Comment: Achieving above-benchmark returns through capital-efficient emerging market debt

31 March 2023

A new study of emerging market debt in the context of regulatory capital requirements for insurance firms has concluded that insurers can achieve above-benchmark returns of c. 42 to 45 basis points for the same capital requirements as the benchmark through the use of capital-efficient portfolio construction.

In addition, the analysis – by the insurance team at PineBridge Investments – found that for insurers seeking to free up capital, capital-efficient security selection can more than halve the capital requirement relative to the benchmark.

It is well known that insurers are required to hold regulatory capital against the market risk of their investments. By explicitly incorporating these requirements into the construction of a portfolio of hard-currency investment-grade emerging market corporate bonds, insurers increase the expected return on required capital relative to the benchmark by 1.6x-3.1x.

Importantly, the analysis found that these results are consistent across four major risk-based capital regimes: European Economic Area and UK Solvency II; IAIS ICS; Hong Kong RBC; and Australian LAGIC.

Two capital-efficient model portfolios

Vladimir Zdorovenin To test the hypothesis, for each of the above regulatory regimes, two capital-efficient model portfolios were constructed: a spread-maximizing portfolio, which seeks the highest increase in option-adjusted spread over the benchmark for the same risk-based capital requirement; and a capital-saving portfolio that seeks the lowest risk-based capital while maintaining the portfolio spread at the same level as the benchmark.

Spread-maximizing portfolios are constructed by shortening the duration of the portfolio by around 0.7-0.8 years, incorporating off-benchmark positions in quasi-government bonds, and allocating to instruments offering the possibility of an attractive return on capital within the limits set by the portfolio manager.

This can result in a 5%-7% increase in the expected return on capital (measured as spread return on required capital) at the cost of a one-notch decrease in average portfolio credit quality (or a two-notch decrease for IAIS ICS).

Capital-saving portfolios carry less than 0.5 times the capital requirement relative to the benchmark, while improving portfolio credit quality by one or two notches.

This is achieved by identifying capital-efficient instruments and positioning the portfolio significantly shorter than the benchmark (by 2.4-3.7 years, depending on the capital regime) – something that a broad investor base may find appealing given volatile/ rising interest rates and an inverted US dollar yield curve. The net result is a compelling 1.6x-3.1x increase in expected return on required capital.

One size would not fit all: the capital regime drives portfolio composition

Emerging market debt portfolios – and insurers' investments more broadly – should be tailored to the requirements of the specific risk-based capital regime.

Under a one-size-fits-all approach, insurers can end up carrying the dead weight of additional capital requirements without utilizing that capital.

To what extent does the specific risk-based capital regime drive the composition of capital-efficient portfolios? The table below tabulates the proportion of overlapping holdings in capital-efficient portfolios constructed under the two objectives and four regimes. The divergence in composition is significant for spread-maximizing portfolios (for most pairs of regimes, 30%-40% of portfolio holdings are specific to each regime) and is even more pronounced for capital-saving portfolios (with up to 85% of non-overlapping holdings for Hong Kong RBC). This divergence would lead to significant differences in portfolio performance and in insurers' return on capital.

The divergence is particularly important for internationally active insurance groups seeking to optimize capital allocation across the group. These groups must navigate portfolio construction under the group-wide regime (and, for the largest groups, under the IAIS ICS) alongside the local regimes applicable to their business units.

Holdings overlap in capital-efficient EM IG corporate debt portfolios under alternative risk-based capital regimes
Spread-maximizing portfolios    
  Solvency IIIAIS ICSAustralian LAGICHong Kong RBC
Solvency II 100%      
IAIS ICS 81% 100%    
Australian LAGIC 81% 90% 100%  
Hong Kong RBC 78% 78% 81% 100%
Capital-saving portfolios    
  Solvency IIIAIS ICSAustralian LAGICHong Kong RBC
Solvency II 100%      
IAIS ICS 83% 100%    
Australian LAGIC 61% 61% 100%  
Hong Kong RBC 15% 15% 35% 100%
Source: PineBridge Investments analysis. The proportion of overlapping holdings between two portfolios is the sum across all instruments of the minimum of the portfolio weight of each instrument in each of the two portfolios.

Why use capital-efficient security selection for emerging market debt?

The universe of emerging market corporate bonds is more heterogenous than that of developed market corporates. It can offer greater opportunities to improve expected portfolio performance through active security selection supported by numerical optimization.

On average, the emerging market universe offers higher spreads and higher returns on regulatory capital. It is also more heterogeneous than the developed market universe, with greater variation in yields, option-adjusted spreads, duration, regulatory capital requirements, and returns on capital – and even more so when adjusting for the difference in median duration between the emerging market and developed market universes.

Vladimir Zdorovenin is head of insurance solutions EMEA & Japan at PineBridge Investments