High yield: a compelling opportunity for European insurers
During the recent sell-off in risk assets high yield bonds have cheapened significantly relative to Investment Grade. Stress in the problematic US energy & mining sectors and the increased expectation of defaults has dragged the broader high yield market wider. However, we note that historically, high yield has delivered equity-like returns with much less volatility, and, from a return on capital perspective insurance portfolios can meaningfully increase their after-capital yield by moving from investment grade to high yield.
High yield is attractive from a return on capital perspective
To see how much of the extra return on high yield bonds is eroded due to the higher SCR charges we assume a base case portfolio of A-rated US corporate bonds and a 6% cost of capital. Our analysis suggests that there are significant gains to be had from moving into high yield even with the higher capital charges accounted for.
Capital adjusted yield comparison, high yield and investment grade
Source: Schroders, 1 March 2016. Indices used are: The BofA Merrill Lynch 1-5 Year AAA US Corporate Index, The BofA Merrill Lynch 1-5 Year AA US Corporate Index, The BofA Merrill Lynch 1-5 Year A US Corporate Index, The BofA Merrill Lynch 1-5 Year BBB US Corporate Index, The BofA Merrill Lynch 1-5 Year BB US Cash Pay High Yield Constrained Index, The BofA Merrill Lynch 1-5 Year B US Cash Pay High Yield Constrained Index.
The above table illustrates the yield pick up net of SCR charge available by switching from single A investment grade bonds into high yield. Carefully chosen single-B securities could increase the after capital charge yield on an investment grade portfolio by more than 6%.
Is it time to invest in high yield?
The fall in the average yield on the BofA Merrill Lynch 1-5 Year Single-A Euro Corporate Index to just 53 basis points on the 1st of March 2016 illustrates the pressure on insurers in Europe to increase the yield in their portfolios. Below we show the spread between the broad global high yield and high yield excluding the problematic Energy and Mining sectors to the US and Euro investment grade sectors. Spreads have widened sharply from June 2015 before stabilising and beginning to contract very recently.
Source: Barclays Live, Bloomberg; at 29 February 2016. Data represent the Barclays Global High-yield xCMBS xEMG 2% Issuer Capped Index.
*Data represent the Barclays Global High-yield xCMBS xEMG 2% Issuer Capped Index ex Energy and ex Metals and Mining
**Data represents the Bloomberg 1-5 Year Single-A Euro Corporate Index
Yield is “Yield to worst”, All indices have USD as their base currency
In their February 2016 Default Report Moody’s said that they expect:
deteriorating credit quality in sectors such as Oil & Gas and Metals & Mining due to stagnating commodity prices. These two sectors’ default rates are expected to remain at significantly high levels – 14.0% for Metals & Mining and 9.1% for Oil & Gas for Moody’s-rated issuers in the US
Moody’s one year corporate default rate forecast by industry sector
Source: Moody’s: February 2016 Default Report
In summary, we believe there are a number of compelling reasons to consider an allocation to high yield:
- Outside of the Energy and Mining sectors, corporate credit metrics in high yield remain generally positive and careful credit selection should allow investors to benefit from the higher yields available without being exposed to unduly high default rates.
- The recent contraction in high yield spreads may signal an end to the widening trend of the past seven months.
- From a strategic investment perspective, we note that historically High Yield has delivered equity-like returns with roughly 2/3 of the volatility.
- From a tactical investment perspective we also observe that High Yield has historically exhibited a low (and much lower than IG) correlation with UST’s which may offer investors useful defensive qualities should interest rates begin to rise.
- A potential 6% yield pick-up net of SCR charge available by switching from single A into carefully chosen high yield bonds.
Additional reading: Please see below our full length article - The case for global high yield - for the detailed investment case