Inverting Expectations in a Low-Rate World

Fixed Income Investment Outlook 1Q2018

Our Fixed Income Investment Strategy Committee examines the drivers of the flat yield curve and explores how insurance companies are addressing persistently low rates.

Historically an inverted yield curve—in which short-dated U.S. Treasury securities offer higher yields than longer-dated ones—has been a harbinger of recession. With the spread between short- and long-dated Treasuries currently at 10-year lows, many are concerned that the end of the long-lived economic cycle may be near.

Despite this red flag, however, we don’t believe a contraction in economic activity is likely in the near future, and the yield curve should steepen later in 2018. Rates overall will remain low, however, and the global search for yield will persist. To illustrate how institutions are looking beyond their traditional comfort zones, we review recent asset allocation trends among insurance companies.

The conventional wisdom suggests that an inverted yield curve heralds recession. In fact, the Treasury yield curve has inverted prior to the previous seven economic contractions, going as far back as the 1960s. As we’ve seen in recent years, however, unconventional monetary policy coming out of the Great Recession has resulted in any number of distortions in the markets—including, we would argue, the predictive value of an inverted Treasury curve.

The spread between the yields offered on 10-year and 2-year Treasuries stood at 64 basis points on November 30, down sharply from the 121 basis points that separated the two maturities at the start of 2017 as spreads in recent weeks have tightened to the narrowest levels in more than 10 years. This is primarily a function of the steady climb of short rates in conjunction with Fed tightening, as the 10-year has been mostly range-bound throughout 2017. That said, current spread levels are emblematic of a flattening trend we’ve seen since early 2014 (depicted in Figure 1); should this trend persist, it’s not too difficult to foresee an inverted yield curve in 2018. We don’t expect a recession next year, however, despite the slope of the curve.

After it has delivered so many correct calls, why do we now doubt the prognostication ability of the Treasury market’s Cassandra? Mostly because of what’s driving the yield curve’s flatness this time around. While the traditional determinants of longer-term interest rates are playing a role in keeping long yields anchored, there are also some temporary idiosyncratic factors at play that we expect to ease in the coming year.

The Fed’s slow-and-steady approach to the normalization of its target fed funds rate—the 25 bp hike in December brought the upper bound of its target range to 1.50%—has successfully pushed up the short end of the curve, which is most sensitive to Fed monetary policy actions. Longer-term rates, in contrast, tend to be more nuanced.

Figure 1. The U.S. Yield Curve Has Been Flattening Steadily Since 2014

10-year Treasury Constant Maturity Minus 2-year Treasury Constant Maturity, as of November 30, 2017

Source: Federal Reserve Bank of St. Louis.

We think there are three key dynamics keeping long-dated U.S. paper in check despite improving economic growth metrics: persistently low inflation, the global rate tether and the divergence between the market and the Fed in their estimates of the federal funds terminal rate.

Persistently low inflation. As inflation and corresponding expectations continue to be moribund, there’s little upward pressure on long rates. Core personal consumption expenditures—the Fed’s preferred inflation metric, which excludes food and energy prices—have consistently undershot the central bank’s 2% target for more than five years and counting. After flirting with the Fed’s bogey in late 2016 and early 2017, core PCE has settled into a lower range, as shown in Figure 2; the October reading came in at 1.4%, consistent with the levels seen in recent months. This all comes despite falling unemployment and a pickup in economic activity, leaving many observers—including the Fed—looking for explanations.

With the Fed raising its policy rate in the face of falling inflation, markets are inclined to believe that the central bank is front-loading the rate hikes in this tightening cycle, which has further contained inflation expectations. While we tend to agree that this is the Fed’s strategy, we think higher levels of inflation will re-emerge, potentially later in 2018, as excess liquidity is slowly drained from the global financial system while the economy continues to perform reasonably well.

