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Tailor-made for Solvency II: Conservative Credits

10-09-2013 | Insight | Patrick Houweling, PhD Insurers need to have higher capital buffers against risk if Solvency II comes into place, forcing many to rethink the investments they are in. A potential solution lies in credits with a lower risk profile – as the clock starts ticking for investors to act.
 
Speed read
  • Conservative credits sit in ‘sweet spot’
  • Lower durations and higher credit quality
  • Superior risk-adjusted returns
  • Available on a mandate-only basis
An EU decision scheduled for October is likely to set a firm timeframe for enforcing capital levels that insurers must hold. The long-awaited regulations put a much greater emphasis on reducing risk by forcing insurers to hold ‘ring-fenced’ capital buffers in case their investments suddenly fall in value. 
 
The Catch 22 for investors
As these institutions are simultaneously trying to find returns for policyholders it produces a Catch-22. It is easy enough to lower credit risk to close to zero: simply fill the portfolio with AAA-rated government bonds and very little capital will be required to offset it.
 
The problem here is that yields on sovereign bonds remain at historic lows, requiring investors to look at higher-yielding products such as corporate bonds – thereby raising risk and the capital needed to act as a buffer. 
 
So what to do? Isn’t there a middle ground? 
 
Robeco’s Euro Conservative Credits strategy offers a solution. It is ideal for investors who are not satisfied with the returns on super-safe sovereigns, but do not want to face the capital requirements that go hand in hand with owning riskier corporate bonds.
 
“Solvency II looks as if it could have been written for Conservative Credits as the strategy allows investors to adopt a low-risk, low-volatility strategy while also accruing returns for their own stakeholders,” says the strategy’s portfolio manager, Patrick Houweling, Ph.D. 
 
‘The strategy sits in a sweet spot between AAA-rated government bonds and general credits’ 
 
How risk is reduced
A corporate bond’s risk depends on its duration and credit quality, which is reflected in its credit rating. The key to Conservative Credits’ risk reduction strategy is its lower duration and its higher credit quality than common benchmark indices.
 
The strategy invests in securities that have 2.4 years to run until maturity compared with 4.5 years for the Barclays Euro Corporate Bond Index. These shorter-duration securities have slightly higher average credit ratings and lower spreads against benchmark bonds.
 
Since longer-duration bonds have a higher sensitivity to rate movements and have wider spreads against benchmark sovereign bonds, shorter-duration securities are better suited to meet Solvency II requirements.
 
“The Conservative Credit strategy sits in a sweet spot between AAA-rated government bonds, which are ultra-safe but have low yields, and general credits, which may have better yields but are a lot riskier,” says Houweling. 
 
The low-risk anomaly
And safer doesn’t necessarily mean less rewarding.
 
The strategy is able to generate superior risk-adjusted returns by exploiting the ‘low-risk anomaly’ in corporate bonds in the same way that the anomaly can be profitable in equity markets.
 
The anomaly exists because lower-risk securities have consistently outperformed higher-risk ones, contrary to the investment theory of the Capital Asset Pricing Model, which predicts that taking a lower risk should result in a lower return.
 
“Investors are realizing that the quantitative strategies used successfully for equities also apply to fixed income. The structure of the quantitative model for credits is very similar to the one we use for equity,” says Houweling.
 
“There is a great deal of cross-over between how a company’s equity and debt is viewed quantitatively. The risk indicators that we use are identical, such as targeting companies with low leverage, a large equity cushion and low equity volatility.”

A Sharpe-r performanceTimeline
The Conservative Credits portfolio has a consistently higher Sharpe ratio, which measures the risk-adjusted rates of returns on an asset. At the end of the strategy’s first full year of operation in May 2013, it had a Sharpe ratio of 1.96, well above the market’s Sharpe ratio of 1.57. In general, bonds with shorter maturities and higher ratings have been shown to have higher Sharpe ratios than those with longer maturities and lower ratings.The issue will be next be discussed by the EU Parliament on 22 October. MEPs first need to agree the wording of the Omnibus II Directive, which will amend certain provisions of the Solvency II Directive, including its timeframe and implementation date. Originally set for 1 January 2014, most EU governments and their financial institutions are not yet ready to implement it, and most industry participants expect the deadline to be put back until 2014.

Investing widely
The strategy focuses on euro-denominated corporate bonds, though the issuers may be domiciled outside the EMU, such as McDonalds (US), Vodafone (UK), Nestle (Switzerland) and Carlsberg (Denmark). Risk is spread across regions and sectors. A second strategy investing in global bonds denominated in all currencies is also available.
 
Aside from the lower duration characteristic, risk is spread by investing in more companies than regular corporate bond funds, with about 100 in the Conservative Credits portfolio compared to 60-80 for a typical credit fund, and with lower concentrations in one region, sector or company.
 
The table below shows how the low-risk nature of the portfolio can be seen in its lower volatility relative to the benchmark (beta), shorter duration, higher credit ratings and less concentrated positions.


Robeco Euro Conservative CreditsBarclays Euro Corporate Bond Index
Beta0.41.0
Duration2.4 years4.3 years
RatingA/A-A-
Yield1.6%2.3%
Spreads vs German govies1.1%1.3%
Largest sector weight23%48%
Largest company weight1.5%3.4%
Largest region weight39%62% 

Source: Robeco, Barclays, September 2013
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