Multi-asset credit investing in volatile times

In the first part of this Insurance Asset Risk / Credit Suisse Asset Management roundtable, insurers discuss their views on the impact of COVID-19 on credit markets, the risks and opportunities they have seen in the last 18 months and their use of ETFs.

Sarfraz Thind: It's been a turbulent year and a half with the pandemic. How have your portfolios held up during that time? And what challenges have you faced as credit investors?

Xiaowei Han: Whether a company portfolio can hold up well or not really depends on whether the losses on assets need to be realized via sale or reflected in its accounting frameworks. A company with good liquidity doesn't need to be forced to sell assets. The stressed market values in fixed income assets with statutory book value accounting are usually not reflected in statutory reporting, unless these assets are written down or in default. We have excellent liquidity position and use statutory accounting. Therefore, we did well. In fact, if a company has a lot of cash to reinvest, one might see this as a great opportunity to take on extra risk.

Todd Hedtke: We went into the pandemic and our risk officers were quite concerned. Even so, what we were really interested in was where were the opportunities. If you look back at it, this is a time when long-term investors were able to have a little bit of an advantage. That's not always the case.

But the opportunities weren't necessarily that great either. Some corporate spreads widened out, which was fine early on. But certainly the opportunities were nothing like 2008 and 2009, given how quickly fiscal monetary policy reacted.

From my perspective, our portfolio was more than durable. But now, where we're sitting today, it is a very rich market across all sectors. You've got to pick through the flowers to try to find something.

Randy Brown: We had spent quite a bit of time de-risking the portfolio in anticipation of a price dislocation and building up ample dry powder and risk budget. We took it as far as multiple trips to the board, to the management team, ensuring that we could be a buyer if and when this price dislocation hit. At that point, we felt highly confident it would be a "when" not an "if".

We wanted to be able to react quickly but also in considerable scale to make a difference. And because we had been working so long towards that, strategized it so much, and anticipated all the potential institutional angst around stepping in when the markets are darkest—which is a big behavioural bias in organisations, particularly in insurance companies—we were ready.

So we stepped in, in a pretty big way for us, and participated. The portfolio held up extremely well and offered a tremendous amount of value. The value slippage in 2020 was low and the value added in 2020 has been very high.

Sean Collins: I would echo those comments and say we probably wish we had more opportunity in 2020. That opportunity slipped away really quickly when the Fed stepped in. You had it for a couple of months after that. We were prepared the exact same way that Randy talked about and went through and de-risked. Because of the nature of the Fed intervention and how 2020 played out, we thought pockets of the market would have been hit harder than they actually were. And whether it's specific corporates and credit migration or specific tranches in structured, the stress didn't play out as we expected. So we were well positioned, but at the same time, those insurers that took more risk, maybe they got supported a little bit more when the market held up after the Fed stepped in.

Brendan White: This was a real test of our risk management processes and we were very pleased that we were able to quantify risk pretty accurately. As a result of the confidence in our risk management processes, we were able to react appropriately. The recovery was so quick that we may not have been able to react to the extent we wanted but I thought that 2020 was a real case study for risk management processes, and we were pleased to see that it worked out well. And we ended 2020 with record GAAP capital and ended June of 2021 with even higher record GAAP capital. So it almost seems like it was a bad dream, a really bad dream. But we came through fine.

Alex Chan: I heard multiple times just how quickly the opportunity actually went away. We bottomed on March 23rd in the loan market. The Fed did its announcement in March and by the end of April we were already up 15 points. The same is true for the high yield market and the structured credit market. I'd like to ask if there is anything changing on your end, in terms of discussing opportunistic trades with your board and your investment committees? Is anyone making any changes to the ability to take advantage of a dip in the market in future?

Randy Brown: We actually did it for the last one. As I said about strategizing it and saying, "here's what we think we'll do, this is the size", etc. and discussing the psychological aspects of stepping in—it's very hard to step in on those days but that's when you often have your best return. Additionally, we also increased our borrowing capacity. That is the next iteration towards being able to react even more quickly with even more size for the next fall.

