Amid the prolonged low-rate environment of recent years, many insurers have looked for ways to enhance yield without taking on more risk.
This piece was adapted from an article published on Barings.com. To read the full piece, please visit: https://www.barings.com/viewpoints/the-more-things-change-the-more-they-stay-the-same
Amid the prolonged low-rate environment of recent years, many insurers have looked for ways to enhance yield without taking on more risk. While there are no magic assets, and “high” yield might not be realistic for “low” risk, there are ways insurers can enhance yield without diminishing quality—namely through allocations to certain types of investment grade (IG) private assets, such as commercial mortgage loans (CMLs).
Yield Enhancement & Strategic Portfolio Benefits
Relative value between public and private IG asset classes tends to shift over time. Even so, IG privates have consistently provided opportunities and added yield. Over the last five years, for instance, CMLs provided roughly 50 basis points (bps) over corporates, on average.1 Although certain real estate sectors have experienced spread compression more recently amid heightened deal volume, CMLs continue to represent a material premium over public corporates—suggesting that while the specific opportunities on offer can and do change, the bottom-up, fundamentals of private market value remain consistent.
The potential yield enhancement offered by private assets is particularly evident by comparing two portfolios of similar duration and credit quality—one with a 100% allocation to IG public corporate debt and one with a 70% allocation to IG public corporates, along with an allocation of 10% each to CMLs, private placements and infrastructure debt.
THE PORTFOLIO IMPACT OF PRIVATE ASSETS
Source: Barings data and market observations.
As demonstrated, including a 30% allocation to private IG assets is estimated to increase overall portfolio yield by 20 bps—based on long-term achievable spread assumptions—with only a small increase in required capital. In Solvency regulatory regimes including the U.K., Europe and Bermuda, the asset yield can be a factor in determining the reserve discount rate, thus further reducing the overall reserve/capital requirements. Each company’s yield assumption/target should be set in a manner consistent with other objectives, including the time to put money to work, diversification within the allocation, tenor, and specific quality constraints.
The lower risk of the 70/30 portfolio is less due to low correlation to other asset classes, and more a result of the strong covenants and high-quality collateral typical of private assets. While the expenses for managing private IG assets are higher than public asset expenses, the expected defaults are lower. Core CML defaults, for instance, are expected to be zero.2
Finding Tactical Value Post-COVID: A Closer Look at CMLs
When it comes to real estate, location is of paramount importance. Commercial mortgage loan originators are familiar with their respective territories and understand their local dynamics, typically visiting and inspecting each property to underwrite the mortgage. From the borrower’s perspective, the relationship with the lender is also important. Specifically, the lender’s ability to execute the mortgage in a timely fashion and to provide consistency in servicing capabilities, as well as flexibility with regard to negotiating contractual provisions like refinancing and prepayment, are critical. Indeed, such considerations could motivate high-quality borrowers to work with non-CMBS lenders.
Favorable Capital Treatment
High-quality CMLs tend to receive favorable capital treatment under most regulatory systems. Outside the U.S., the solvency rules vary and require differing levels of stress tests and modeling—however, the liability matching characteristics as well as the historically low risk have resulted in a favorable view under many regimes. Additionally, CMLs allow for “make whole” provisions in the event of prepayment, which is particularly important under the U.K. Solvency II rules, to meet the Matching Adjustment criteria. For these reasons—and with the added benefits of enhanced diversification and a quicker ramp period—there can also be benefits to including CMLs originated in the U.S. as well as those originated in the U.K./Europe.
Historically Low Delinquencies
At the end of 2020, life insurers held roughly 15% of all outstanding CMLs.3 Over time, the high-quality nature of insurance company CMLs has resulted in extremely low delinquency rates, even in times of turmoil. In fact, delinquency rates for CMLs have not exceeded 0.5% since 2000, remaining below 0.5% during the GFC and just above 0% in the wake of the pandemic—well under their peak of roughly 7% in the 1990s. In contrast, CMBS delinquencies were 7.5% as of the end of last year, having peaked at 9.5% during the financial crisis.4 And while these delinquency rates are not directly comparable among investor groups, as the risk/reward trade-offs and credit quality differs, the rates do serve as a helpful reference point to contextualize the low risk associated with insurance company-owned CMLs.
IG privates have consistently provided opportunities for insurers to add yield without diminishing quality. Core CMLs, in particular, can offer a number of benefits—from a material spread premium over similarly rated corporates, to low historical defaults and delinquency rates, to diversification. However, market access and relationships with market participants, alongside fundamental, bottom-up underwriting, is key to uncovering the best risk-adjusted opportunities. Further, given the tendency of relative value to fluctuate over time, partnering with a manager that has a wide frame of reference and visibility across public and private markets is critical.
Only investment professionals may use this article and for informational purposes only, so it does not constitute the offer of any security, product, service or fund, including investment products or funds sponsored by Barings, LLC (Barings) or any of its affiliated companies. The information that the author deals with here is his own opinion as of the date indicated and may not reflect the actual information of a fund or investment product managed by Barings or any of its affiliated companies. Neither Barings nor any of its affiliated companies guarantees that this information is accurate or complete and accepts no responsibility for any loss, direct or consequential, resulting from its use. PAST PERFORMANCE DOES NOT NECESSARILY INDICATE FUTURE RESULTS. An investment always carries risk of loss.
1. Source: Based on Barings data. As of March 31, 2021.
2. Based on Barings data and market observations.
3. Source: Mortgage Bankers Association Quarterly Databook. As of December 31, 2020.
4. Source: Mortgage Bankers Association Quarterly Databook. As of December 31, 2020.