This NordicInvestor virtual roundtable gathered three insurance company allocators and asset managers from Norway, Finland and the Netherlands to discuss how they are seeking acceptable returns, risk, diversification and Solvency II compliance, from public and private fixed income and credit markets.

You can read the summary in this article or watch the video below.

For more insights into how Nordic insurers are investing, read our full report here

Panelists:

– Tomi Viia, Head of Insurance Assets at OP Asset Management in Helsinki

– Thor Abrahamsen, Senior Risk Analyst at Gard in Oslo

– Frank Meijer, European Head of Alternative Fixed Income at Aegon Asset Management in The Hague

– Moderated by Jonas Wäingelin, Editor in Chief, NordicInvestor

Yield pickup

Though US Dollar or Norwegian Krone investors might still get a small positive yield from short term government debt, investors based in Euros, Swedish Krona or Danish Krone have had to live with negative yields for some years, even on ten year bonds.

Alternative and private debt are now essential for yield, even for USD based investors like GARD:

“a large part of the portfolio has to be in fixed income for regulatory reasons. We have invested in alternatives for 15 years, balancing return against risk and regulatory constraints. We previously sought diversification from alternatives, but since interest rates moved near to zero post-pandemic we now also seek yield, to increase expected returns,” says Abrahamsen.

Viia agrees:

“As Europe based investors we have faced lower for longer for a long time. Our shift to private debt started before the pandemic, as interest rates went down. We have to increase risk or settle for less return, and also need alpha as a source of return”

Alternatives can provide varying amounts of extra yield for the full range of risk appetites:

“the clear baseline is outperforming liabilities, and we also consider relative value. Alternative credit can provide absolute returns and yield enhancement across the spectrum of credit ratings and risk types, all the way from AAA to CCC and unrated debt,” says Meijer.

“At the AAA rated level the pickup will not be 2% but it might be around 0.50%. We invest in some investment grade private placements that might only offer a pickup of 70 basis point in Europe, but only 50 in the US because illiquidity premiums vary by region. We invest in insured loans to companies offering spreads of LIBOR plus 200 basis points. For high yield corporate debt, the pickup could be several percent. In lending to smaller and medium sized firms, (SMEs) we can even get 10% on great companies that we would classify as equivalent to a BB minus credit rating,” Meijer continuous.

That represents a yield pickup of between 5% and 8% versus liquid public high yield corporate debt in Europe.

In contrast, some other areas of alternative credit have become less attractive.

“Infrastructure debt is starting to get overcrowded and may only pay a spread of 100 basis point over LIBOR, which does not offer the best relative value within alternatives and illiquids,” says Meijer.

Reasons for premiums

The most obvious reason for private debt yielding more is simply that central banks are not buying it.

“The ECB has not targeted illiquids. If ECB put a trillion into private credit the arbitrage would be gone,” says Meijer.

But even before the advent of central bank asset purchases, private debt usually offered a premium return over comparable public debt. Commercial banks may not finance small companies at the same leverage multiples as private lenders.

“We will go to 4 or 5 times leverage on SME lending, while the banks are capped at 3 times,” says Meijer.

Private lenders are also filling market gaps because they are more versatile in accepting a wider variety of assets to lend against.

“Their definition of collateral is more flexible than a bank. Any asset can be priced and haircut. Direct lending is interesting because there are different ways of approaching markets and assets, one cannot easily generalize,” says Abrahamsen.

The return premiums can be split into multiple categories.

“We expect return premiums for illiquidity, information, complexity, and sourcing to access dealflow. It is difficult to define a beta benchmark and measure alpha, but we do expect alpha from security selection. But we do not expect all managers to meet their targets – we usually cut them by 25%,” says Abrahamsen.

“We also expect to get complexity premia from private debt. We agree on targets with specific managers and divide them into the return drivers,” agrees Viia.

Diversification, sizing and Solvency II

Allocations to alternative credit could well grow.

“We have between 5% and 10% of our credit assets in alternative credit now and this may grow further. There is no set target but it does partly depend on Solvency II treatment. Our internal models on Solvency II are similar to the regulator’s standard model, and a higher credit rating gets a lower charge. It really depends on our overall risk appetite, and we could find ways of allocating more up to a point,” says Abrahamsen.

Diversification is important both for the overall portfolio and within credit allocations.

