As the equity bull market continues to roll on, headlines and broad-market investors focus on returns, but risk management should be their principal concern. While it is easy to be tempted by the potential for higher returns that comes with higher risk securities, higher quality credits reduce portfolio volatility, say Brian Allen, Bryan Johanson and Jason Pettner at C.S. McKee.
For a captive, risk management is essential to the very nature of its operations. While each captive is unique in its ability and willingness to take investment risk, risk management is an essential piece of the investment equation for all captives.
“Adverse economic conditions can disproportionately affect lower rated bonds, causing negative returns and providing little diversification to the total portfolio when it is most needed.”
Fixed income risks
In terms of volatility, high quality fixed income is considered the safest investment, second only to holding cash. While safe, there are certain risks inherent to fixed income that are important to understand, two of which are duration risk and credit quality risk.
- Duration risk: risk caused by changes in interest rates
Higher duration = higher risk
Can be mitigated by matching the length of your investments to your goal time horizon
- Credit quality risk: risk caused by the financial stability of the bond issuer
Lower credit quality = higher risk
Lower credit ratings offer higher potential returns, but are more likely to suffer with negative changes to the issuer or the overall economy
Although duration is an important factor in fixed income investing, duration decisions within insurance portfolios can be strongly influenced by time horizon, specifically the length of liabilities being insured. On the other hand, credit risk is a multidimensional decision that can be affected by captive lifecycle stage, insurance type, risk tolerance, and several other factors.
Credit quality is often oversimplified by lumping all bonds into two buckets, investment grade and non-investment (speculative) grade. However, within each bucket, the credit quality of bonds varies greatly.
Investment grade vs non-investment (speculative) grade
Investment grade and non-investment grade refers to the credit rating of a bond. Bond credit ratings are issued by a rating agency (S&P, Moody’s, Fitch, etc) and provide a “forward-looking opinion about the creditworthiness” of the issuer, according to S&P.
Bonds within the investment grade space have higher credit ratings than non-investment grade bonds, which means they have a greater ability to service their debt and make good on their obligations.
Investment grade bonds have credit ratings of BBB/Baa or higher, while non-investment grade bonds have ratings of BB/Ba or lower. As the credit rating moves lower, the likelihood of default or the inability to fulfil the obligation goes up, making it a riskier investment. Table 1 shows a basic breakdown of credit ratings.
As Table 1 illustrates, the issuer’s ability to meet its financial obligations decreases as credit ratings decrease, with a significant drop-off below BBB-rated securities. The declining ability to meet its obligations is investment credit risk, since investing in these bonds makes your portfolio the counterparty receiving the payments from the issuer.
As a result of added risk, lower-quality bonds offer higher yields and more attractive return potential for investors, tempting them to chase performance. The past 10 years have been favourable for lower quality bonds, driven by stable economic growth and low interest rates, an environment that allowed most issuers to meet their obligations. As a result, lower quality securities outperformed higher rated issues (Table 2).
While the returns of the lower quality securities appear much more attractive over the previous 10 years of economic growth, they have not experienced the impacts of adverse conditions on issuers. In contrast, Table 3 highlights the performance of lower quality fixed income bonds during a recent period of adverse financial conditions, namely the 2007–2009 financial crisis.
While all bond cohorts rated below AAA suffered negative returns, non-investment grade (rated BB and lower) suffered at least double the losses of A or BBB-rated securities, as their ability to meet financial obligations decreased.
Rise in BBB allocation
Understanding credit risk is essential to fixed income investing, whether buying individual bonds, an investment manager’s fund, or an index itself, especially given the current low yield environment.
Over the previous 10 years, the BBB market has expanded much faster than the other credit qualities. As a result, BBBs now represent a larger portion of the most popular investment grade fixed income index, the Bloomberg Barclays US Aggregate.
Similarly, due in dual part to the growth of the BBB allocation in the index and the stellar returns of BBBs, many investment managers have increased their allocation to BBB securities (Table 4).
Impacts on balance sheet risk
While BBB-rated bonds are still investment grade securities, they hold more inherent risks than higher quality securities and sit only one ratings grade above the threshold of non-investment grade. When a bond is downgraded to non-investment grade, its price will likely drop significantly, as investors who can hold only investment grade bonds will be forced to sell into a smaller group of investors.
When the bond enters the speculative grade bucket, the remaining bond holders are left to hold an asset in a less liquid and riskier market. While this may be an acceptable risk for the average investor, they most likely do not have the same level of concern about their balance sheet strength as a captive.
One important consideration for a captive is its AM Best rating of financial strength, which factors balance sheet strength into its evaluation. According to Best’s credit rating methodology: “balance sheet strength analysis at the rating unit level encompasses an assessment of capital adequacy, liquidity, reserve adequacy and investment risk”.
AM Best further states that companies “holding illiquid, undiversified, and/or speculative assets and significantly exposed to volatile lines of business that are vulnerable to unfavourable changes in underwriting and/or economic conditions can jeopardise policyholders’ surplus”.
Additionally, AM Best considers the “quality and diversification of assets” when assessing financial stability by looking at the investments to “assess the risk of default and the potential impact on a holding company’s capital if the market value of these assets declines unexpectedly”.
As a result, if adverse conditions were to push investments to non-investment grade, there may be adverse effects on the captive’s balance sheet risk.
When constructing a portfolio allocation, it is important to consider all goals and risk tolerance, rather than simply looking at potential returns. While risky assets have performed well during this decade-long economic expansion, understanding the bond market’s heightened sensitivity to growth is essential to portfolio success moving forward.
Given the recent outperformance of lower quality bonds and their current yield characteristics, portfolios may not be adequately compensated for the inherent credit risk of BBB-rated bonds in the current market environment.
Be wary of the credit risk in the portfolio. Although markets have been strong for the past decade, adverse economic conditions can disproportionately affect lower rated bonds, causing negative returns and providing little diversification to the total portfolio when it is most needed.
Even though higher quality securities may underperform at times, they provide stability and consistency to a portfolio through most market conditions. As with many other captive insurance considerations, keep risk management at the core of investment decisions.
Brian Allen is a portfolio manager at C.S. McKee. He can be contacted at: firstname.lastname@example.org
Bryan Johanson is a portfolio manager at C.S. McKee. He can be contacted at: email@example.com
Jason Pettner is a marketing analyst at C.S. McKee. He can be contacted at: firstname.lastname@example.org
C.S. McKee, Captives, Insurance, Risk management, Brian Allen, Bryan Johanson, Jason Pettner, North America