Sean Collins: And maybe beyond that, not just thinking about how we react quickly, but recalibrating how we believe asset classes will behave in the next stress. We saw how some of them were supported in 2020. So maybe the risk models we relied on prior to that—I mean, there's a risk to drifting too far from that—but thinking how the valuations and how certain asset classes will play out may be different in the future. So recalibrating that into our investment decisions today is part of what we're thinking about.

Todd Hedtke: I'll take a little bit of a different angle. What we learnt— and what we hadn't done so much in the past—was the importance of bringing the entire firm into the discussion. So, bringing in our risk and product folks, we spun off a quick group of experts who met every morning. This is probably not traditional if you come from an investment standpoint—but that was something that we did this time which we didn't do in the previous crisis as much. And we were able to move very nimbly. I don't know that it hugely impacted our credit decisions, but it certainly had a big impact on our ALM and hedging decisions.

Brendan White: The one thing that we did a little differently this time was to manage risk on the liability side in addition to the asset side. Since we have efficient distribution, we could take prudent risk on the liability side. And we were able to put on some of the most profitable business in April and May of 2020. So sometimes you can look at both sides of the balance sheet to manage risk. And our company had very effective ALM cross collaboration that worked out well for us.

Xiaowei Han: I totally agree. With the ALM function you have "L" as well. We are using sophisticated analysis in my team. Part of it is for this kind of stress event to understand our capital position and understand how much risk we can take ahead of time. So, when the opportunity comes, one knows how to use it.

Sean Collins: One more thought on the credit side is understanding some of these new instruments where you can take credit risk potentially quickly. I'm thinking a specific example would be ETFs. Understanding those instruments and how they trade and how the market accepts them as a way to quickly put on risk when you see that market dislocation. Because it might be hard to source all the bonds, but if you can put on high yield or emerging market or investment grade risk quickly en-masse, that's something we are exploring and thinking about now as well.

Sarfraz Thind: Did anybody else start to investigate the ability to take advantage of these opportunities through the use of ETFs or any other tools?

Todd Hedtke: Absolutely. If you went a little bit further down [the credit spectrum] there were some interesting opportunities in high yield and obviously that's a space where it takes a little bit more underwriting and generally a little bit more time. So that was a core thing that we did. We've been using ETFs—which is probably a trend overall—for different purposes. But, on this point about getting the credit position in place ASAP, for sure we did that a lot more during the last year.

Randy Brown: We didn't have many ETFs when I joined, the only ETFs that were allowed really were equity broad index ETFs, so we introduced a suite of bond ETFs to allow us to take advantage of market liquidity for exactly that reason.

Sarfraz Thind: Are ETFs something that you would use just in a very short-term basis, or do you think you might incorporate it even for longer term investing purposes?

Randy Brown: For me, it's more opportunistic. The ALM matching is so critical to what we do that you need CUSIPs or ISINs, ultimately. ETFs are a way to react quickly, to put risk on or take risk off.

Todd Hedtke: And for cash management.

Sarfraz Thind: As insurers which specific areas offered you the potential for good investment?

Todd Hedtke: I would just say it was more looking for opportunities that didn't really exist for a very long time. I look back to 2008—a trade that we did then en-masse was CMBS. CMBS contagion was across the whole stack. Even the AA, AAA space gapped out massively. You just didn't see that on this occasion.
It was such a short window. Spreads widened out and there was opportunity early on across the board, but I didn't see any of those more structural opportunities.

Brendan White: Where we took additional liability risk, we allocated that to the credit markets, including in BBBs and even high yield. Those were attractive from a total return standpoint and a relative value standpoint. But they were even more attractive from an ALM standpoint. We were booking a lot of spread, a lot of ROE. With surplus capital we did allocate more to the equity markets. We're a little unique in our equity allocation, but we were able to tactically allocate some to the equity markets. We entertained some asset opportunities in the private market, but it just took too long to execute there. So we missed that opportunity.

Part II is available here
Part III is available here