Like a finely tuned, yet incessantly blaring marching band, the Federal Reserve continues its financial repression march. If your insurer is like most, the preferred scenario for rates is typically ‘slow, up’, meaning rates moving higher, consistently but slowly over time. However, this is unlikely in the present regime.
As Chrysler’s latest controversial ad says, it is halftime in America. Meanwhile, the marching band called ‘the Fed’ has entered the stadium and will continue to play, loud and long, a medley of tunes from the Financial Repression songbook. (It almost makes one pine for Madonna’s halftime show.) Until they finish their “prelude to an inflationary day” finale, do not expect to see a change from continued low rates for longer, in all its less than melodic variations.
What this all adds up to for insurers is plainly the largest investment challenge over the last thirty years. It is one thing when equity markets slump (most well managed firms realize that equities can easily sell of 20-30% in a given year, as we have occasionally seen in that period). However, it is another when fixed income market interest rates fall so low that they not only threaten product profitability but product viability.
With negative real US Treasury rates leading the way, insurers have few places to achieve adequate yields in the core fixed income universe. So, step 1 for successfully dealing with financial repression is to perform a few projections. First, project your company’s portfolio yield over several years, assuming no change in current market yields. Then, start ‘shocking’ the results, by assuming a 50, 100 or 150 basis point drop in market yields. The shorter the duration of your portfolio, the greater will be the drag of current yields on the portfolio’s yield.
We are reminded of the insurer who wanted to be conservative, so, over the years their long time investment manager had kept duration in the 1-3 year range, despite their predominantly long tail line of business. This is obviously a huge mismatch in interest rate risk, meaning what looked like a ‘conservative’ portfolio on a standalone basis was far from it when considering the entire enterprise. Now, faced with meager short term investment yields, and their (and their manager’s) lack of realizing the true riskiness of their so-called ‘conservative’ investment policy, they have an even more difficult decision to make: Do the right strategic thing (move the portfolio duration closer to the duration of reserves), or consider the decision in light of tactical considerations and their mark to market of assets (how low can rates go?). More on strategic versus tactical approaches later.
As we have been discussing for some time in various conferences and with our clients, there are basically four possible investment related responses (or some combination thereof) to financial repression:
1 – Change Risk Profile (credit, duration, liquidity, etc.)
2 – Use non-Core Fixed Income as a source of additional income
3 – Decrease Risk – waiting for more attractive yields
4 – Do Nothing substantially different
Even the ‘do nothing substantially different’ is a decision which should be carefully weighed. All of these options will be discussed in various levels of detail at our upcoming Insurer Investment Forum XII (I have been told rooms are going quickly.) However, let’s touch on a few of the responses to Financial Repression we’ve seen from that creative bunch known as investment managers.
We are starting to see managers propose different core fixed income asset classes (such as private placements or commercial mortgage loans) as well as various non-core fixed income classes. In the latter category, we’ve seen emerging market debt, high yield, bank loans, and non-agency residential mortgage backed securities (you know, the ones that some of us had to work to sell). And this is just a subset of what the managers are starting to talk to their clients about. (You can hear from at least two top tier managers about this subject – as well as your peers – in much more detail at the conference.)
In order to provide this subject sufficient attention, this blog entry is divided into two parts. In the second part, we will discuss more issues surrounding financial repression and successfully dealing with low for longer rates, including:
– Strategic v Tactical approach – When does it makes sense to change your portfolio risk profile and how can you determine if it might be worth the risk?
– Why your company’s risk appetite is oh so important and how to include this key attribute into your decisions about financial repression.