“Residential mortgages can give exposure to consumer risk, which is not the same as government risk or corporate risk. Pension funds are now competing with large banks in allocating a lot to Dutch mortgages, lending directly to consumers. We manage EUR 30 billion of third party client money in this area. We have 50% of our balance sheet of our mother company in alternatives, which we define broadly to include mortgages with high credit ratings. It could go up to 60%,” says Meijer.

Alternative credit can also be an efficient use of capital for investors subject to Solvency II:

“RMBS is 35% which is huge but 1.6% for AA credit risk makes a lot of sense. The solvency charge is very low, it works tremendously well,” Meijer adds.

Other asset classes such as some forms of trade finance can also have low solvency II charges.

Of course allocations need to be sized appropriately for the mandate.

“Alternatives do not have to be assets with a B or BB rating, and we could not have 60% in those assets. In AAA rated we go for government guaranteed but less liquid loans for an extra 50 to 100 basis points. B or BB rated assets work better for unit linked not balance sheet assets,” says Meijer.

Some allocators take a barbell approach within private debt, investing at both ends of the risk spectrum.

“Our private debt side has two levels. We invest in well diversified portfolios of high quality collateral with very low solvency II charges. We are also active in distressed debt,” says Viia.

In both areas, expected returns are now lower than a year ago.

“We want to increase diversification and add different return drivers. We emphasise a holistic view with concentration limits, considering Solvency II and risk constraints, to make sure you do not have too much exposure in one area,”  Viia adds.

Liability and liquidity matching

Clearly some private debt strategies could create a liquidity mismatch with liabilities, but allocators are well aware of this.

“We do some complex modelling on the liability side, looking at different investors’ liquidity needs. We do not want to be forced sellers in a distressed situation,” says Viia.

There are different opinions about evolving liquidity in private debt:

“we monitor secondary markets in private debt and private equity”, says Viia.

“We expect that the secondary market in private debt will further develop as the market grows, but it might require selling at a discount. This limits our allocations based on stress tests, but it varies with liabilities. For long dated liabilities we can afford a higher allocation. For instance, pension funds with longer liabilities can afford more illiquidity, while property companies with shorter term liabilities cannot,” says Meijer.

Can general insurers with short dated liabilities invest in a direct lending fund with an eight year lockup? Yes and no.

“For our short-dated general insurance liabilities of one to two years, we would have a possible mismatch. But fortunately, we are overcapitalized, and we can invest some of our surplus capital in longer term assets to increase returns. We have more flexibility than a life insurer or pension fund,” says Abrahamsen.

Why still own government debt?

A high proportion of government debt issuance is being bought by central banks and some investors who can find banks, brokers or custodians who will give them zero interest rates on a bank deposit will not buy bonds with negative yields. Why would any return-seeking investor still buy them? There are in fact several reasons, besides the Solvency II rules:

“German Bunds could be an insurance policy and may rise in value if risky assets all sell off together. We also need liquidity and Government bonds can always be sold if needed. And government debt is acceptable collateral for cash calls on derivatives, while private debt is usually not,” points out Meijer.

Outlook

At broader portfolio level, how does alternative fixed income fit into portfolios? It needs to consider possibilities beyond the market climate of the past decade.

“For the past 10 years investors have not been paid to diversify. If they just bought US equities with leverage they looked great. Some investors think that will work long term as well. Assumptions about correlations may not always work, especially when interest rates are negative. A diversified portfolio in future may look very different from 10-20 years ago,” says Abrahamsen.

Even before Covid, the current credit cycle seemed very mature and extended, but some participants are even contemplating an eternally benign credit market.

“Is there still a credit cycle?,” asks Abrahamsen.

The answer is that investors should not be complacent about various macro economic risks and threats to the “Goldilocks” scenario of low interest rates, low inflation and steady growth which has been benign for credit markets.

Policymakers are now admitting that inflation may prove to be more than transitory.

“The market expects the ECB to step in and solve any crisis. If inflation comes along, that will be more difficult. Inflation or hyperinflation is a tail risk. If inflation goes up and bond yields go up and valuations go down, that could scare people,” says Meijer.

“We also still see risks including inflation, asset price bubbles, policy errors and political risk in general in Europe. We invest monthly but always think about long term risk,” says Viia.

Abrahamsen agrees:

“policy errors are a risk but are difficult to explain or quantify”. Neither policymakers nor investors have perfect foresight and policy errors are usually only seen with the benefit of hindsight. A more diversified approach is one way to guard against nasty surprises.