An Insurers’ Guide to Below-Investment Grade Exposure: The Platform Approach

Exploring the advantages of a broad platform approach to fixed income and credit for insurance company investors.

Insurance companies have been broadening their below-investment grade allocations to include loans and tranches of collateralized debt obligations (CLOs) alongside high yield bonds. This has clear advantages, providing greater degrees of freedom with which to tailor portfolio yield, duration and credit quality to investment objectives. However, many still allocate only to local markets, and most allocate to asset class-defined silos benchmarked against traditional market indices. In this paper, we argue that many of the advantages of a broader credit universe are realized only when investors take a “platform” approach, breaking down the silos and considering all asset classes, regions, currencies and access routes through the same fundamental lens, unconstrained by traditional market index benchmarks. We call this “thinking like an issuer”: corporate treasurers will tap into different credit markets to get the best deal from their perspective, and investors ought to do the same.

Executive Summary

  • Insurance companies have grown their exposure to below-investment grade credit during a decade of benign default rates.
  • Our central scenario is for a soft landing for the economy; nonetheless, we are entering the later stages of a cycle that is likely to see increasing default activity, but more importantly, lower recoveries than historical averages.
  • This increases the challenges of credit investing and raises some key questions for insurers:
    • Should insurance companies hold below-investment grade credit primarily for income or total return, and can a broader universe help to achieve their goals?
    • Is it better to allocate to below-investment grade sectors in separate silos so that a portfolio manager can focus entirely on a single asset class, or are there benefits to managing portfolios with the flexibility to allocate across the spectrum of bonds, loans, CLOs and other asset classes?
    • What are the risks associated with the traditional focus on generating alpha measured against a standard market benchmark?
  • We show that broadening the below-investment grade credit universe brings greater degrees of freedom with which to tailor portfolio yield, duration and credit quality.
  • We argue that investors should go further and adopt a “platform” approach: breaking down the silos and considering all asset classes, regions, currencies and access routes through the same fundamental lens.
  • We call this “thinking like an issuer”: corporate treasurers will tap into different credit markets to get the best deal from their perspective, and investors ought to do the same.
    • Why allocate to a highly leveraged, B rated loan when a USD-hedged, BB rated EUR-denominated bond from a less leveraged issuer offers the same yield?
    • Why force capital to B or CCC rated bonds if a more reliable yield exists from BBB and BB rated CLO mezzanine debt?
  • Breaking down the asset-class silos also breaks an investor away from traditional market-index benchmarks: it focuses an investor on its own risk profile and credit fundamentals rather than on tracking-error risk, which, particularly as a cycle matures and credits begin to deteriorate, should mitigate forced exposure to weak credits.
  • Customized benchmarks and the platform approach to credit markets are a challenge to governance: insurers need to get the most out of their experienced credit portfolio management partners in order to realize the benefit.

An Investment Universe That Is Diverse in Yield, Duration and Quality

Size of bubble is proportional to universe size

Source: JPMorgan, ICE Bank of America Merrill Lynch, S&P Capital IQ LCD.

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The ICE BofAML U.S. High Yield Index tracks the performance of below investment grade, but not in default, U.S. dollar-denominated corporate bonds publicly issued in the US domestic market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P.

The ICE BofAML 0-5 year U.S. High Yield Constrained Index tracks the performance of short-term U.S. dollar-denominated, below-investment grade corporate debt issued in the U.S. domestic market with less than five years remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $250 million, issued publicly.

The ICE BofAML Euro High Yield Index tracks the performance of below investment grade, but not in default, euro-denominated corporate bonds, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P.

The S&P/LSTA Leveraged Loan Index is designed to measure the performance of the U.S. senior loan market.

The S&P/LSTA European Leveraged Loan Index is designed to measure the performance of the European senior loan market.

The J.P. Morgan CLO Index tracks floating-rate CLO securities in 2004–present vintages, indexing them on a market-value weighted basis.

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