Risk Pool Investment Considerations for the Near Term (2nd Half - 2023)
We spoke with AAM to discuss where gov't risk pools' short-term focus should be as they review their investment portfolios. This includes what to communicate to their investment manager and balancing the short-term strategies vs. the long-term organizational perspective.
SAA: What is the biggest question pools should be asking their investment manager today?
AAM: From the beginning of 2022 through 6/30/2023, the bond market, as measured by the Bloomberg Aggregate Index, has returned -11.2%. This has left the vast majority of bonds held on risk pool balance sheets in significant unrealized loss positions. As many risk pool boards have undoubtedly heard by this time, as long as there is no event which requires a large liquidation of the bond portfolio, the prices of bond holdings should recover as they approach maturity.
This leads to a critical question that we think all pools should be considering: What liquidity buffers are in place to ensure a pool has access to cash while limiting the risk of being forced to sell bonds at steep realized losses?
One advantage of the inverted yield curve is that it has drastically reduced the opportunity cost of holding short term investments. Today, money market funds that invest in US Government securities typically have yields around 5%. To enhance short term yields, several risk pools have established portfolios specifically to invest in short term investments like Treasury Bills or CDs. The goal of the short-term portfolio is to align expected bond maturities with expected cash needs of the pool. If cash is needed sooner than expected, selling one of these very short-term investments will have minimal realized gains or losses.
For example, for one client with hurricane exposure we recently created a portfolio of T-Bills with securities maturing in each of the next several months to align with hurricane season. This portfolio has a yield of 5.3% as of August 17, 2023. Hopefully, they will not need the liquidity and after the hurricane season we can invest the cash in longer term investments. This strategy can allow the pool to maintain liquidity and earn competitive yields while limiting the risk of needing to liquidate long term bond holdings to pay for cat claims.
If a pool does need to sell assets to raise cash, they may consider reviewing their risk asset allocations, if they have one. Since the beginning of 2022, equities have handily outperformed investment grade bonds. As a result of these market moves the allocation to risk assets has meaningfully increased for many pools. Further, if the risk asset allocation has been in place for many years, the position is likely in a significant unrealized gain position. By selling some risk assets and some of the bond portfolio, pools can reallocate the portfolio back to target allocations for each asset class and can minimize net realized losses, or in some cases generate a net realized gain.
Pools may also consider exploring a line of credit with a local bank. A line of credit can be used to protect against a sudden need for a significant cash amount. In our experience this is most effective if the cash need is short term. For example, if a pool settles a large claim and has to pay soon thereafter, but reinsurers will not pay until after the claim is paid. In this situation using a line of credit allows the pool to meet the claim without needing to sell any assets and disturbing the overall investment program.
An important source of inherent liquidity is a prudent asset duration. Ideally, a pool should have a bond portfolio duration target aligned with the expected cash flows from the liabilities and expenses. Having that target in place and sticking to it through cycles should help alleviate significant cash crunches. The importance of duration discipline was best demonstrated in the banking sector in the spring of this year. A significant mismatch between asset duration and liability duration led to large-scale forced selling at depressed values by Silicon Valley Bank immediately preceding its failure. A disciplined, documented asset duration policy for a pool can significantly minimize the risk of needing to sell a significant portion of the portfolio as depressed prices.
SAA: Short yields are so low, why not just buy 1 year assets for now?
AAM: We actually get this question often especially after talking about the benefits of a short-term portfolio with yields above 5%. However, we think it is important to differentiate a cash portfolio for short term cash needs from the long term investment strategy of the pool. The short term portfolio is tactical in nature to address a potential cash requirement. The strategic fixed income allocation should be designed to serve the needs of the pool for the long term.
As of July 31, 2023, the 1-year treasury yielded 5.4% and the 5-year treasury yielded 4.2% (source: Bloomberg). I can see why it is tempting to only buy short bonds. However, as I mentioned in my previous response, the best long term policy is to have an asset duration target that is aligned with expected claim and expense cash flows.
Let’s look at a hypothetical example where a pool has $1 million to invest and would typically buy a 5-year bond to align with cash flows. That investor can buy a 5-year treasury and lock in $42,000 per year of income ($1,000,000 * 4.2%) for each of the next 5 years. If instead they buy a 1-year bond yielding 5.4%, they will earn $54,000 in the first year, but then the pool will have to reinvest after the first year. If interest rates have fallen during that year the investor will not earn as much in year two. If interest rates have risen in that year, the investor can earn more. In fact, looking at the futures market, the expected income of buying a 1-year bond each of the next 5 years is about the same as buying a 5 year bond today. Moving away from the 5 year target becomes a bet on the direction of interest rates.
Taking a step back from the details, the opportunity to add bonds to portfolios at current interest rates is a completely different experience for bond investors compared to the past several years. The future path of interest rates is unknown, but building long term dependable income in the portfolio by buying high yielding bonds today should position pools well in the future.
Our view has always been that the primary reason to change the duration target of the portfolio is to address changes in the liabilities of a pool, for example if there is a long-term shift in expected claims payments. While it can be tempting today to buy primarily short bonds, our view has been that adhering to targets can lead to the best long-term results.
SAA: If AAM is advocating continuing to invest out the curve, what sectors do you favor today?
AAM: We are in an environment where the next recession is seemingly always 6-9 months in the future, or it may not materialize. Given that uncertainty, and recent strong performance in riskier bonds sectors, we are being cautious around adding credit risk. We are still buying corporate bonds, but the outlooks for sectors varies as some sectors are more vulnerable than others going forward. For example, bonds in the auto sector have performed well, but the road ahead may be more challenging with some consumers feeling more pinched by economic conditions and a looming UAW contract negotiation. We have been investing in secured utility bonds issued out of the operating subsidiaries.
For years, the Federal Reserve bought Agency guaranteed mortgage backed securities as part of several rounds of Quantitative Easing (QE). The involvement of the Federal Reserve caused valuations in this sector to be unattractive for several years in our view. With the Federal Reserve undertaking Quantitative Tightening (QT) and reducing their purchases in the sector now, valuations in the sector are more attractive again. We have been adding bonds in this sector. In our view, yields today fairly compensate investors for the prepayment risk associated with the investments, and given the guarantee from Fannie Mae or Freddie Mac we expect they will perform well in periods of stress in the market.
One other sector that has performed well is AAA rated Collateralized Loan Obligations (CLOs). These are structured securities whose underlying collateral is comprised of senior secured loans to high yield US companies. The name often invokes bad memories from 2008, but this a sector that performed well through 2008 and subsequent periods of stress in the markets. They are floating rate securities, so the coupon resets when short term interest rates rise. As a result, while the Fed has been raising rates, the yield of these holdings continues to increase. Using the Palmer Square AAA CLO index as of July 31, 2023, the yield on this sector is 6.1%. Allocations to this sector are typically less than 5% in our client portfolios for which the asset class is approved, but they do provide diversification if the Fed does continue to hike rates, and the current yield is competitive.
Disclaimer: This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Any opinions and statements contained herein of financial market trends based on market conditions constitute our judgment. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different than that discussed here.
Source: Strategic Asset Alliance, AAM. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.