Justin Hook: Yields were much lower coming into 2022, ahead of the US Federal Reserve’s 11 consecutive rate hikes. This meant that investors had to dip into lower-quality or higher risk assets to maintain the yield advantage and income targets they were looking to achieve. That changed towards the end of 2023 as all-in yields started to look much more attractive across higher quality assets.
So, the shift now is focused more on higher quality. Spreads across US Corporate credit have compressed to post-COVID tights and you’re not getting paid to drop down to lower quality assets. As a result, investors are evaluating opportunities within the private markets as we see a shift across credit and more infrastructure to capture the risk diversification and unique characteristics there. That’s where we’re seeing opportunities throughout 2024.
"Following the regional banking crisis in March of 2023,
CRE came under tremendous pressure."
The resilience of capital markets in 2023 was pretty phenomenal and was predicated on continued strong consumer spending and a robust labour market. The markets weren’t as stressed as anticipated going into 2024 because 2023 was one of the longest telegraphed recession years that didn't happen.
We also saw markets continue to perform well outside of some stress areas such as commercial real estate (CRE). That’s an area where you want to make sure you're sharpening your pencils. It's a matter of delineating between an overall sector allocation and focusing on specific property types and geographies within that sector.
Following the regional banking crisis in March of 2023, CRE came under tremendous pressure. Office, in particular, is one of the ones that's most stressed – facing not only cyclical challenges but also secular headwinds. Other property types of CRE are facing pressure as well due to their association with the office sector. While commercial mortgage-backed securities (CMBS) spreads have benefited from strong Year-to-Date (YTD) tightening, they remain under pressure and there are opportunities to invest in higher quality properties at attractive spreads– and to be the lender that steps in and provides liquidity.
Justin: Insurers such as us that have longer-dated illiquid term life and group annuity liabilities are in a great position to invest in these more capacity-challenged sectors to take advantage of the structural dislocation that we're seeing there and the wider spreads.
They can also take advantage of the structural benefits that you receive within private markets to capture that illiquidity premium, whereas others might not have the flexibility to participate.
There are attractive opportunities across investment grade private credit, first lien senior-secured commercial mortgage loans, and infrastructure project finance debt too.
"Within the challenged markets, insurers should take a high-level view
in navigating those capacity-constrained areas."
There continues to be attractive spreads across asset classes with strong credit protections that provide diversification as we think holistically about portfolio positioning. Insurers should continue to focus on sourcing high quality assets in private markets given where we are in the economic cycle. Market conviction around a “soft landing” has caused risk assets to have strong performance YTD and as such selectivity is key as you assess attractive risk and capital adjusted opportunities in private assets.
Within the challenged markets, insurers should take a high-level view in navigating those capacity-constrained areas. I’d suggest utilising a more pragmatic approach to risk management by designing an overall framework that maps out exposures broadly across asset classes and geographies and then setting specific risk appetites based on a blend of valuation, underlying fundamentals, and integration of climate-specific considerations – which help inform investment decisions.
I would also highlight that the starting point matters and plays a crucial role depending on which jurisdiction you're looking to invest in. Sticking to a robust framework for risk appetites can help dictate how you appropriately utilise the risk budget in terms of investment opportunity.
Justin: As insurers think about investing their portfolio in the second half of the year, a key consideration should be a continued focus on high quality. We could be seeing an environment that has an elevated level of rating migration, specifically within corporate credit and securitised assets. Now is the time to focus on a bottoms-up approach when looking at different capacity-constrained areas. You should be looking to diversify your portfolio in 2024 while being mindful of the best relative value opportunities.
Insurers should continue to monitor potential regulatory changes proposed by the National Association of Insurance Commissioners (NAIC) and incorporate their views on potential impact as part of the investment process. There is a lot of discussion around structured assets, specifically with initiatives on bond definition, Securities Valuation Office (SVO) ratings/designation, and CLOs, for example, and like other insurers we continue to watch how these discussions evolve closely.
"Coming into 2024, markets were pricing in four to seven cuts with
a soft landing, but that narrative is evolving."
With regards to the later stages of a credit cycle, and where credit migration is occurring – there will be an opportunity for some to take advantage of the spread compression and clean up any cuspier credits.
One of the things that insurers can benefit from now in the higher rate environment is locking in higher yields on the fixed rate side because there isn’t pressure to dip into high-yield credit assets to get the same returns. Coming into 2024, markets were pricing in four to seven cuts with a soft landing, but that narrative is evolving. Inflation has continued to come in higher than the Fed’s target and labour markets haven’t cracked. This means that if we do end up in an environment where rates are higher for longer, we need to think about the investments that will underperform in that scenario and make sure that we are positioned appropriately.
As you think about the higher-for-longer environment, the other dynamic to highlight is where opportunities are across the various markets. Sponsors and borrowers, especially on the private side, are anchored to short-term financing in the three-to-five-year range vs. the medium- and longer-term duration needs of insurance companies to better match their liabilities.
From an ALM perspective, investors will want to stay close to home across the curve, but also around their overall duration positioning. The higher rate volatility we saw in 2023 is expected to remain – so it doesn't make sense to take an outsized position on duration risk.
Investors can also take advantage of the relative value opportunities to achieve the duration targets they need. They can put on barbell trades – whether it's a credit or a duration barbell – and take more credit risk in the front end where we’re seeing spreads widen, specifically in structured finance space across asset-backed securities (ABS) markets. Then, pairing that with higher quality corporate investment grade (IG), investors can end up with good results from a duration perspective, and achieve higher spreads.
Justin: From a broad market’s perspective, seeing a shift from public to private assets will change the way insurers look at investing across their balance sheet.
Private markets have always been a consideration across strategic asset allocation (SAA) for insurers, but we're seeing the opportunity, if you have the liquidity capacity on your portfolio, to step in and provide that liquidity to sponsors and take advantage of those opportunities. Whether it's infrastructure, project finance, CMLs, or even private credit, you do see this opportunity to step in.
"Areas that we expect will continue to provide opportunity are in the
digital infrastructure space around data centres and fibre."
The other thing I'm excited about in 2025 is that we're seeing innovations across structured finance. You're seeing new opportunities that are complementary to the Artificial Intelligence (AI) and technology trends that are coming across as we see structured finance with a collateral move away from traditional consumer-oriented underlying collateral.
Areas that we expect will continue to provide opportunity are in the digital infrastructure space around data centres and fibre; these subsectors offer attractive, capital efficient investment opportunities that also help diversify portfolio asset risk. Also, digital infra assets and services enable organisations to improve their productivity and be more nimble while contributing to the overall productivity of debt in the system.
Any views, thoughts and opinions expressed in this article are solely those of the author and are not intended to reflect those of their employer.
