The majority of assets owned by insurers are invested in investment grade fixed income. In search of a way to achieve more capital-efficient returns, diversification and illiquidity premiums, insurers often turn to high yield markets and alternative asset classes. But we argue factor investing in corporate bonds is an attractive alternative approach to generating capital-efficient returns.
Insurance companies are significant investors in credits and hold capital buffers to protect their portfolios against negative events. Insurers are also always looking for the best way to diversify their investments and to enhance their return on insurance capital.
Factor-based credit strategies provide diversification benefits to traditional, fundamental, research-based credit strategies for insurers. Their differentiated investment style and their ability to utilize a broader investment universe explain why factor strategies provide an important source of diversification relative to the fundamentally managed portfolios of insurers.
A multi-factor credit strategy uses a highly systematic method to construct the portfolio, taking into account multiple quantitative factors and is designed to neutralize the portfolio’s exposures in terms of interest rate duration and credit beta. Meanwhile, fundamental strategies typically follow only one style, often carry or value, and regularly take duration and/or beta bets.
In terms of the investment universe, a factor-based strategy can efficiently invest in all companies and bonds, irrespective of their size. Fundamental managers inevitably have to focus on a smaller subset, given their limited resources for analyzing issuers. Generally, this subset consists of the larger, more liquid names and their more recently issued bonds.
Because of these differences, while the realized returns of most fundamental strategies tend to be positively correlated, the realized returns of our factor strategies are negatively correlated with those of their fundamental peers. Adding a factor strategy to a portfolio of fundamentally managed credit strategies can be a strong diversifier.
In this article, we introduced factor-based strategies as an alternative to traditional, fundamental, research-based strategies for insurers. Their differentiated investment style and their ability to utilize a broader investment universe explain why factor strategies provide an important source of diversification relative to the fundamentally managed portfolios of insurers. Importantly, by systematically harvesting factor premiums, we believe factor strategies can be expected to deliver a higher return on capital than passive credit portfolios. We also showed how we can explicitly integrate insurance capital requirements into factor credit strategies to further enhance the return on capital.
Our factor approaches aim to provide a cost-efficient building block for insurers. The strategies can also be tailored to address specific requirements, for example when insurers wish to match a liability cashflow stream or aim for a certain level of income from a low-turnover buy-and-maintain credit portfolio.
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