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Navigating the yield drought

By: Richard Ley

18/12/2019

Fixed income investing has become far more difficult in recent years as interest rates and yields have plummeted.

Many so-called ‘safe haven’ government bonds are negative across the yield curve: 10-year yields from countries including Germany, Switzerland, the Netherlands and France are in negative territory (World Government Bonds) , while bonds from ‘peripheral’ Europe such as Ireland, Portugal and Spain, that were deemed high risk just a few years ago, are yielding less than 0.5%.

This is posing problems for even the largest of investors: Norway’s $1.1trn Government Pension Fund Global reported that a quarter of its fixed income holdings – equivalent to roughly $65.5bn – were negative yielding at the end of June 2019.

At the time, the sovereign wealth fund had 28% of its total portfolio invested in bonds. For insurers, bonds often make up a much higher proportion of investment portfolios – so how to cope with an asset class that is losing money?

“Insurers are increasingly being forced to become very creative,” says Mark Fehlmann, head of European insurance at DWS. “For the past several years many thought they could wait it out, but now it seems clear that the ‘low for longer’ scenario is really happening.”

Larger investors have been diversifying into higher-yielding assets with lower credit ratings for some time, Fehlmann explains. Those that have yet to do so must now “take a hard look at the future development of running income given reinvestment at negative to low yields”. This presents an opportunity for innovative asset managers.

Globally, insurers have begun to recognise the importance of diversification and of having “a holistic portfolio framework for strategic asset allocation across all asset classes”, according to Charles Hatami, global head of BlackRock’s Financial Institutions Group.

Writing in the asset manager’s 2019 Global Insurance Report (View the report) , Hatami said: “We expect this trend to intensify as the proportion of global fixed income assets with extremely low or negative yields increases and as equity markets encounter incremental volatility.”

Arguably the biggest beneficiary of the hunt for yield has been the private debt market. Traditional banks pulled out of many areas of unlisted debt in the wake of the global financial crisis, leaving a funding gap that has been filled by asset managers serving pension funds and insurance companies. At the end of 2018, private debt funds had a combined $763.6bn in assets under management, according to data company Preqin. This total included $294.4bn of dry powder .

BlackRock’s 2019 survey showed that appetite for alternatives, and in particular private market assets, has grown steadily in recent years. It reported that a third of insurers considered private markets investments as part of their core strategic asset allocation .

Fehlmann highlights direct corporate lending as a potential substitute for high yield fixed income exposure with an additional uplift from an illiquidity premium, while real estate debt can also offer attractive risk-adjusted returns.

Infrastructure debt has grown in popularity in recent years. However, Fehlmann warns that “unfortunately this is a secret to exactly no one… Spreads are, in our opinion, way too tight”. According to Goldman Sachs Asset Management’s (GSAM) latest insurance investing survey, just 8% of insurers expected infrastructure debt to provide the strongest returns over 12 months. However, 31% still planned to increase their exposures.

Away from the unlisted markets, high-yield corporate bonds and hard-currency emerging market debt (EMD) are still of interest to insurance companies, according to the BlackRock and GSAM reports. However, Fehlmann warns that hedging currency on EMD allocations can be prohibitively expensive if investors are not buying euro-denominated assets or funds.

While there are still many opportunities for investors in these areas, insurance companies must ensure they have the governance budget to ensure adequate oversight of alternative debt investments. In its report, BlackRock urged insurers to “review and enhance” internal governance structures as well as risk management and capital modelling processes.

Even traditional fixed income investments may require investors to allocate more resources, DWS’s Fehlmann adds: “In standard investment-grade-rated credit universes there are absolutely pockets of positive return areas available, but top-notch credit research capabilities are critical.”

In early 2020, Research in Finance is teaming up with sister company, Research in Insurance to launch The UK Insurance Investment Study.

This project will provide a deeper understanding of the investment strategies within the asset side of UK general insurance companies. How asset managers can effectively communicate, influence and engage with this audience.

There is an opportunity for a limited number of stakeholders to be involved and help shape this influential study. If you are interested, please contact Richard Ley or Phil Davison on 020 7104 2235

Richard Ley

Richard Ley

Richard has over 16 years experience within the financial services market. Having begun his career working in international media across the financial sections of some of the worlds leading newspapers.

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