Current market volatility impacts private placement markets

In the second part of this Insurance Asset Risk / Loomis Sayles roundtable, insurers discuss the current market volatility and how it impacts their investment decisions in private placements

Vincent Huck: If we look at today's environment. We have high inflation, volatility, rising interest rates and a potential recession in the mid- to long-term. How does this impact your decisions and do you see opportunities in that environment or do you see more risks?

Mary Beth Cadle: It is tough because the future is so uncertain, at this point: do we prepare for a recession? Do we prepare for stagflation?

You have got market volatility, geopolitical uncertainty, supply chain COVID-related issues - it sometimes feels overwhelming.

From our perspective, the key is to stay focused, ensure that we understand the credit/portfolio risks and that the risk is adequately priced. We run base case and downside scenarios concentrating on ratings migration. That then leads to honing in on obtaining strong covenant terms as downside protection. I think the next few years are going to be a tough environment.

Chris Gudmastad: I am curious, Nakul and Sean, considering your positions as allocators with higher rates, how are you doing with the asset allocation balance of publics and privates?

Nakul Nayyar: Generally speaking, public corporate assets are a core investment for an insurer and if spreads were to widen, can represent an opportunity. Public Corporates provide quick access to a diversified source of liquid securities with various duration profiles. From a risk perspective, there is a lot of historical data to leverage on migration and default, research and underwriting, deeper markets, and operationally easier asset class to deal with versus privates. This is again on a high level.

So spread widening in Publics is then an attractive development. Public spreads today are in this midpoint area, not at historical tights but not 2008 like levels either. Additionally, insurers generally have large portfolios of legacy assets at often high yields so incremental purchases this year may not have a huge impact on overall NII. A short term spread widening event is not going to cause a dramatic movement or shift in allocation at this point in my opinion. If spreads blow out for example or continue to be elevated while Private spreads react in a slow fashion, then of course allocators would look closely at moving back into Publics or slowing Private purchases.

Chris Gudmastad: What is interesting in a higher yielding environment is it is hard to be tactical managing a buy-and-maintain portfolio in our view. You are not going to make dramatic shifts. However, the growth in private credit was in part due to low yields as you saw investors allocate more to this asset class to take advantage of the illiquidity premium.

However, if you look at the recent rise in yields and volatility, we believe there are increased opportunities in the public market. That being said you can still have negative real yields so the illiquidity premium offered by private credit is still important. The private markets might not look attractive right now -there is generally a lag as the private market is less quick to adjust to market volatility. And I do think once the private market adjusts, it should continue to be attractive to investors. We believe the train has left the station on private fixed income and it is going to continue to be a core asset for institutional investors.

Sean Collins: That echoes some of the opening comments I made. We have a core allocation to private credit and that is not going to change in any market scenario. However, as an insurance company you consistently have cash that you need to invest. So rising rates are not necessarily a bad thing for insurers, because you are dollar-cost averaging into higher yields. Which is something we have been able to do. You can be a little tactical and if you think a recession is on the horizon then maybe you want to go up in quality a little bit in on the public side.

However, there are going to be opportunities in private credit and, yes, the low-yield environment brought investors into private credit, but there are going to be a lot of opportunities through these market dislocations. Some of that will come when companies need capital quickly in a downturn. As a borrower, if you have a relationship with a lender, you can get that capital through the private markets potentially faster than the public markets. As an investor, this may provide some extra yield, whether it is a premium for speed or complexity, which is very attractive for an insurer. These opportunities can be in that solid BB, low BBB range. Those are potentially attractive credits that generate a lot of free cash flow, but you are getting a nice yield given challenged market conditions.

So, market dislocations, as long as you are sticking to your fundamental tenets of credit investing, are generally good for insurance portfolios.

Andrew Hanson: When we talk to issuers, we explain that the investment-grade private placement market has always been a much more reliable, stable source of capital for borrowers than the public markets. Going all the way back to 9/11, we were doing new issue privates shortly after that when the IG market was effectively still closed. The rising interest rate environment that we are in right now is causing a lot of volatility in the US capital markets which, in a way, makes all of our lives more challenging, and should have a dampening effect on new issue markets, both debt and equity.

