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October 08, 2020

Investment grade private credit: The fix for fixed income

Yield and income remain critical components for U.S. insurers, and a reconsideration of their core fixed income portfolio should include serious conversations about investment grade private credit. In short, we believe it’s where the yield is.

This article first appeared in Institutional Investor’s Insurance Asset Management Special Digital Report on September 30, 2020.

Read the Q&A and access the full Special Report: Opportunities for insurers in investment grade private credit.

It’s a changing world for insurance companies. Their reliance on fixed income is at odds with the lower for longer (and longer and longer) era, but insurers haven’t stood still. Their investment strategies are being reconsidered, and they’ve become so good at understanding their liquidity issues that they can survive and indeed thrive during economic shocks such as that brought on by the COVID-19 pandemic – assuming they were prepared for the challenge. Still, yield and income remain critical components for insurers, and a reconsideration of their core fixed income portfolio should include serious conversations about investment grade (IG) private credit, often known as private placements. In short, we believe it’s where the yield is.

To get a sense of how insurers think about IG private debt, why they should be thinking about it more, and how it can fit into their portfolio, II recently sat down with Andrew Kleeman, Managing Director, Private Fixed Income, SLC Management, Louis Pelosi, Senior Director, Client Solutions, SLC Management, and Andrew Coupe, Senior Consultant, NEPC. Employee-owned NEPC is one of the industry’s largest independent, full-service investment consulting firms, serving over 350 retainer clients with total assets over $1.1 trillion. SLC Management is a global institutional asset manager with $193 billion in assets under management (as of 6/30/2020). They provide a range of alternative asset class funds and liability-driven strategies to insurers and other institutional investors.

What are you hearing from insurers these days given the economic fallout from the pandemic – specifically about their fixed income portfolios?

Andrew Coupe: The trend among many of the different types of insurers I speak to is that they are trying to be alchemists. They’re trying to create gold without adding risk to the portfolio. That’s the place we’re at now. And they’re looking at things like securitized assets, with more interest in exotic collateral types, because insurers can’t afford to take additional accounting risk because of the constraints they are under – but they are desperate for the extra return.

Andrew Kleeman: I would add that the big U.S. life insurance companies have been including investment grade private debt in their portfolios for decades – in some cases maybe a century – and they understand the asset class, the protections, and the diversification aspects of it. They like the additional yield they get from it, and there’s no wavering in their commitment to the asset class. Increasingly, asset managers at larger insurance companies are offering access to the asset class to third party clients, whether it’s insurance companies that don’t have their own private placement teams, or even companies that may find their private placement teams are unable to access the full spectrum of the market and thus looking for help supplementing internal production. But there’s certainly been a lot of attention on the asset class, driven by its performance characteristics.

Louis Pelosi: We’ve been in a declining interest rate environment for 30 years, and we have seen all insurers’ yields suffer from it. COVID-19 and its market implications really pushed a lot of insurers over the edge, with reinvestment in core fixed income, depending on maturity, under 2%. So, the pressure on yields is really much tighter this go around as we hit historic lows. The pandemic really highlighted that insurers who took the appropriate risk management steps prior to the COVID-19 outbreak were able to take advantage of huge dislocations in all the markets – equities, private markets, even core fixed income. They understood their liquidity position, and maybe took steps to have a Federal Home Loan Bank line of credit or appropriate cash reserves. They were able to hold current investments, and deploy cash to improve yields and returns.

Coupe: The very sophisticated insurance companies who were able to pivot during the dislocations are the ones who have separated themselves. All insurers, by regulation, are very conservative in their portfolios. But those who were being a bit more reactive weren’t able to buy-in to a very tight window of opportunity. Given the quick bounce-back, there hasn’t been an inordinate amount of pain felt across the industry, but the insurers who could utilize all the tools on the liability side and on the asset side during that small window are sitting a little more comfortably now.

Andrew Kleeman, you were touching on how IG private credit is something for which large insurers have long had an affinity. Why is that?

Kleeman: It’s an asset class that has performed very well over an extended period of time. You have more time to underwrite the underlying investment, and you have more access to the management team when you have questions. For a lot of life insurance companies, there’s a recognition that their buy-and-hold investments form the vast majority of their bond portfolio anyway. So, if you have a $20 billion portfolio and you’re going to hold $4 billion of that in privately placed investment grade debt, if you can earn an extra 20 to 50 basis points that’s a lot of money every year that falls to the bottom line. And you have the same capital charges that you would with public debt.

There is no insurance company that has 100% turnover in their bond portfolio in every given year – that doesn’t exist, right? So, for a lot of insurers, having anywhere from 10% to 30% or 40% in privately placed debt – the diversification, the covenants, in some cases collateral, the ability to do longer durations that might be attractive to them – say 12- or 15-year – all of that more than offsets illiquidity issues, because they’re not selling these bonds anyway.

Do all types of insurers share a similar appetite for IG private debt?

