The Intelligent Quarterly from the publishers of The Insurance Insider

Autumn 2017

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Emerging opportunities

Colm McDonagh

Insurers are facing considerable economic, political and regulatory uncertainty. The lack of clarity surrounding the UK's Brexit negotiations, clouded further by the recent general election result; the political gridlock facing the Trump administration; and heightened terrorist threats are just a few recent examples. We believe that this uncertainty is likely to persist.

One longstanding constant though, has been the low interest rate environment in most developed countries. This has forced insurers to seek new asset strategies that provide sufficient returns to meet investors' and shareholders' requirements.

Government and corporate bonds have long formed the bulk of insurers' portfolios, however in the last few years a clear increase in allocations to corporate bonds, combined with a progressive move down the credit spectrum into lower-rated debt, including high-yield issues, has been evident.

More recently, many insurers have been attempting to take advantage of the retrenchment of banks from lending markets to capture an illiquidity premium without significantly increasing the credit risk in their portfolios.

We are strong believers in the benefits of diversification across credit markets and geographies. In the current yield environment, we believe there is a compelling argument for expanding the investment universe to emerging markets (EM). The breadth and type of opportunities, as well as the credit quality of issuers, is often underestimated in this $20.6tn asset class.

Opportunities in emerging markets

With more than $7tn of government debt trading at negative yields (as of the end of June 2017), the opportunity in EM debt seems increasingly compelling. We believe it offers some of the most desirable risk-adjusted income streams around and, unlike in developed markets, valuations are still relatively attractive (see chart).

Click to enlarge EM economies now account for more than half of global GDP, and are generally less indebted than developed markets. The share of corporate finance via bond markets in EM has nearly doubled since the global financial crisis as banks have aimed to deleverage and shrink their loan books.

The opportunities for insurers are many and varied. Some EM have a fully developed range of capital markets instruments, including interest rate swaps and foreign exchange options. A larger group of EM countries offer at least four types of debt instruments to foreign investors.

The key challenge for insurers is how best to access the opportunity in a risk-managed way.

Managing exposures for insurers

Given a desire to avoid excessive volatility, an opportunistic approach to EM debt that harnesses multiple return drivers, while aiming to preserve capital, could be more suited to insurers' objectives.

Many EM issuers are under-researched, under-owned and unloved by mainstream investors. This creates mispricing and opportunity, in spite of EM debt's status as a rapidly maturing asset class.

According to the Institute of International Finance, net capital inflows to EM will rise to $78bn in 2017, reversing the large outflows experienced in 2015 and 2016. Inflows are expected to accelerate to $167bn in 2018.

Through much of 2016, headlines were unremittingly bad - focusing on fears of a hard landing in China, sharp declines in commodity prices and perceived negative impacts of an appreciating US dollar on EM debt sustainability, as well as idiosyncratic events such as the political crises in Brazil and Turkey.

These concerns became factored into the valuation of EM debt instruments and caused currencies to weaken, enabling many countries to improve competitiveness and external balances.

Many of these stories have now turned around. Concerns about Chinese growth have dissipated, and capital outflows have stabilised. Commodity markets appear to have bottomed, with the oversupply of recent years coming to an end as growth in demand has brought many markets back into balance.

The US dollar could strengthen once again, but policy tightening is well signalled, whilst missteps from the Trump administration have raised concerns about its ability to legislate for its pro-growth and pro-business agenda.

As the fundamental outlook has improved, with painful reforms in many countries now allowing them to benefit more fully from improving external factors, so currency volatility has declined.

This in turn has reduced fears regarding debt sustainability and a potential spike in defaults, due to mismatches between dollar-denominated liabilities and local currency-denominated assets - a fear we have long felt was misplaced.

The emerging market debt universe

The asset class consists of three types of exposure which have different risk profiles and a different regulatory capital treatment for insurers: US dollar-denominated government debt, local currency-denominated government debt, and corporate US dollar-denominated debt.

For example, actively managed local currency debt offers insurers without significant net currency risk genuine diversification and potential capital benefits under regulatory frameworks such as Solvency II.

Additionally, much of the EM debt universe is investment grade, meaning that insurers have access to plenty of opportunities without needing to increase credit risk exposure
(see chart).

Insulated from Brexit

EM countries should be relatively insulated from the implications of the UK's decision to leave the EU.

Click to enlarge The major exception is Eastern Europe, which is an integral part of the European manufacturing supply chain. For now, the region is benefiting from the broad upswing in regional growth, but if tariffs were introduced on exports to the UK, then demand could be negatively impacted.

Another argument, though, is that in order to remain competitive in that scenario, even more investment could be directed towards those lower cost countries from the core.

Asia and Latin America are both more insulated from events in Europe and the UK, with China and the US the key drivers for those regions. We believe that as the global economy shifts towards an increasingly tri-polar world, it will create investment opportunities.

Meanwhile, a very gradual normalisation of policy in the developed world, with the neutral level of interest rates believed to be well below historical levels, should continue to press investors into EM assets, particularly given the availability of significantly higher prospective yields for the same credit ratings as developed market equivalents.

Local rates markets also look attractive overall, while local currency will continue to move in step with global risk appetite, warranting a tactical approach.

As with all investments there are risks, which ironically look more centred on events in developed markets, such as the ongoing policy uncertainty in the US or the potential for early Italian elections.

Reconsidering allocations

In light of depressed long-term yields, insurers are reconsidering asset allocations to try to access higher returns without taking excessive risk.

EM debt may be one of the few asset classes that can achieve these conflicting aims, provided that exposures are managed appropriately with a focus on downside protection.

While some strategies combine exposure to different segments of the market as part of the total return approach, insurers' portfolios are still typically managed with reference to mainstream indices seeking to minimise tracking error.

In our view, a better strategy is to seek to harness the favourable characteristics exhibited by EM government and corporate debt issued in both local and hard currencies and target portfolio diversification, income generation and capital growth.

These types of approach can be aligned more closely with liabilities and tailored to specific risk requirements and objectives. They aim to enhance returns beyond traditional index allocations without being overly influenced by either US interest rate policy or moves in EM currencies.

Colm McDonagh is head of emerging market debt at Insight Investment

This article was published as part of issue Autumn 2017

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