However, in a way, it kind of helps private markets. Whether it is private equity or private credit, the more volatile the public capital markets are, the more things shift over to private execution, because it is more reliable. You can have a dialogue directly with borrowers and investors, because the investors who are investing in these asset classes are not as worried about things like "I committed at a rate today, and tomorrow the market changes". That is okay, because we are not trading oriented market. And my personal opinion is this volatility is going to continue for a while, because interest rates are high, and they are going to go higher. I am not in the camp of recession, but I just think the volatility is something we are all going to have to manage for a while.

Colin Dowdall: Compared to the end of the year, we see a lot of insurance companies that are sitting on large unrealized losses whereas, previously, they were sitting on large unrealized gains and that has really changed the tone of the conversations that we are having with these companies. There is a concern about loss realization in the portfolio. So what you owned at year-end largely is what you own today, for the most part, in talking to insurance companies. However, I will say it is about, like you talked about, Sean, cash coming in and where does the next dollar go? First of all, some of the private commitments are made months or years in advance, so that money is going where it is going, but we believe the public markets are becoming a beneficiary just due to ease of execution and that you can get yields that you could not have dreamed of, even four months ago. However, I do not think it changes any of the discussion that we have had around the secular trends of public to private, this is just the short-term where do you put the next dollar—and insurance companies think of things in terms of decades instead of where do I go for the next month or so with my dollar.

So it has been very interesting outside of purely the life insurance market. We have seen companies that historically were total return oriented that have really changed their tune and have been thinking a little bit more on book yield orientation or buy and hold, because any relative value trades could result in a realized loss through the P&L.

Nakul Nayyar: One other element of this conversation is related to the competition. Whether it's in participating whole life or spread based product, you compete on dividend levels or pricing which is ultimately a reflection of your portfolio spread. So, when you look at asset allocation it also matters to a degree what your competition is doing.

Sean Collins: That is a great point, that comes down to how do you fill the gaps in your portfolio to make up a few basis points of competition? You are talking about very small margin for error here in these products. So, in the private credit markets, you are thinking about something like esoteric ABS. You are using these products to fill that gap to get that extra couple of basis points. And then it comes down to does your manager have the capabilities and the deep expertise in some of these asset classes, particularly some of the asset classes that are new without a lot of history through multiple downturns.

You can get a huge advantage if you have a manager that really understands the market, and has a large platform from which they can go out and source deals. If you are competing over basis points, you need to be able to get significant deal flow. One-off deals are not really going to help you compete on those products. You need volume.

Dmitry Baron: Since we are still in the early build up of our private structured group for us volatility represents an opportunity. There are some deals which are getting pulled from the market but also some deals getting priced more attractively, so, overall, we are seeing yield pick up versus publics compared to just five months ago. Obviously, on a net basis with inflation it still does not look as attractive but still better than publics in our view. And also– talking about uncertainty of the future – private ABS market provides good diversification. Some deals like, let us say, music or film royalties are kind of recession-proof, because people do listen to music in good and bad times. If a deal is well structured this provides additional protection versus downside.

Mary Beth Cadle: Have any of you thought about investing in real assets in the context of inflation? I am starting to hear initial conversations that investing in real assets, such as timber, could offer protection. Perhaps real asset financing could be another way to bring further issuance into the private market?

Chris Gudmastad: Honestly, I have not heard that but where you could tie the private fixed income market with inflation is in some of the infrastructure investments that have revenue tied to CPI, where you can seek to minimize risk.

Going back to your comment, Nakul, on the yields, do you think that is driving the interest with smaller insurers just re-insuring portions of the portfolio to the competition?