Coupe: Life insurers are very familiar with private placements, but the same is not necessarily true for P&C and health companies. There is no buy and sell of these assets – a well-performing private placement will just sit on the balance sheet and generate income – it is a beautiful thing, but that comes at the expense of liquidity. In addition, we’re really only recently starting to see the providers in this space – the asset managers – bring out some really high-quality products that have attractive fee schedules, and I think that really opens up the asset class for non-life insurers.

Kleeman: P&C insurers typically have shorter duration needs, and the life companies, which have been dominant in this space, typically have longer duration needs. That contrast has created opportunities for P&C companies because the shorter end is less competitive. There can be a lot of value in investment grade private placements in that three-, five-, seven-year kind of tenures, and that can fit the P&C companies very well, apart from all the other benefits of higher yields, covenant security, and diversification.

Coupe: I think it’s fair to say that the consulting community hasn’t necessarily embraced private placements either. Some of that is down to the challenges that it presents from an asset allocation perspective. It has very similar characteristics to public market fixed income with some additional spread. So, the incentive to add that to an asset allocation for some consultants who maybe aren’t as familiar with the insurance space, is quite challenging.

Pelosi: IG private credit is really your complement to, or replacement for U.S. public corporates. They share a lot of similar statistics and correlations. IG private placements will be a growing asset class because the alternative of a 1.5 yield, 10-year corporate is not as attractive.¹ Also, P&C and health insurers are very focused on liquidity, but over the past 10 or so years all insurers – doesn’t matter which line – have become much better capitalized. They have materially improved capital positioning and generally speaking, as highlighted by COVID-19 earlier this year, a good portion of insurers were ready for a material liquidity crunch. They have access to lines of liquidity, many have modeling in place to understand their total liquidity risk. There’s no free lunch, but this is the nearest thing to it for many insurers given the increase in yield versus the trade-off for illiquidity. In short, insurers have become better at addressing liquidity issues, which gives them the flexibility to add less liquid investments that increase yield.

Where does IG private credit fit into the SLC Management playbook? And what are the traits of the businesses the strategy looks to invest in?

Pelosi: When we do modeling, regardless of insurer type, the simplest adjustment for our clients is to move out of traditional publics and into traditional privates. How we do that is two-fold. First, we get them comfortable with their liquidity positioning through operational modeling – that’s what our Client Solutions Group does. We look at your business, we understand your liabilities, liquidity position, and access to liquidity. If we and the client jointly conclude there is some excess liquidity, IG private credit is typically the first yield or return lever we pull, because it’s such a large pick up compared to other securities – and with little to no regulatory impact, as opposed to some other investments.

Kleeman: In terms of where we look to invest, we are looking broadly across a wider range of a deal structure. We manage more than $30 billion of private placements. We have a team of nearly 60 analysts, broken into several smaller teams, and we have a higher relative value focus –so that’s led to a lot more specialization in those teams. For example, we have a team, focused on private real estate deals, whether that’s credit tenant leases or ground leases or similar structures. We have a dedicated team that does a wide variety of infrastructure-backed loans, whether that’s power projects or toll roads or other social projects. And we also have a dedicated corporate finance team that has multiple areas of specialization, as well as doing more traditional broadly-syndicated private placement deals.

In general, we’re looking for stability of cash flows in the underlying credit, and to build a diversified portfolio for our clients. We’re looking for structural protections through security where it really matters, where it’s actually secured. We’re looking for covenants and we’re looking for high relative value. Our job is to find those opportunities, and this year in particular it’s been really attractive as the public bond markets – and all markets, really – have gone through quite a gyration, really stressed in March and snapping back quickly. Private market pricing responds slower than the public market, which is hard when spreads are widening in the public market, but when they’re tightening the relative value tends to sustain for quite some time. It has been a great year for us in kind of the value we’ve been able to add in private placements, despite the pandemic.

Pelosi: One differentiator at SLC Management is that due to our focus on investing for insurers all of our private credit holdings are publicly rated by the SVO. Therefore, whether our clients are focused on solvency risk based capital (RBC) or rating models (AM Best BCAR) these securities receive capital treatment the same as their public counterparts. Some private credit shops are not as focused on ratings, but we know that’s critical to insurers.

In the context of all those areas of specialization, are any areas in particular resonating with clients right now?

Kleeman: SLC Management is very focused on ESG issues and it’s something that our clients feel is important. And maybe just as important, a lot of us who work at the firm are personally passionate about those issues as well. So, we’ve found a lot of opportunities, both in the infrastructure team and corporate finance team, that blend well with our appreciation of ESG but still offering substantial relative value relative to public corporate bonds. That’s been a win-win on both the relative value front, as well as our desire to not only be good investors but to invest in opportunities that improve either the environmental impact or the social impact in our world and in our communities.

Let’s dig a little deeper into the IG private debt strategies. Investors today like flexibility – do your strategies provide that?

