25 July 2019

What's behind the wall: US insurers' investments in EM debt

Emerging markets should be an attractive option for US insurers as the Federal Reserve looks to cut rates, making opportunities at home less attractive. But, as the Trump government continues building trade barriers, are US government policies stymying enthusiasm for the asset class? Sarfraz Thind reports

These are volatile times in US politics. President Trump's attraction for building walls and pursuit of more insular US economic policies have thrown up barriers against the outside world. It comes at a moment when insurers were looking to put their money into emerging market (EM) debt. The effect is palpable.

In June, Fitch downgraded the sovereign rating on Mexico to BBB from BBB+, a couple of steps above junk, citing oil and trade tensions. Before it was downgraded Mexico was the largest EM debt holding in US insurer portfolios, making up 32% of total EM bonds according to figures for year-end 2017 from the National Association of Insurance Commissioners (NAIC).

Since the downgrade, the credit is teetering precipitously at the limit of an acceptable investment for insurers. Anything below could see a mass migration out of the credit.

Mexico has suffered from political tampering in Washington. Being hit by 25% trade tariffs if it does not address the immigration policy mandated by Trump could be ruinous.

"We are in an age where there is more anti-immigration universally, which is being translated into regulatory frameworks not just in the US, but also in Europe and other countries," says Ricardo Adrogue, head of Barings global sovereign debt and currencies group. "It was not necessarily because of US policy that Mexico was downgraded. But it was downgraded two or three days after Trump said he would put 25% tariffs on the country. This makes it more difficult to hold the credit."

Indeed, EM debt has never been a principle focus for domestic insurers who have historically been more insular in their approach to the asset class than their European counterparts. As of year-end 2017, US insurers had $44.2bn in EM bonds and stocks, less than 1% of total cash and invested assets, according to the NAIC. Part of the reason for this is the depth and range of the domestic bond market. With some $43trn in fixed income outstanding locally why go abroad?

"Being a continental country make US investors less aware of foreign opportunities," says Adrogue. "Domestic opportunities have been good. Spain, for example, does not have the size and variety you see in the US."


In truth, EM debt has a lot to offer. Proponents of EM investing believe the 1% NAIC figure of end-2017 underestimates the actual volume of EM debt allocations in the country. And—anecdotally—it appears to have grown in the last few years.

"From an insurance asset management perspective, we have been seeing a fairly significant uptick in insurance companies who are looking for EMD capabilities as they broaden their investment strategy," says Lisa Longino, head of insurance asset management at MetLife Investment Management (MLIM), who estimates allocations to EMD being between 2% to 4% of assets, based on discussions with insurance investors.

Capital charges for investment grade EM debt are the same as for developed markets. Yields, however, are far higher. MLIM analysis shows that EM credit consistently outperformed the US on both an absolute and a risk-adjusted basis over the past 20 odd years. It gives rise to an odd anomaly.

"The market still sees the difference between EM and developed when the economy is the same size," says Adrogue. "Australia and Brazil—look at the stability and macro policy—they are almost indistinguishable. But one is labelled developed the other emerging and the former yields half the other."

Then there is risk. Investors with reasonable memories will recall previous EM crises which spread across countries like Mexico's "Tequila" crisis in 1994, Russia's default in 1998, and Brazil's crisis in 2002 all of which became major contagion events.

However, things may have changed. Participants believe the contagion effect of EM in crises appears to be a thing of the past. Research by MLIM which looked at EM-specific stress events over the past 15 years that could have triggered contagion concluded that spread movements outside the impacted country are not nearly as sensitive as they used to be. According to an MLIM report, while contagion may have been a serious problem 15 or 20 years ago, "it's just not the case anymore".

Far from risk enhancer, EM debt is now seen as offering a solid hedge against future market falls. EM debt recovery post-crisis has tended to track that in developed markets. While spreads widen along with US investment grade debt they no longer lead to large unrealised losses or distressed events.

"Some investors think EM debt is similar to high yield bonds," says Sean Kurian, managing director and head of institutional solutions at Conning. "It is similar in how it has tended to move in benign conditions but as you get into more tail risk scenarios equities and high yield are both more impacted. EM debt can be more robust at weathering these which is valuable for risk averse insurance investors."

The attraction of diversifying out of US credit is encouraged by the US Federal Reserve's dovish announcement that it will begin cutting interest rates in the next year. As many domestic fixed income sectors get squeezed, the value in EM debt becomes more attractive.

"Despite the strong absolute returns this year, EM spreads to treasuries are over 100 basis points off the lows of February 2018," says Jim Barrineau, head of emerging market debt relative at Schroders. "As the idea of interest rates ever normalising continues to fade and income opportunities recede for all investors, accessing EM will become a mainstream choice to generate yield."

US policy

And yet, despite all the arguments in its favour, the charge for EM debt faces one almighty obstacle—namely the US's foreign trade policy. President Trump's strongarm tactics have created an unstable outlook on emerging markets from Mexico to China.

"Over time as the trade war theme has gone into and out of prominence, it has affected allocations," says Barrineau. "One example would be with Mexico and corporates that might be directly in the line of fire, such as the auto sector. In China, it seems clear additional tariffs will represent a drag on growth so that has to be taken into account especially for non-investment grade corporates with dollar debt."

Doug Meyer, managing director of life insurance at Fitch, believes the trade tensions are relevant. While he says trade agreement will be reached with Mexico, lifting the threat of a 25% tariff, the instability "is having an impact".

Nor is Meyer entirely confident that a market downturn in the US would push more investors toward EM debt. Investors could gain some benefit from going into the asset on the diversification principle but, at the same time, a domestic downturn could see insurers focus their attentions on capital preservation.

"In a downturn you are likely to see the opposite," says Meyer. "If there is a correction in US markets usually we have seen companies pulling back from EM. The focus is on capital conservation," According to Fitch.

Longino also sees both potentials: "If there is a downturn in the US you get the diversification benefit in EM—but, then again, when the US sneezes the world catches a cold."

Ratings agency—what role?

The 2008 financial crisis was not good for ratings agencies. Sad and shambolic, the agencies came out of it with their heads hanging low after their misratings on structured debt led many investors to buy and eventually drown in their losses, rather like the Pied Piper leading the rats into the river. For insurance investors, however, the importance of ratings agencies never diminished.

"After the crisis ratings agencies lost face—but rather than learning to ignore them actually the opposite happened," says Barings' Adrogue. "Insurers need to go by third-party assessors and that is the ratings agency."

Undoubtedly, the ratings agencies play a key role in EM debt investment. While investment grade EM debt has the same capital charge as developed, Fitch's Meyer says: "By definition there is not a tonne of investment grade assets in EM." The squeeze on ratings in recent times will limit investments further. Some say it may be time that insurers started considering other sources of analysis to make their judgements.