An unpredictable market environment indicates the need for a more diversified portfolio, investment experts say.
In the new year, the return expectations of captive owners have to moderate, their investment portfolios will need to be more diversified, and some conservatism is needed in an unpredictable market environment, an investment panel at the Cayman Captive Forum warned.
Captive insurers have a unique investment approach in that their investment priorities are generally linked to the objectives of the captive itself. Traditional captive insurers have underwriting liabilities and seek to generate passive income to offset administrative costs.
The types of assets a captive will invest in are largely determined by the captive’s required rate of return to meet its obligations and the timing and cash flow profile of the captive’s liabilities. For a captive that has short-term liabilities, capital preservation is the dominant theme. However, while keeping a large portion of the portfolio in cash may seem safe, it won’t offset inflation.
Traditionally captives invested mainly in the bond market, because bonds more closely match their liabilities, often provide capital in the form of coupons – or interest payments – during the life of the investment, and because fixed income investments were considered less risky.
However, after years of declining interest rates, the risk profile of fixed income has changed, and the potential for rising rates will dominate the investment themes for captive owners in 2015.
Investment experts at the Cayman Captive Forum agreed that they do not know exactly when interest rates will rise, but eventually they will go up slowly.
Interest rate risk
Investment managers for captive insurers, therefore, have to be conscious of the interest rate risk in their fixed income investments going forward.
“We have been in a declining interest rate environment for basically 30 to 35 years. At some point interest rates will go up and bond prices will come down. You have to find a way to mitigate this interest rate risk,” said Hugh Barit, chairman and CEO of PRP Performa.
Although economists have been trying to read the tea leaves of every Federal Reserve announcement during the past two years, predicting the timing of when the Fed is going to raise rates remains difficult.
Expectations for a changing interest rate environment were similar 12 months ago, with many believing that returns in the bond market in 2014 would be flat or possibly negative. Instead, bond returns were up 2.5 percent to 3 percent. This was a pleasant surprise for captive investment portfolios, but return expectations still have to come down, said Barit.
“Looking for 7, 8 or 9 percent return going forward for long term returns is just completely unrealistic,” he said. “You just cannot take that level of risk to get that kind of return.”
Any fixed income allocation for captives will have to be conservative, Barit argued. Because captives cannot afford a dramatic capital loss, they have to keep the duration of fixed income investments short.
Duration is a measure of how long it takes in years to repay the price of a bond with internal cash flows. The longer the duration, the higher the price volatility and sensitivity of a bond to interest rate changes.
Andy Baron, senior portfolio manager, Fixed Income, at Butterfield, agreed that to reduce their interest rate risk, captive investors will have to give up some return.
“Everybody is underweight duration, because the risk-reward ratio is too unfavorable. If you are longer duration and you are wrong, you get punished severely.”
Nominally, lower returns are not a problem, as long as the portfolio meets the investment objectives and return needs of the captive, added Barit. “[Then], if you happen to underperform, an unexpected bull market like the one we have seen in the fixed-income markets [in 2014], so what?”
Given that interest rates are so low and likely to go up, the interest rate risk in a captive portfolio with the once-typical 90 percent investment grade fixed income and 10 percent index U.S. equity allocations is now simply too high.
“Bond allocations are not so conservative anymore. You haven’t got the coupon to protect against interest rate rises when bond prices come down,” Barit said. As a result, investment portfolios need to be more diversified and should include non-correlated asset classes based on an absolute return strategy.
However, other investment classes have to be chosen deliberately, said Baron. Simply investing in a bond fund will often not meet the investment mandate of a captive portfolio, since the Fed’s quantitative easing program has prompted style drift in many bond funds as managers are searching for yield. Even the PIMCO bond fund includes 25 percent of assets from emerging markets, he said.
High yield as an asset class
According to Barit, high yield bond investments are one way to diversify the investment portfolio of a captive. Although there is still interest rate risk in these types of bonds, which are rated below investment grade, the coupons of about 6 percent provide a cushion against falling bond prices.
High yield bonds represent instead a larger default risk – the risk that the principal and remaining interest will not be paid at all – which needs to be addressed by selecting the right manager with credit experience in non-investment grade markets, said Barit.
Returns in the high yield market have come down in recent years, while the risk in the asset class remained. But even if nominally a return of 5 percent to 6 percent seems low, investors remain adequately compensated for the risk they take on a relative basis compared to what they can buy in other markets, said Butterfield’s Baron.
The risk-return profile depends also on the segment of the large high yield market. For instance, Baron favors the U.S. market over European high yield issuers, even though both offer about the same yield.
Barit agreed, adding that the high yield asset class is a mature and large market. “It runs from double B to default. We tend to be at the higher end, an average of B+ to BB-. You don’t want to have too high of a credit rating in your portfolio because then it becomes more interest-rate sensitive. We try to get away from that.”
Brandon Swensen, co-head U.S. Fixed Income at RBC, concurred that a certain amount of conservatism is needed in the investment approach. “Principal preservation remains a core focus. Our view is that rates will rise. They are probably not going to rise very fast. So having income in your portfolio, high quality income that you can count on and that is not going to have a lot of volatility in it, [is important].”
Swensen said his portfolios are therefore overweight spread products, high quality corporate bonds, mortgage securities, asset-backed securities and municipal bonds.
“It is not a time to swing too hard with the bat at risk,” he said, and once again recommended concern about interest rate risk.
“Long duration assets would be ill-advised at this point in the cycle. In your equity or riskier allocations, make sure that you are in high quality,” he added.
Barit concluded that captive managers have to put capital preservation first and think about the absolute return of their portfolios rather than relative return.
“If you have 90 percent in fixed income, don’t expect much of a return and be aware that it does not equal low risk,” he said. Investors should worry more about the downside, he added. For equities, this means, for example, not buying the S&P 500 index because it is too expensive.
“Can it keep going up?” he said.
“Absolutely. Can you afford to take that risk? I don’t think so.”