Interview with Eric Kirsch, Aflac for the Insurance Asset Management, North America 2016 report
David Grana: With interest rates at historic lows and yields being squeezed, what non-investment grade securities are insurers investing their money in?
Eric Kirsch: Based on our own work and discussions with peers in the industry, there are a number of opportunities in the non-investment grade space, as well as investment grade. In the non-investment grade sector, we are seeing a lot of attention in the private lending space. This includes bank loans, middle market loans, as well as loans in the real estate sector. These are typically BB and B rated. In the real estate space, these loans may include commercial mortgage loans, and transitional real estate. It’s also worth mentioning that within some of the real estate sectors, you can find value in investment grade assets as well. Finally, within the investment grade space, there is a fair amount of attention to infrastructure assets. The traditional high yield sector is drawing some attention, but insurance companies have had allocations to this asset class historically and are searching for new investments that have other characteristics to ensure diversification.
With the first few asset classes I mentioned, that’s where there’s more focus and attention. And there are a couple of reasons for this. The macro reason in this private lending space is interesting. While it has been around for quite a while, banks were the traditional sources of capital to the lenders. With the advent of Dodd-Frank, banks are far less active and the lenders are searching for new pools of capital. And this has drawn them to the insurance industry, where there is not only a potential large capital base, but also , synergies, as insurance companies are traditionally comfortable with credit risk. While insurance companies invested in the space to some degree, in the era of low interest rates, it’s fair to say this is getting a lot of attention.
David: Is there a minimum hold period for liquidity to be available on some of these securities?
Eric: In the middle market loan space, you are actually making a loan to some company in the U.S., typically a middle-market company that generates $20-$30 million of profit per year. Some may be larger, and some even smaller, but in general they are good fundamental companies and business models. There are thousands of these types of companies across the U.S. and they need funding for their businesses. They come to the private market looking for 3-7 year loans, depending on their circumstances. And they’re typically senior secured loans.
When you make them a loan, you are the loan holder on record and will be holding it until maturity. However, the benefits are that you get to negotiate strict and tailored covenants to the loan, providing superior credit protection. If you have a credit issue, most likely it will be because a covenant was breached, and you will have the opportunity to work with management to address that in the loan documents or business model. But you should be prepared to hold it until maturity, knowing that there are limitations on liquidity. So again, if something is going wrong at the company, you will be proactive. You have the ability to work with the company to improve the matter before it becomes a material issue and a threat to their ability to pay back the loan.
David: What’s a ballpark estimate of how much of insurers’ portfolios are allocated to these types of securities?
Eric: If you think of it as non-investment grade, it does have limitations, because you are paying higher risk charges for below investment grade. These asset classes typically have very attractive yields - LIBOR plus 400-500 basis points, BB, and a short, 3-10 year tenure. Many of them are floating rate in nature, so the coupons do reset based on LIBOR, though some are fixed rate. The downside is that you are paying a higher risk charge. But even on a risk-adjusted basis, it still makes sense to allocate to those assets versus investment grade. But because it is below investment grade, everyone will have their internal risk rules and diversification limits, so it’ll make sense to have some limit on it. If you look at it as a percentage of your total balance sheet, for a life insurance company, they’ll probably have between 5-8% exposure to below investment grade securities. That’s a very reasonable limit.
David: We’re seeing some economic hurdles in the U.S. and the global economy as a whole. Do you see these hurdles adversely affecting some of these holdings?
Eric: We certainly spend significant time analyzing macro-economic trends and integrate that thinking into our credit work. We look at how the economy is likely to perform over the next 3-5 years and how will that company perform in that economic cycle. Of course, we look over longer time periods as well. Some sectors, like automobiles, can be highly impacted by a downturn; if there is a recession people buy fewer cars. On the other hand, there are certain industries that do well in a recession – such as discount retailers. This is all part of our credit work. We look at the loan market and which sectors we like today versus others we may be concerned about. You definitely want to do that macro work and factor it into the segments and industries of the loan market you want to overweight or underweight over time.
It helps you when you are underwriting and doing new loans today, but perhaps you made loans 3 years ago, when you believed the economic cycle was going to be positive for the next 7 years. It may not have worked out that way, so you are holding a loan in an industry that is suffering and the company you’ve lent to is feeling the impact. This is why in the private lending space you get to negotiate the covenants with the company. These are your protections. It is critical that you think that through the economic cycle changes and how that affects the company’s profit margins, sales, and demand, to name a few factors. Again with a focus on less liquidity, ensuring strict loan covenants is critical to protecting you. This is very different than when you buy an investment grade bond from, say, AT&T. You have no control over AT&T’s business, but on the other hand, with the AT&T bonds, we have a lot more liquidity options where we can sell the bonds. Granted, the price may be impacted.
David: What will it take to have non-investment grade credit allocations increase? Is this down to ratings agencies and the NAIC making changes in their own policies?
Eric: The 5-8% industry allocation reflects the risk charges that insurance companies use from the NAIC now. And even with some of the changes that they are talking about, I don’t see this changing very much. It is very company-specific, and every insurance company has their own capital objectives. But when the new standards come out, for this part of the credit spectrum, I don’t feel that there will be large differences but there will be more tactical adjustments.
David: Do you feel that if we have prolonged low interest rates, the regulators will increase allowances for non-investment grade securities?
Eric: In my opinion, I don’t think that the regulators will lower the risk charge for non-investment grade securities just because you don’t have anywhere to invest due to the low rates. That could be perceived as them saying that firms should take more risk, especially credit risk. Prolonged low interest rates are a challenge, and it is going to take a holistic approach if they continue to stay this low. This means that, as an insurance company, at the top of the house, you are going to have to evaluate what products you offer to the market and if you can you still afford to offer them. If you know what you can get from investment yields in a prudent, risk adjusted manner, and the features you want to give to the policy holders, but the economics just don’t make sense, then you need to adjust your product set to reflect this. You could adjust features in the product as well. With all the good work that insurance companies do with credit underwriting, risk management, etc., I think we would look at it from the top down. Take a close look at at the business model in a low rate environment and adjust accordingly.
David: Thank you for sharing your thoughts on this topic.
