“As spreads on insurance bonds widened last year, we increased our exposure to insurance bonds.” While investor concerns led to a sell-off of insurance debt Robeco’s Global Credits Team got more convinced. “The insurance sector is more resilient and the market did not make a distinction between insurance companies with solid and with more challenged business models. Our positions are paying off now.”
Despite the outperformance over the first quarter Jan-Willem de Moor still sees good value in subordinated insurance debt1. “Insurance sub-debt trades significantly wider at an average of 300 basis points over government bonds as compared to subordinated bank debt, of which tier 2 debt is now trading at an average of 170 basis points over government bonds”, concludes the portfolio manager of the Robeco Financials Institutions Bonds fund and member of Robeco’s Global Credits Team.
“The overweight position in insurance debt across our credit portfolios continued to perform well in the first quarter of 2017 thanks to attractive valuations resulting from the quality of investment grade credit compared to non-financial corporate debt and subordinated bank debt. The outlook for the insurance sector improved as short and long term interest rates are no longer declining and as the outlook for economic growth improved in both the US and Europe. Following the strong performance, we took some profits in life insurers the past three months.”
Robeco’s Credits Team started to increase the exposure to the insurance sector across its global and European credit portfolio’s in 2016. Spreads on subordinated insurance debt widened to levels of more than 400 bps over government bonds at the beginning of last year. Low interest rates and uncertainty surrounding the implementation of Solvency 2, the new regulatory capital framework for the insurance sector, were the major themes driving spreads on insurance debt wider.
Investor concerns led to indiscriminate selling of insurance bonds during the first quarter of 2016. This offered an opportunity to take some contrarian positions. “Our analysis showed that the insurance sector was generally much more resilient amid low interest rates and capital market volatility than market pricing implied. Further, the market did not make a distinction between insurance companies with solid business models, which hedge their capital base against low interest rates and those with more challenged business models”, explains De Moor.
“We therefore increased the exposure to subordinated insurance debt in our European and global credit portfolios. Because relative spread levels were much higher than in comparable rates instruments in the corporate sector, as well as in the banking sector.” The graph below shows the spread development of subordinated insurance debt versus investment grade corporate bonds.
“We further increased our exposure to insurance debt in the second quarter mostly through the addition of Dutch and French insurance companies. There were some large insurance companies in the Netherlands and France which traded at attractive spread levels while the underlying fundamentals were solid”, explains De Moor.
After a volatile first half of the year, and just two days after the Brexit referendum in the United Kingdom, markets started to recover strongly, especially the subordinated bank debt market. One important reason for the recovery in spreads was the fact that the Bank of England joined other central banks in announcing a corporate bond-buying program.
The outcome of the US elections was an important development during the last part of 2016. The election of Donald Trump raised inflation and economic growth expectations, resulting in a sharp rise in bond yields. Rising bond yields served as a strong catalyst for the performance of insurance debt, as higher bond yields are beneficial for the long term profitability of the sector and promote the long term viability of the life insurance business model. “During the third and fourth quarter of 2016, we further increased our exposure to the insurance sector, as our conviction regarding the reflation trade strengthened”, tells De Moor.
Insurance debt performs well in an environment of rising rates
De Moor continues to see value in subordinated insurance debt for the remainder of this year. “We have entered the second year of the Solvency 2 regime and these requirements have added many positives for investors, while the main uncertainties faded away during 2016. Our credit portfolios include Dutch insurers NN Group and ASR, trading at approximately 350 bps over government bonds and subordinated debt from French insurer Crédit Agricole, trading at 375 bps over government bonds. But we also see attractive investment opportunities in Switzerland and Spain where we recently bought a Swiss and Spanish insurer.”
All these subordinated bonds are investment grade but provide a significantly higher yield compared to non-financial investment grade corporates. At the same time many of these insurance companies continue to improve their capital ratios further. Another reason why we continue to like insurance debt is that it has been shown to outperform non-financial corporate debt in an environment of rising bond yields. We therefore maintain our overweight positions in subordinated insurance debt in our Global and European Credit funds and in our Financial Institutions Bond Fund.
1 Subordinated debt is a loan that ranks below other loans with regard to claims on a company's assets or earnings. In the case of a default, creditors who own subordinated debt won't be paid out until after senior debtholders are paid in full. Bondholders of subordinated debt are able to realize a higher rate of interest to compensate for the potential risk of default. (www.investopedia.com)