The majority of investors are defining what comes next as a period of ‘new normalisation’ in fixed income investing, characterised by lower yields, low inflation and renewed central bank intervention. A significant minority have a contrary view of a deflationary storm caused by an end of cycle downturn in still fragile economies. Relatively few see an inflationary boom commonly associated with the end of an economic cycle, despite this being implicit in the policy objectives of the Trump US administration.
The study, conducted face-to-face amongst 79 fixed income specialists and CIOs across Asia Pacific, EMEA and North America, shows that over half (58%) of the fixed income investors interviewed believe the global economy is on the path to recovery, but not the typical normalisation which has historically occured after an economic slump. According to the majority of investors surveyed, a shift has occurred and improvement in key metrics is expected to be subdued with moderate rates of economic growth; gradual increases in central bank interest rates, resulting in yield curves rising at the short end faster than at the long end; and little concern over the risk of rising inflation.
New set of challenges for insurers
Over the last three years, the dominant challenge facing investors has been navigating the low yield environment as yields have fallen further with each successive year. However, whilst the low yield environment is still seen as having the biggest impact, there are a new set of challenges which will impact fixed income portfolios.
For insurers, tightening regulation is the major concern, in particular with Solvency II in Europe and Risk-Based Capital and C-Ross in Asia all aiming for greater transparency and better risk management. These will be particularly challenging for insurers with large guaranteed books which have high return requirements to ensure guarantees are met.
Insurers investment strategy
The long period of falling yields on fixed interest securities have seen many investors forced to increase their risk profile in their search for adequate returns. Combined with a pullback by banks in certain forms of lending, this has seen alternative credit – a diverse range of assets such as high yield, structured credit and infrastructure debt – move into the mainstream. For insurers, alternative credit is now an average of 15% of fixed income portfolios, with the largest appetite in North America at 24%.
While institutional investors view alternative credit favourably, insurers, in particular, see a range of benefits. The leading rationale for investing in alternative credit is to increase alpha, slightly ahead of generating income and improving diversification [figure 1]. This trend is set to continue with 42% of insurers expecting to increase allocations to alternative credit over the next three years.
Appeal of illiquid alternative credit
With insurance regulation placing greater emphasis on asset-liability matching and forcing insurers to hold more liquid, less volatile assets via lower capital charges, insurers particurarly favour illiquid alternative credit. This allows insurers to achieve the dual objectives of generating alpha and income, while adhering to enhanced regulation.
The study shows that over the last three years, 42% and 35% of insurance respondents have been increasing allocations to infrastructure and real estate debt respectively, a higher proportion than any other alternative asset class, while no insurers have reduced allocations. This trend is set to continue over the next three years, albeit at a slower rate, with 15% and 23% of insurers expecting to increase allocations to infrastructure and real estate debt respectively.
Commenting on the study, Ed Collinge, head of UK insurance at Invesco, said: “Insurers continue to innovate and diversify their exposures within their fixed income portfolios. Whilst the low yield environment and changing regulations have created some obstacles for insurers, they have also importantly resulted in many opportunities for insurers to enhance their returns in a risk controlled and capital efficient way. We expect the shift towards alternative and more illiquid credit to continue over the coming years.”
Nick Tolchard, Head of Europe, the Middle East & Africa (EMEA) for Invesco Fixed Income at Invesco, added: “With the global economy on the path to recovery and central banks starting their journey back towards more conventional policies, fixed income investors sense an end to the long march down in yields, but are uncertain about what comes next.
“Whether the perceived ‘new normalisation’ or another scenario unfolds, pressure remains on fixed income investors to meet performance expectations. The toolset available to investors to do so has become much broader, and they are increasingly making use of it, either via their own teams or more commonly with external asset manager partners.”
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