Global rate tether. Put simply, today’s Treasury curve is not what it was 20 or 30 years ago. The increasing interconnectedness of global markets and economies has taken care of that. No central bank—not even the highly influential Fed—exists in a vacuum. In fact, we think the most important force determining the yield on the 10-year U.S. Treasury bill these days is the prevailing 10-year rate around the world. Continued highly accommodative policy by non-U.S. central banks, notably the European Central Bank and the Bank of Japan, has dampened longer rates in those regions, effectively exporting lower yields to the United States by stoking demand for relatively higher-yielding U.S. Treasuries. For example, while the 10-year U.S. Treasury was yielding 2.42% as of November 30, German bunds and Japanese government bonds of that same maturity stood at 0.37% and 0.04%, respectively.

This pronounced divergence in policy among the major developed market central banks may be nearing its end, however. With the European economy finally showing signs of sustainable momentum, the ECB plans to cut its monthly bond purchases in half beginning in January, though the program will continue until at least September and its policy rate is slated to remain at zero until the QE tap runs dry. The BOJ likely will be slower to move off its key rejuvenation efforts—which include a negative policy rate and “yield curve control” in which it buys JGBs at the level necessary to keep the yield on its 10-year notes pegged to zero—given its multi-decades-long battle against deflation, though there are reasons to believe the BOJ’s commitment to these policies may begin to wane in 2018. Most prominently, it will become increasingly difficult for the BOJ to defend open-ended stimulus measures as the Fed and ECB are heading in the opposite direction.

Terminal-rate disconnect. The terminal rate has been a source of great disconnect between the market and the Fed. The terminal rate—also known as the natural, neutral or equilibrium rate—reflects an inflation-adjusted federal funds target rate that results in an economy with full employment, trend-level growth and stable prices; that is, an economy that needs neither stimulation to help its reach its potential nor dampening to prevent it from overheating. From a practical standpoint, the terminal rate is the rate at which the Fed will discontinue the hiking cycle. The Fed’s estimate of the terminal rate—as represented by the median of Fed governors’ longer-run projections for the fed funds rate (i.e., the “dot plot”)—has fallen steadily over recent years (see Figure 3) as inflation failed to emerge and economic growth remained modest. Rather than manage market expectations as it’s intended to do, the dot plot in recent years has had to chase the market, whose outlook for the terminal rate was much less optimistic than that of the central bank.

Figure 2. Core PCE Has Shifted Lower in Recent Months

As of November 30, 2017

Source: U.S. Bureau of Economic Analysis.

Figure 3. The Fed’s Estimate of the Terminal Fed Funds Rate Has Fallen Steadily

FOMC Median of Longer-Run Fed Funds Projections, as of November 30, 2017

Source: Bloomberg.

Lack of faith in the Fed’s projections has had a dampening effect on longer-term interest rates. However, given the market’s reticence to take the Fed’s lead in terms of interest rate expectations, it’s conceivable that the market currently is undershooting the terminal rate. If and when inflation starts rising and the global rate tether lessens, market pricing may need to adjust more rapidly to a new equilibrium. However, the length of this process could prove frustrating for investors looking for more attractive yields sooner rather than later.

Looking ahead to 2018, we expect the Treasury yield curve to continue to flatten in the near term before beginning to steepen later in the year. We think it’s quite possible that the Fed hits the pause button on its rate-hike cycle at some point in 2018, likely after two hikes in the first half of the year to bring the fed funds rate up to 2%. There are a few reasons for this. First, the Fed does not want to get too far ahead of its compatriots at the ECB and BOJ, even as they lean toward tightening cycles of their own. Second, the central bank likely will want to avoid becoming a talking point in the contentious midterm elections that are coming up in November. And finally, we suspect that data hurdle for justifying additional hikes will get higher as the Fed approaches its current 2.75% terminal rate estimate; the central bank is going to be very careful about firing its last bullets.

