste, CEO of RSA wrote: “In 2008, we took a number of actions to enhance yield on the bond portfolio, including
selling low yielding government bonds and reinvesting at longer duration to take advantage of higher yields…. In 2009, we will continue to be a cautious purchaser of high quality non-government credit and selectively extend duration.”
Mark ten Hove, group general manager of investments at QBE, says: “We think that, selectively, corporate credits look attractive and – generally speaking – government paper looks expensive.” Reinsurers tend to purchase high quality shorter duration assets, implementing a buy and hold policy that aim to see the bonds redeem at par. Hove says that QBE has a short duration fixed income strategy with strong focus on the quality of the portfolio. It also has strict investment guidelines – a
minimum of 75% in Aa3 or above and a minimum of 95% in A3 or better.
Boizard says Paris Re has a short duration portfolio of around three years. “We seek to hold the bonds to maturity and are not overly concerned with mark-to-market (MTM) valuations since we anticipate redeeming the bonds at par at maturity.”
But some say that while buy and hold strategies might look like they can get around illiquidity in the secondary market and the possibility of realised losses, MTM valuations still play an important role in fixed income portfolio valuations.
Johnson: “Even if you aim to hold to maturity, MTM valuations still matter. MTM losses can lead to increased regulatory capital requirements – and even credit rating problems for reinsurers – so it’s important that they make the right investments.”
All investors take seriously the spectre of default risk. Rating agency Moody’s has predicted that the global default rate among speculative grade corporate bonds, which have low credit ratings, will jump to 15% this year, compared with 4% in 2008. According to a separate report from Standard & Poor’s, released in January, companies started the first three full weeks of this year defaulting at a rate of nearly one per business day.
“There is a big risk of downgrade and default,” says David Astor, chief investment officer at Hiscox. “A triple-B downgrade would translate into a massive mark-to-market hit.” Hiscox itself does not have many BBB bonds. “We recognise that investment yields are important but 2008 was not a normal year, and 2009 is shaping up to be another extraordinary year. The emphasis is still of de-risking the portfolio instead of returns.”
That means highly leveraged, structured securities remain off limits to many. “We would not touch structured securities right now,” says Boizard. “They are pure evil. They are just so risky and illiquid. You simply can’t get out of them in case of a problem. They have absolute zero appeal at this moment.
We are even reluctant to invest in asset-backed securitisations except if they have a state guarantee.”
But some say that they would consider investing in structured securities, if the product was the right one.
Hove says that QBE does invest in structured securities but they make up less than 0.5% of the total portfolio. The company is selective and will only buy securities denominated in Australian dollars “where we can see the quality of the underlying security”.
Adds Hiscox’s Astor: “Even though we are conservative right now, our minds are still open to structured securities. We aren’t selling what we have and we will invest in the assets again. Our attitude is never say never.”
The key is timing as Richard Hextall, group finance director at Amlin, explained to shareholders in the firm’s annual report: “Last year, the credit portfolio expanded a little in proportionate terms but we were right not to push into this area too early. We were also cogniscent of the illiquidity of the non government portfolio – in our view it is important that clients do not become concerned about the cash flow characteristics of the asset side of the balance sheet, even if long term the investment value is compelling.”
And so it seems that, for the time being, reinsurers are setting to one side of Warren Buffet’s advice in favour of another line from his note to shareholders: “When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”
William Rhode is a freelance journalist.