Nakul Nayyar: Re-insurance is an interesting development. There are lots of reasons why reinsurers are becoming a bigger part of the marketplace. Many insurers have legacy liabilities written decades ago utilizing assumptions that may have been too optimistic and need to deal with these. Insurers are looking at their balance sheet, at their capital usage, and saying is this optimal? Do I want to have this balance sheet volatility? Reinsurers can provide solutions. They can leverage greater risk appetite or other capital optimization strategies and can price those solutions where it makes sense to the insurance companies.

Chris Gudmastad: We believe the investor landscape is certainly changing given the involvement of reinsurance and maybe for some smaller and medium-size insurers you could potentially see lower levels of assets over time managed in-house. From Loomis Sayles' perspective, as we build out our platform, as a firm that has the breadth across the structured asset class where we can leverage a structured team, our credit research team, and our emerging markets team, that should help us in terms of participating on the reinsurance side and improve portfolio yield potential.

Sean Collins: You are going to continue to see the reinsurers participate because large traditional insurers want to clean up their liabilities from products underwritten 10 or 15 years ago and focus on their core competencies. So, you may have liabilities that do not fit your overall business strategy now—and reinsurers play a role in helping insurers clean that up. That is a natural fit to the ecosystem and we will probably continue to see that happen.

Chris Gudmastad: what are the core companies?

Sean Collins: We had very big variable annuity book with a lot of interest rate sensitivity. We decided to reduce some of our interest rate and market sensitivity, and reinsure some of our legacy variable annuities business — that happened this year. We just did a large deal. That has been a theme in the insurance space where there are these large blocks of business going to reinsurers to help insurers refocus their business mix.

Nakul Nayyar: There is likely bifurcation when talking about reinsurance. The large institutions may be looking for reinsurance from a balance sheet optimization lens. However, from a mid-sized to small insurer it can offer an opportunity to essentially outsource the portfolio and leave the company to focus on core competencies like sales or distribution. Do they build an internal investment team, do they have the talent, the resources, the capital? What is the cost compared to an external manager? And so, a lot of insurers are asking themselves those questions.

Colin Dowdall: One of the things with that, that is interesting, as you look under the hood of the reinsurance companies, is the underinvestment in technology and data. The costs are high to be at the cutting edge and we believe scale is critical to be able to keep up with that. We have seen it as an interesting opportunity share our proprietary technology with insurance companies. But my sense is you are going to see this convergence of asset management and technology and the bar continues to get higher each day to be successful with that, as you think of risk analytics and making sure you understand what is under the hood within your portfolio.

Chris Gudmastad: I absolutely agree. If you look at the increased complexity that has come to our market like in the case private ABS. These are assets that are harder to source and originate. They are also more difficult to structure in our view. You need special skills to do that. And then on the operational side they can be more difficult to manage operationally as well.

As I see the market evolving, we will likely see more floating-rate investments and potentially more complicated transactions that involve revolvers or involve multiple fundings, which is typically more complex. That is going to be more difficult for insurers that do not have access to strong technology or operations to invest in those asset classes.

Andrew Hanson: That is driving consolidation on the buy side.

Colin Dowdall: On both sides, insurers and asset managers. The bar continues to get higher and higher, specifically around technology.

Sean Collins: If you are an asset manager you are going to think 'is there a way to bring some of these technology capabilities in-house, rather than trying to build them from scratch?'. Insurance can be seen as a sleepy industry to some extent historically, so, do you have the ability and culture to make those changes in-house? I do not know the answer, but I think that is a question that is certainly in the market.

Dmitry Baron: Technology definitely is a low-hanging fruit I believe and fixed income in general, insurance in particular, is so much behind the curve in terms of technology. And there are so many different opportunities, not just in the back office, not just in middle office, front office should be moving away from the Excel spreadsheets into more sophisticated tools. Right now, we have many analysts scrubbing through indentures, 10-Ks, 10-Qs. It takes technology seconds to come up with an analysis of what is important for you, and analysts can spend time thinking about the direction the company is going, the portfolio construction, things like that, rather than spending days reading through the hundreds of pages of sometimes not very useful text. So solutions are out there, just the insurance world is not using it as much as it could for now. However, I think it is going to change.

Part I is available here