How Insurance Companies are Adapting to Low Yields

Taking into consideration our perspective above, interest rates across the curve are expected to remain well below historical levels in 2018 and beyond, in keeping with post-crisis trends. As such, the search for yield will continue to drive investors toward creative fixed income solutions and into corners of the financial markets to which exposures have been limited or even nonexistent.

Take, for example, insurance companies, which represent more than $30 trillion of investible assets globally. We estimate that around 80% of that—or $24 trillion—is invested primarily across fixed income markets; the sheer magnitude of global insurers’ presence has a meaningful influence on the direction and behavior of fixed income markets. Given the rigors of regulatory criteria and capital standards designed to protect policyholders, it’s not surprising that the vast majority of insurers’ fixed income exposure is targeted toward investment grade securities, ranging from government bonds to corporate credit, mortgages and asset-backed securities. With a significant bias to these markets, the insurance industry is acutely concerned about the direction of interest rates, market yields and the length of the business cycle.

With persistently low yields and ever-evolving global regulatory standards, insurance companies are continually tasked with identifying creative solutions in an effort to support their liabilities and contribute to overall profitability. While data tracking the investment allocations of insurers has yet to register any significant shifts in strategy of late, our discussions with insurance clients suggest that more and more are considering a wider array of investment solutions as they seek to use their capital more efficiently through improved asset liability management. Insurers of all types and geographies are considering how to supplement their capital-friendly corporate and government bond-heavy portfolios with larger helpings of fixed income strategies like emerging market debt, municipal bonds, collateralized loan obligations and private residential whole loans.

Emerging markets debt. Interest in emerging markets debt among our insurance clients across geographies and business lines continues to grow, which is encouraging given that insurance companies as a whole are underexposed to this asset class. Even those life and P&C insurers with the largest allocations to EMD as a percentage of their portfolios had investments of only 3.4% and 2.1%, respectively, as of end-2016, and the industry as a whole averages far less than that. Within these allocations, much of the exposure is highly concentrated and not representative of a true diversified allocation to the asset class.

Figure 4. EMD Delivers a Compelling Risk/Return Profile

January 1, 2003, through October 31, 2017

Source: J.P. Morgan.
Note: EMD Hard Currency = JPM EMBI Global Diversified; EMD Corporates = JPM CEMBI Diversified; EMD Local Currency = JPM GBI-EM Global Diversified; EMD Short Duration = JPM EMBI Global Diversified 1 –3yr and JPM CEMBI Diversified 1 –3yr; EMD Blend = 25% EMD Hard Currency/25% EMD Corporates/50% EMD Local Currency; U.S. Corp IG = Barclays U.S. Agg Corporate Index; Leveraged Loans = Credit Suisse Leveraged Loan ; Global Agg (Unhedged) = Barclays Global Agg Total Return Index Unhedged; U.S. Corp HY = Unhedged Barclays U.S. Corporate High Yield; U.S. Treasury = U.S. Benchmark 10-Year Datastream Government Index.

Given its evolution over the years, EMD has been accepted as a strategic allocation by institutional investors of all kinds. The EMD market has grown significantly over the past decade, more than tripling in market capitalization to exceed $3.5 trillion today. A large part of this growth has been concentrated in local-currency government debt, which is an important trend because it has helped transform emerging market economies and their ability to manage currency reserves, thus making them more stable. In addition, the embrace of macro-prudential policies in these economies has helped push down borrowing costs. Combined, these dynamics afford emerging market issuers greater flexibility and provide policymakers with the tools needed to manage down cycles more effectively. The byproduct of this market evolution is a growth in investor confidence and in the role EMD should play within asset allocations.

The potential for additional return that EMD historically has provided relative to traditional fixed income asset classes, depicted in Figure 4, paints a compelling picture for insurers, particularly those considering how to diversify away from U.S. credit markets. Local-currency exposure tends to appeal to investors with higher expected returns over a longer investment horizon. EMD hard-currency sovereigns and corporates may present an interesting alternative to U.S. high yield given expected growth trends. Short-duration EMD presents an insurance capital-friendly yield alternative that can fit neatly into a wide variety of risk cultures.

