We spoke with AAM – Insurance Investment Management to discuss how volatility stemming from the effects of COVID-19 will continue to affect markets, and in turn, affect the investment portfolios of government risk pools.
Dan Byrnes, CFA
Senior Portfolio Manager
AAM – Insurance Investment Management | www.aamcompany.com/
SAA: Volatility has ebbed in the markets for now, but do you think volatility will stay subdued? How are you positioning portfolios considering your expectations?
AAM: Following the volatility in March and April, there has been a significant recovery in credit spreads. For example, the Option Adjusted Spread (OAS) on the Bloomberg Barclays Investment Grade Corporate Bond Index has rebounded from a high of 373 basis points in March to 150 basis points at the end of June. In July, the OAS has continued to fall. To put that in context, the OAS of the index was 102 basis points at the end of January. We have seen similar, though less dramatic, spread changes in other investment grade sectors. The Federal Reserve was critical in restoring order to the credit market with their rapid response early in the crisis, and we expect the Fed will remain highly accommodative to support functioning markets. However, the equity market seems to be pricing in a relatively quick economic rebound and possibly additional fiscal stimulus.
Our baseline expectation has been that the economy would not experience a “V-shaped” recovery. Our view has been that there will be a rebound in the second half of 2020, but it will take many quarters to fully recovery from the economic damage from COVID-19. Currently, new waves of COVID-19 in certain areas of the country and world are resulting in delays in re-opening economies or rolling back some re-opening steps that have been taken. These actions will very likely result in a more protracted recovery.
Also, as we approach the election in the Fall, it seems less likely that any further fiscal stimulus will be approved until after the election. In the meantime, we expect joblessness to remain elevated, small businesses to continue to close permanently, headline grabbing bankruptcies to persist and continued cautious consumer behavior.
As a result of all of this, we expect the market will experience more volatility in 2020, though not likely to the same extent as late March, 2020.
The most significant downside risk to our outlook is if a proven vaccine is not available by early to mid 2021 resulting in continued social distancing, reduced travel and consumer spending. This would likely result in a deeper recession with significant implications for the markets. On the upside, if a viable vaccine comes to market sooner than anticipated, the lasting damage to the economy should be muted. Other risks to our outlook include the possibility for additional fiscal stimulus sooner than expected, a more aggressively accommodative Federal Reserve, and the significant demand for investment grade debt by market participants globally keeping any volatility subdued.
Regarding portfolio positioning against this back drop, we are starting to reduce risk in client portfolios. In late March and April, we sold Treasury securities and Agency MBS to add spread sectors to portfolios, taking advantage of spread widening. With the rapid tightening of spreads recently and our expectation of future volatility, we are again rebuilding positions in liquid, high quality sectors such as Agency MBS Passthroughs and US Treasuries. We are doing so by selectively reducing portfolio exposures to spread sectors.
Beyond sector themes, 2020 is a year where credit research becomes even more important. As the pandemic continues to unfold, different industries and different credits will be impacted differently. It will be important for portfolio managers to actively manage credit exposure throughout the balance of this cycle to ensure pricing volatility in portfolios is temporary and does not transform into a permanent loss.
SAA: With the Fed supporting the markets through extremely low interest rates again, are there any concerns specific to risk pools?
AAM: As you note, the Federal Reserve was instrumental in quickly returning calm to the markets in April. They were able to respond with the menu of programs they created in 2008, they added a few new programs, and continue to explore other programs to support the market.
The most impactful tool in their toolkit has always been their ability to impact interest rates by changing the Federal Funds rate. The Fed Funds rate most directly impacts short Treasury yields and rates earned on savings accounts and other short term instruments like money market funds. The Federal Reserve cut the Fed Funds rate to a target range of 0.0% – 0.25% and recently issued their Dot Plot indicating they do not expect to increase the Fed Funds rate until after 2022.
Most savers are likely aware that the rate they can earn on their ultra-safe money market accounts is just above 0.0%. While this is painful for all investors, the timing of the Fed’s rate cut is likely hitting Risk Pools at a difficult time. For many pools, especially Property/Liability and Workers’ Compensation programs, annual contributions are paid around June 30 every year. The contributions are then used to pay claims and expenses throughout the year, with some of the funds invested in the pools’ long term investment programs. Until recently, pools could invest some of the proceeds longer term, and hold cash in liquid accounts while still earning some income.
In the current environment, pools are faced with a more difficult decision regarding cash. They can hold the contributions in liquid accounts and effectively earn nothing, or they can invest longer term and sell securities as cash needs arise throughout the fiscal year. If Risk Pools choose the former option, investment income, which is already going to be diminished in 2020, will be further negatively impacted. If they choose the latter option, Risk Pools risk selling securities into a period of volatility, resulting in poor prices and higher transaction costs.
We have started to work with pools to build a very short term portfolio strategy distinct from the core portfolio. We invest in high quality, very short maturity, liquid securities that earn a spread over Treasuries and money markets. The securities are a bullet structure to avoid cash flow variability. For the risk pool portfolios where we have implemented this approach since the Fed cut the Fed Funds rate, we have been able to increase book yield compared to the pools’ money market, but also provide a degree of confidence that cash will be available when needed.
For Health pools, contributions are usually more consistent throughout the year to align better with cash flow requirements. The money market challenge is not as acute for Health pools as a result. However, Health pools do generally have shorter duration bond portfolios. With the Fed expecting to be on hold through 2022, shorter interest rates will likely prevail for years. As the shorter securities in the Health portfolios mature, pools will likely be forced to invest in a lower interest rate environment. As a result, we expect the investment income deterioration that will occur across the Pooling landscape will be more rapid for the Health pools in the coming two years.
While nothing in this answer is really very positive, it is important to keep in mind that the goal of very low interest rates is to spur growth and hopefully shorten the time to recovery. In my opinion, the Federal Reserve has done a good job of reacting to the turmoil, and we expect they will do everything normalize their policies when the economy has recovered.
Source: Strategic Asset Alliance, AAM – Insurance Investment Management
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