John Simone, managing director and head of Voya’s Insurance Investment Solutions business in Chicago, says old ideas for insurance companies are new ideas for defined benefit (DB) plans.
Just as DB plans are challenged by low interest rates and the late credit cycle, so are insurance companies; they have to meet long-term obligations too. And, as Brett Cornwell, fixed income client portfolio manager at Voya Investment Management in Atlanta, Georgia, points out, it is insurance companies that DB plan sponsors turn to when transferring the risk of their plans.
According to Cornwell, DB plans, in the last 10 or 15 years, have been adding more fixed income instruments that match the duration of their liabilities, such as long-duration bonds. They have also been moving out of growth-seeking assets. “DB plans are discounted with the AA corporate bond yield, so intuitively, plan sponsors are using more long-duration bonds to match the discount rate,” he says.
But fixed income has grown to 60% or as much as 80% to 90% of DB plans’ portfolios. Cornwell says that’s largely worked, but now it is a risk factor that corporate bond exposure is so high. “LDI 2.0 is more about now diversifying portfolios so they don’t have too much in a corporate bond name or sector,” he says.
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When diversifying, some DB plan sponsors take on a lot of risk with non-fixed income assets, Simone says, but insurance company investment ideas do not necessarily dial up risk.
Diversifying from long-duration bonds
A Cerulli Associates survey shows U.S. insurance companies view the late stage of the credit cycle as “very concerning.” In response, nearly two-thirds (64%) plan to increase their allocations to private debt and half expect to add to structured or securitized debt during the next 12 months. Among alternatives investments, which are limited in insurers’ general account investment portfolios due to regulatory capital constraints, a majority of insurers plan to add to infrastructure investments (75%), alternative fixed-income strategies (63%), and private equity (55%).
Cornwell says insurance companies use a variety of securitized sectors—fixed income sectors not as narrowly defined as what DB plans use. He believes DB plans should take a more diversified approach.
For example, insurance companies use investment-grade private placements, which he says is a direct extension of what DB plans are already doing—adding corporate credit. A private placement is a sale of stock shares or bonds to pre-selected investors and institutions rather than on the open market. It is for an investor seeking to raise capital.
Cornwell explains that private placement can offer covenant packages—an investor may be asking for capital to fund a business, so a DB plan loans the investor money. Private placements have “make whole provisions.” Such provisions allow parties to agree in advance on a measure of damages for prepayment of the loan. Lenders use make-wholes to lock in a guaranteed rate of return on their investment at the time they agree to provide the financing, while borrowers may benefit by obtaining lower interest rates or fees than they would otherwise. Cornwell says private placements are credit-oriented instruments that come with protections from downgrades, defaults and credit-rating migrations.
NYC-based Tas Hasan, partner and investment committee member at Deerpath Capital Management, a direct lender to the lower-middle market, says for DB plans, there are elevated leverage levels in direct lending, while generating a low yield. “Pension funds need to generate yield, but in the late credit cycle, they are thinking more about safety,” he explains. “When pushed to take increased risk, the upper-middle market is overheated, so they can move into the lower-middle market. We don’t see an erosion of the quality of loans with an elevated level of risk in the lower-middle market.”
Direct lending is a form of corporate debt provision in which lenders other than banks make loans to companies without intermediaries such as an investment bank, a broker or a private equity firm. The lower-middle market consists of companies with less than $50 million of earnings before interest, tax, depreciation and amortization (EBITDA).
According to Hasan, the reason for direct lending in the lower-middle market is that a lot of capital has been raised in direct lending, but most has concentrated on lending to companies with more than $100 million in enterprise value. More than 80% of those loans are now “covenant-lite,” meaning they lack traditional requirements for companies to maintain certain financial benchmarks that protect the investors who pay for them. In the lower-middle market, there are still protections and covenants in place to mitigate risk.
A sustainable, long-term approach
Mike Anderson, vice president and portfolio manager for asset and liability management (ALM) strategies at Securian Asset Management, based in St. Paul, Minnesota, says, “In my role working with ALM strategies for [insurer’s] general accounts, I look at each liability and work to manage assets against those liabilities, taking a sustainable, long-term approach.”
He says securitized assets help with that. When the overall general account is in investment-grade fixed income, commercial mortgage loans are a good percentage of the portfolio. In addition, fixed income investments include asset-backed securities and corporate credit.
Anderson says regular feedback of liability and longevity information from actuaries helps to improve the ALM process as far as security selection and pricing, especially when thinking of credit risk and liquidity needs.
Jeremy Gogos, vice president and portfolio manager of quantitative strategies at Securian, based in St. Paul, Minnesota, says pension plan sponsors have the advantage of a good projection of liquidity needs. They have the ability to allocate into commercial whole loans and private placements variations, taking on a liquidity premium above that of the insurance market.
According to Cornwell, there are some securitized assets not available to DB plans, but there is still a wide array they can use. He adds that long duration collateralized mortgage obligations (CMOs) have structural protection and collateral that is government-backed. A CMO refers to a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment. Organized by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages that act as collateral on these securities.
Some key things for DB plan sponsors to consider, according to Cornwell, is that DB plans and insurance companies work under different regulatory environments and DB plan liabilities are valued differently than insurance valuations. Also, DB plans are governed by the Employee Retirement Income Security Act (ERISA), so plan sponsors should consider what is and is not allowable. He adds that there’s some ambiguity about whether DB plan sponsors governed by ERISA can invest in below investment-grade securitized assets, but he believes most would say it is not allowed.
Still, Cornwell says, “We advocate for DB plan sponsors to take investing lessons from insurance companies to the extent it works for their plans.”
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