Ratings quality should be noted as another important factor impacting insurance allocations; currently, the J.P. Morgan EMBI Global Diversified Index, which tracks hard-currency government bonds, is tilted toward investment grade ratings. Given the overall yield benefits associated with EMD, insurance investors today have the ability to take on exposure to investment grade issuance to tailor their capital usage.

Municipal bonds. At more than $3.8 trillion, the U.S. municipal bond market is one of the largest sectors within the global fixed income investment universe. Municipals long have been a staple of U.S. insurance company portfolios, contributing tax efficiency in the case of P&C companies and providing a source of highly rated yield and duration to support asset/liability management for life companies. Though long overlooked in Europe, insurers there have become increasingly aware of the muni market’s appealing characteristics and—with the emergence of Solvency II—the favorable capital treatment certain types of municipal securities offer.

While municipal debt issuance tends to be thought of as intermediate-maturity financing, issuance exists across the entire curve; in fact, longer-dated issuance is easier to access than the belly of the curve. Notably, these maturities are available to investors via high-quality bonds; more than 85% of the municipal market is rated single A or higher. The default rate of municipal bonds is substantially lower than that of corporate bonds, as munis are not exposed to the corporate action and M&A risk that exists in the corporate market (as shown in Figure 5), and recovery rates also have tended to favor municipals over equivalently rated corporate bonds.

This quality profile is one important reason why U.S. taxable municipal bonds are so attractive for investors regulated under Solvency II, as it helps to limit the solvency capital charge levied against them when they are held as assets against regulated insurers’ liabilities. By far the biggest positive impact on the solvency capital charge, however, is the fact that the capital charge against infrastructure investments under Solvency II is expected to be around 30% lower than the capital charge against corporate bonds with an equivalent risk profile, as long as the projects concerned are within the OECD—meaning that most U.S. taxable municipal revenue bonds would qualify.

It’s worth noting that the somewhat insular marketplace for munis creates a complexity that may be unfamiliar to investors more accustomed to the relative ease of access inherent in the investment grade bond or even the high yield bond and loan markets. Moreover, the relative illiquidity of the municipal bond market can make it challenging for investors lacking an extensive network of dealer relationships to create well-diversified municipal bond portfolios.

Collateralized loan obligations. Insurance companies often turn to CLOs as a source of income typically offering yields above comparably rated corporate debt. A securitized portfolio of leveraged loans, CLOs are structured as a series of tranches offering investors various risk/return profiles based on subordination and credit rating. After drying up in the aftermath of the financial crisis, CLO activity has rebounded steadily over the past seven years. According to the Loan Syndications and Trading Association (LSTA), 2017 was the second most active year on record in terms of U.S. CLO issuance, while the volume of CLO refinancings and resets has already set a new all-time high this year. And there has been ample demand for this supply from all types of yield-hungry institutions, sending spreads on CLOs across tranches to post-crisis lows.

As floating-rate instruments, CLOs provide a combination of relatively high income potential with low duration and relatively stable prices. In addition, purchasers of senior CLO tranches—typically where insurance companies position themselves—are exposed to less credit risk, as their seniority results in lower expected losses compared to other tranches of the CLO. In fact, the LSTA reports that AAA- and AA-rated CLO notes have never suffered a default and that the default rate on BB-rated issues is only about 2%.

Burnishing the appeal of CLOs in recent years has been the adoption of new regulations in response to the financial crisis. The Volcker Rule dictates that CLOs vintage 2014 and beyond are capitalized only with loans (pre-crisis, high yield bonds were also included in CLO pools). More recently, Dodd-Frank mandates that CLO managers must maintain some “skin in the game” by retaining 5% of the CLO’s original value and thus aligning their interests more closely with those of their investors.