Pelosi: Ours is definitely not a one-size-fits-all approach. While we do offer funds in this space that are popular with other institutional investors, like pension plans, in the insurance sphere private credit funds, more often than not it’s going to be treated in a much less favorable capital fashion. Typically for insurers we’re going to tailor a separate account strategy for the type of client and their specific liability needs. Just yesterday we were having some internal conversations around specifically trying to avoid high correlation assets with current liabilities. For example, if a property and casualty underwriter in the Northeast has large exposures to the general New England area for their business, we’ll try to avoid underlying line items that also have similar exposures. If a large Hurricane Sandy type event were to have material impact to the Northeast, you’re not doubling down on both operational risk and investment risk.

Coupe: The IG private placement is likely to add between 50 and 100 basis points to BBBs. This isn’t a double-digit return type, and you really see that in the risk factor. You look at the default rate, you look at the recovery rate. It doesn’t look like what the broader investment community would consider to be private debt. We have certainly seen, across all insurers, a real run on private debt overall the last few years. The driver of this trend is the exact reason that investment grade private placements make sense; more yield per risk-based capital unit relative to similar investments. It’s really two parallel stories in private debt, but there’s not necessarily a crossover component of investors looking to move out of lower quality private debt into investment grade private debt.

Kleeman: That’s interesting, because when you talk to people from the broader investment world and say you do private debt they assume it’s below investment grade. And then as you start to describe what you actually do, they look at you like it’s something they’ve never heard of before. So, it’s definitely a market that’s less familiar to some investors. It’s hard to tell how big it is because there are a lot of direct deals or club deals that are done, but we think the investment grade private placement market is somewhere between $90 and $100 billion per year in volume.

Coupe: I actually think the nomenclature does the asset class some harm. There can be key stakeholders who don’t necessarily understand investments and hear the word “private” and just say, “Oh, I don’t want to do it, it’s private.” Or they look at the return profile and say, “Well, why are we doing this for a private asset?” That one word can do some harm to people who are looking at the asset class for the first time.

Including some of those total return investors we mentioned earlier?

Coupe: NEPC is spending a lot of time talking with insurers about that now, because in a prolonged low rate environment the total return concept is much more difficult to make work. The income focus – which will ultimately drive total return – may be more important on the bond side than capital appreciation or any sort of additive from money due on a total return basis. Going forward, P&C and health insurers could certainly look and say, “Okay, we have a lower for longer environment. Investing in income-focused assets might be a preferable way to go rather than some of the total return fixed income strategies.”

Pelosi: Some of the more sophisticated P&C and health insurers who have adapted to the market environment quickly, as Andrew just mentioned, have seen explosive growth in IG private debt space. From an asset allocation viewpoint overall, IG private debt replaces traditional IG public fixed income. With similar correlation, volatility, and capital charges, but higher yield characteristics, IG private debt tends to be the lowest hanging fruit in our asset allocation models. Across the board, the question is not “Should you use private placements?” Rather, it’s “How much can you use?” They just make so much more sense than a traditional core asset in the current market environment.

Kleeman: If you’re asking how they fit into a portfolio, we have achieved an 85-bps premium to corporates of the same rating and tenor over the last five years, and this year it has been around double that.2 I think that extra yield fits nicely into anyone’s portfolio.

We’ve mentioned larger insurers a few times in this conversation. Would smaller insurance companies have any difficulty accessing IG private debt?

Kleeman: It takes a certain scale to access the market well. There are some huge insurance companies that have big teams. There are much smaller insurance companies that have dedicated teams as well. But at some point, particularly if you want to get into the more niche sectors, it requires a level of specialization from an asset manager. A lot of the asset managers at larger insurance companies are offering third party services now. The key is making sure that whoever you sign up with, you can get a reasonable allocation. And it’s interesting that traditional life companies view this asset class as gold and they don’t want to give it up. Just understanding those allocation policies and going to a manager who’s got the ability to give their new clients reasonable allocation is a critical aspect of the client experience.

We’ve talked about a few things that differentiate SLC Management’s approach and strategies in IG private credit – what are some others?

Kleeman: One is our focus on fundamental underwriting. These are not deals announced on Tuesday and priced on Thursday. These are deals that take at least two weeks and sometimes months to underwrite and negotiate. We take a lot of pride in underwriting, so we get access to information. We use third party resources to verify our underwriting and collect more data on the underlying industries.

As I mentioned earlier, we are a team of specialists. For example, the origination capabilities required for private investment grade debt are unique. We have people that are dedicated and focused on origination. There’s a fair chunk of privately placed investment grade debt that comes from the large banks, but there’s a lot of interesting deals that come out of other sources as well, whether its boutique investment banks, a direct situation with a borrower, or other kinds of structured opportunities. Along with origination capabilities and complex fundamental underwriting, we have a dedicated legal team to get through the deal documentation – which in a lot of these situations, can be negotiated, unlike in a public deal. A robust effort is required to get each deal across the finish line – and we have all the specialists to make them happen.

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