Low interest rate, cut in corporate earnings serve up a double-whammyA new A.M.Best’s Special Report looks at vulnerable industries and a new risk for default. Access the full report here.
OLDWICK, N.J., August 18, 2020— Recent macroeconomic uncertainty due to the COVID-19 pandemic is a concern for insurers’ balance sheets as corporate bonds constitute a majority of the insurance industry’s assets, according to a new AM Best special report.
The Best Special Report, titled, “Corporate Bond Holdings Pose Risk to Insurers’ Balance Sheets,” states that the corporate bond sector has been hit on two different fronts. First, many companies have taken advantage of the low interest rate environment, and as a result, are more highly leveraged than they were a decade ago. Second, a cut in corporate earnings due to closures of nonessential businesses and the significant rise in the unemployment rate will severely hamper earnings.
Corporate bonds account for nearly 70% of the bond portfolios of each of the three insurance segments, and those bonds from industries such as services, manufacturing, retail, energy and public utilities will be affected more negatively than others. Many of these sectors already had heightened below-investment-grade ratings as of year-end 2019.
A Leverage Bubble
According to the report, the leverage bubble may have led to a downward migration in credit quality, but the pullback in consumer demand is likely to exacerbate the credit crisis for borrowers. State shutdowns have sparked a rise in new bond sales, driven by companies trying to borrow their way through the economic downturn. The shutdowns also have driven a surge in the number of bonds trading at distressed levels, with a greater potential for defaults. Companies with heightened exposures to the aforementioned vulnerable industries will be at a higher risk of experiencing downgrades and defaults.
In aggregate, the industry’s exposure to these sectors appears to be modest; however, individual insurers with larger allocations to these industries may face balance sheet risks. Less than 20% of the bond portfolios of almost 90% of the property/casualty and health rating units are allocated to these sectors, versus just 47% of life/annuity (L/A) rating units. The 20 rating units with the largest exposures to the high-impact sectors are predominantly L/A companies. Some insurers also have large amounts of below-investment-grade assets in these sectors, although less than 2% of the rated companies have exposures that exceed 20% of capital and surplus.
If liquidity becomes a factor for many U.S. bond holdings, the macroeconomic environment could prompt many insurers to re-evaluate portions of their asset holdings and lead to redistribution across market sectors and risk classes.
Excerpts From The Report: Corporate Bond Holdings Pose Risk to Insurers’ Balance Sheets
NAIC-2 Rated Bond Allocations on the Rise for Years
Insurers have been steadily increasing their allocations to NAIC-2 rated bonds for over a decade, to gain yield. The life/annuity segment has the largest allocation, over 34% of bonds at year-end 2019, while the property/casualty and health segments both doubled their share from roughly 8% in 2009 to around 16% in 2019. Although these assets include securities other than true corporates (such as collateralized loan obligations, or CLOs), total exposure is notable, given that numerous asset classes in investment portfolios will be facing headwinds. As cash-strapped and revenue-starved corporations experience heightened financial difficulty, we may again see a spike in “fallen angels”—i.e., investment-grade assets falling into the below-investment-grade bucket, potentially leading to higher capital charges.
The share of below-investment-grade bonds held by the L/A segment has been declining consistently since the financial crisis, to a decade low of 5.2% of bonds in 2019, but allocations in the P/C and health segments have risen, though these exposures are not as high as the L/A segment’s.
Part of the dynamic that has led to the increase in NAIC-2 allocations is that bonds in the BBB rating category constitute more than half of all new investment-grade bond issuance since 2017, according to “Corporate Bond Market Trends, Emerging Risks and Monetary Policy” from the OECD. This compares to almost 39% on average from 2000-2007. A deeper view of the rated L/A and P/C insurers shows that they invest at the higher end of the BBB range— their share has grown from five years ago, and insurers seem not to have strayed much from the higher end, as only about a quarter of NAIC-2 bonds are in the BBB- range.
Still, given the low interest rate environment and cheap debt, firms near the median of each investment-grade rating category have higher leverage ratios compared with a decade ago. The ability of companies to cover their current interest obligations has improved, with the strong economy providing consistently favorable earnings, which, along with low interest rates, has resulted in enhanced interest coverage. Lower earnings and profitability ratios limit the ability to offset high leverage. In an economic downturn, higher leverage will likely lead to more downgrades and higher capital charges for insurers.
Pain Easing — The Fed Establishes a Secondary Market Corporate Credit Facility
On March 23, 2020, the Federal Reserve established the Secondary Market Corporate Credit Facility (SMCCF), which began purchasing a broad and diversified portfolio of corporate bonds to support market liquidity and the availability of credit for large employers. The lending facility was originally set to expire September 30, but has been extended until December 31.
The nearly 800 companies the Fed identified as being eligible to buy bonds from on the secondary market constitute almost one-quarter of the insurance industry’s total bond portfolio and nearly half the corporate bond portfolio, according to our analysis. The financial and services sectors are the only two sectors for which less than half the holdings are of companies identified for SMCCF eligibility.
Although insurance is generally a buy-and-hold industry with regard to investments, and some insurers had already tapped lending facilities earlier in the year in anticipation of a prolonged pandemic, the SMCCF provides an avenue to sell bonds from these companies on the secondary market.
This could reduce potential defaults if the pandemic remains widespread and continues to wreak havoc on markets over the near term. AM Best reviews investment portfolio watchlists provided by companies and will continue to assess the impact any deterioration in bond quality will have on cash flows, liquidity, and other metrics.