Private residential whole loans. We are seeing insurers seek out opportunities in less-liquid corners of the market as well, including private residential whole loans. This market could be best characterized as “Alt-A 2.0,” though it can be challenging to access. While borrowers in this cohort tend to be self-employed, underwriting quality has improved greatly post-crisis given regulatory enhancement and standards in part related to Dodd-Frank.

A nascent but growing market, residential whole loans allow investors to exploit the capital gap in U.S. housing finance that emerged in the wake of the 2008 financial crisis. While consumer and housing market fundamentals have improved significantly in the years following the crisis, mortgage lending remains constrained as private capital has not returned in full. Banks have exited many residential finance markets to comply with changing risk and regulatory regimes; as a result, government-related mortgage origination now accounts for the bulk of the market.

Figure 5. Muni Bond Default Rates are Much Lower Than Those of Equally Rated Corporates

Source: Moody’s Investor Service.

By building a diversified portfolio of high-quality performing loans sourced from qualified mortgage originators, investors potentially can generate attractive risk-adjusted yields superior to those being offered by public markets, where investment opportunities are limited and spreads are near all-time tights. Moreover, investment in residential whole loans can serve as an effective replacement to the shrinking availability of securities in the non-agency market, which historically has been a staple holding of insurance portfolios.

Impact of Solvency II on Insurance Investment

Insurance companies today face more stringent risk management and solvency requirements. While this is particularly true for those insurers subject to the European Union’s Solvency II Directive, which finally came into force in January 2016, this regulation also has exerted a strong influence on the capital-adequacy rules employed in the U.S., Australia, South Africa, Japan, China and beyond. These rules introduce risk-based capital principles for investments that are not dissimilar to those proposed for banks under the Basel III accord.

Solvency II carried stringent capital requirements for investments in private and public equities, hedge funds and low-rated corporate bonds challenging for insurers; for example, a Solvency II-regulated insurer must now hold capital worth 49% of the value of a new private equity investment.

Solvency II’s treatment of lending is more forgiving, however. Securitizations were initially set to incur punitive capital charges, even for highly rated senior paper, but the asset class was eventually split into higher-quality “Type 1” and lesser-quality “Type 2” securities for the purposes of calculating capital-adequacy treatment. Private loans are treated as fixed income, which is generally favored with lower capital requirements. From an economic perspective, insurers generally like illiquid paper, as they are well positioned to harvest illiquidity premiums by exploiting the long-term nature of their liabilities.

 

Market Outlook

Sector views from our Fixed Income Investment Strategy Committee.

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Fixed Income Investment Strategy Committee Members

Brad Tank | Biography
Chief Investment Officer, Global Head of Fixed Income

Thanos Bardas, PhD | Biography
Head of Global Rates

Ashok K. Bhatia, CFA | Biography
Senior Portfolio Manager, Multi-Sector

David M. Brown, CFA | Biography
Head of Investment Grade Credit

Rob Drijkoningen | Biography
Co-Head of Emerging Markets Debt

Patrick H. Flynn, CFA | Biography
Senior Portfolio Manager, Non-Investment Grade Fixed Income

Terrence J. Glomski | Biography
Head of Residential Finance

James L. Iselin | Biography
Head of Municipal Fixed Income

Andrew A. Johnson | Biography
Head of Global Investment Grade Fixed Income

Jon Jonsson | Biography
Senior Portfolio Manager, Global Fixed Income

Ugo Lancioni | Biography
Head of Global Currency

Julian Marks, CFA | Biography
Senior Portfolio Manager, Investment Grade Credit

Thomas J. Marthaler, CFA | Biography
Senior Portfolio Manager, Multi-Sector

Thomas P. O’Reilly, CFA | Biography
Head of Non-Investment Grade Fixed Income

Jason Pratt | Biography
Head of Insurance Fixed Income

Thomas A. Sontag | Biography
Head of Global Securitized and Structured Products

Gorky Urquieta | Biography
Co-Head of Emerging Markets Debt

Ronit Walny, CFA | Biography
Senior Portfolio Manager, Multi-Sector

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