Sean Conaghan, NEAM, spoke at the Insurer Investment Forum XVIII to share their investment views, including commentary on portfolio positioning, fixed income sectors, and the possible implications of a reversal in central bank policy. We spoke with Sean again to discuss the various updates and changes that occurred since March.
SAA: You said in March that you expected solid economic growth in the near term, with U.S. real GDP growth of approximately 3% in 2018.
Do you continue to have a similar outlook for U.S. growth despite various geopolitical developments and headlines over the past few months?
SC: Yes, we continue to expect U.S. real GDP growth of close to 3% in 2018. Recent U.S. economic indicators have been positive, and we do not expect challenges in certain emerging markets, political uncertainty in Europe, or other geopolitical events to derail U.S. growth in the near term. We do, however, expect growth to slow in 2019 as fiscal stimulus fades and higher interest rates start to weigh on parts of the economy, with the odds of a recession increasing as we move through 2019 and into 2020.
SAA: Some commentators have debated how much longer this expansion might continue. At the Forum, you had alluded to late cycle indications and some signs of excess in the capital markets.
Where do you think the greatest vulnerabilities might emerge when the cycle does turn?
SC: Identifying the epicenter of a future dislocation is, of course, always challenging. For instance, high levels of capital spending and increasing levels of debt were among the warning signs in the energy sector prior to the recent downturn, but OPEC’s decision to temporarily abandon its position as the swing producer in the market (a development that was more difficult to predict in advance) was also an important catalyst.
Having said that, we are seeing some signs of excess in various parts of the credit markets and are positioning our portfolios to be able to weather a downturn, whenever one does materialize.
The growth of BBB rated corporate debt has recently garnered some headlines. We have pointed out the growth of BBB- rated debt specifically, and we believe that added leverage leaves many non-financial corporate issuers with less margin for error in a downturn. We are also seeing increasing risks in parts of the structured credit markets. For instance, subprime auto loan underwriting remains aggressive while we are seeing increasing percentages of interest only loans within CMBS deals and a slowing in the pace of increase in properties’ net operating income.
However, given post-crisis trends in debt levels, we think the greatest vulnerabilities might emerge in parts of the corporate market where the ability to shoulder higher levels of debt could be tested by industry evolutions.
SAA: During the conference you said that as the Fed raised rates, you were thinking about risks to the mutual fund / ETF inflows and foreign purchases that had contributed to very strong demand for U.S. dollar corporate bonds in previous quarters.
Can you comment on recent demand for USD corporate bonds and your outlook for the sector?
SC: Rising front end U.S. dollar rates appear to be eroding some of the demand for USD corporate bonds that had been very consistent in 2017.
Mutual funds and ETFs that invest in high grade corporate bonds continue to receive inflows. However, we believe that the pace of these fund inflows has declined. We expect the higher rates available on money market funds and other alternatives (as well as negative total returns in recent months for bond funds) to result in fund inflows that remain below the levels that we saw in 2017.
We also expect foreign demand to remain more subdued. Higher front end USD rates have led to higher hedging costs for some foreign investors. Anecdotally, we understand that some foreign investors continue to add USD corporate bonds, but some sellers have also emerged. In fact, Federal Reserve data suggests that foreign investors may have slightly reduced their holdings of U.S. corporate bonds in the 1st quarter of 2018 (after this Fed data showed foreign investors adding over $300 billion of U.S. corporate bonds in 2017).
While funds and foreign investors may continue to add USD corporate bonds in 2018, we do not expect a return to the overwhelming level of demand that we observed in 2017. The access that some issuers now have to overseas cash via deemed repatriation could, depending on M&A funding supply, result in lower issuance this year. Though lower issuance could serve as an offset to reduced demand, we nevertheless expect a more balanced supply and demand equation in the corporate market this year. Given still elevated leverage for many issuers and valuations that remain toward the tighter end of longer term ranges, we continue to have a cautious outlook and would maintain a higher quality bias within our corporate portfolios.
SAA: In March, you discussed the impact of tax reform on municipal bond demand. Can you share any observations from the past few months about demand from banks, P&C insurers, life insurers, or other investors?
SC: A number of larger banks and property & casualty insurers have sold municipal bonds in 2018 following the passage of tax reform. However, demand from individual investors and very modest issuance so far this year have outweighed the decline in bank and P&C insurance involvement in the market. We have heard a few anecdotes regarding life insurance participation in the market, but have yet to see evidence of life insurers meaningfully adding to tax-exempt securities following the passage of tax reform.
Federal Reserve data released in June showed a 0.5% contraction in the municipal bond market during the 1st quarter of 2018. Notably, banks shed 2.8% of their muni holdings during the quarter. We were surprised to see that, at least according to this data, the overall holdings of P&C insurance companies were unchanged. Finally, the Fed data suggests that life insurers were net buyers on the margin.
SAA: How have municipal bonds performed so far this year?
SC: Municipal bonds have performed very well relative to other fixed income asset classes so far this year. Through the first five months of the year, the ICE BofAML US Municipal Securities Index has produced a total return of -0.4%, which compares to the -2.6% return of the ICE BofAML US Corporate Index. In addition to benefitting from limited issuance, municipal performance (relative to corporate bonds) has been bolstered by, among other factors, more limited sensitivity to geopolitical events and a lack of exposure to M&A activity.
SAA: Your presentation highlighted the array of assets across the structured securities universe that might allow insurers to accept other types of risks (complexity and illiquidity, for instance) while diversifying away from corporate bonds and managing credit risk.
Can you comment on your current view of some of the more esoteric asset backed securities?
SC: In general, we believe that an allocation to structured securities can be an important way to add diversity to a portfolio. Structured securities allow insurers to accept risks associated with complexity and illiquidity, allowing insurers to diversify and manage credit risk without sacrificing yield. However, we believe that security selection within the structured securities market is becoming increasingly important given weaker underwriting trends for some underlying loans, less favorable structures (for investors) in some transactions, and diminishing incremental spread for some non-traditional asset types.
We continue to believe that some security types, such as the AAA and AA rated tranches of CLOs, are attractive. However, we have become less active in some more esoteric sub-sectors, such as whole business securitizations and aircraft securitizations, as spreads have compressed relative to alternatives in the corporate bond market.
Source: Strategic Asset Alliance, New England Asset Management
The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.