As investors continue to search for yield in this prolonged low interest rate environment, credit spreads have compressed considerably. Within the investment grade fixed income universe, buying the highest yielding securities in a given rating category may have negative consequences in the future. This paper examines the performance of BBB industrial bonds through the downturn. The historical performance suggests that insurance company investors should exercise caution when reaching for yield, particularly at this point in the credit cycle.
Margins within the insurance industry continue to be pressured by historically low interest rates with little end in sight. The Federal Reserve, along with other central banks around the world, has taken steps to pump liquidity into the global economy and use low rates to spur economic growth. Until recently, fixed income investors could take some solace in the fact that with heightened global volatility, credit spreads had remained modestly wide.
However, in the last few months, volatility has subsided. Both the VIX Index, a gauge of stock market volatility, and Bank of America Merrill Lynch’s MOVE Index, a measure of Treasury market volatility, have approached post-recession lows. The European Central Bank has bought some time for European nations to find a solution to their debt issues with their pledge to buy sovereign debt of fiscally challenged countries. GDP in the United States continues to grow slowly, and is expected to expand by approximately 2% in 2013. With increased calm in the market and the Fed’s policy to remain highly accommodative, even if economic data starts to improve, investors have become more comfortable adding risk. Consequently, credit spreads have compressed significantly across the investment grade universe. Exhibit 1 shows the trajectory of investment grade bond spreads over the past year.
Source: Barclays Capital Aggregate Index
Credit spreads reflect the market’s perception of the riskiness of bonds. If Bond A’s spread is wider than Bond B’s spread, the market is indicating that Bond A is riskier in some way. When credit spreads compress, resulting in little differentiation in yield between weak and strong credits, credit selection becomes even more important. In tight spread environments, many times, investors are not properly compensated for adding riskier securities relative to less risky bonds. In the fixed income universe, where investors receive coupon payments and par at maturity when all goes well, if spreads continue to tighten, we would encourage insurance companies to further consider the risk and reward of new investments.
While everyone would like an extra 20 or 25 basis points (bps) of yield, buying fundamentally weaker investments to earn incremental yield usually does not benefit investors over the market cycle. Examples abound of weaker credits that traded near stronger peers prior to the market correction in 2008-2009, but ultimately performed much worse once the markets and economy deteriorated. For example, at year end 2005, Sprint 10-year bonds were only 10 bps wider than AT&T 10-year bonds[note]Assumes Life & Health RBC charges of 1.3% for NAIC 2, 4.6% for NAIC 3 and 10% for NAIC 4[/note]. Sprint has had several operational challenges and is now rated B. Meanwhile AT&T has maintained A ratings. Similarly, at year end 2005, Washington Mutual 10-year subordinate bonds were 24 bps wider than JP Morgan 10-year senior bonds[note]Assumes Property & Casualty RBC charges of 1.0% for NAIC 2, 2.0% for NAIC 3 and 4.5% for NAIC 4[/note]. The fate of Washington Mutual was widely publicized. Of course not every bond with a wider spread fundamentally deteriorated through the recession. Some bonds simply exhibited more spread volatility.
We reviewed the spread history of all 10-year BBB-rated industrial bonds beginning at December 31, 2006. The average spread for these bonds at the time was 130 bps. Eleven bonds had a spread at December 31, 2006 that was one standard deviation greater than the average spread. Exhibit 2 shows the spread changes of bonds whose spreads were the tightest at December 31, 2006 (those with a spread one standard deviation below the average), bonds with the widest spreads at December 31, 2006 (those with a spread one standard deviation above the average) and bonds with average spreads (within one standard deviation of the mean).
Source: Merrill Lynch U.S. Corporate Index, BBB rated; AAM
Bonds with the tightest spreads among all BBB-rated securities performed the best through the recession with much less spread volatility. While the bonds with the widest and average spreads both exhibited more volatility, bonds with the widest spreads before the recession performed worse through the recession. Exhibit 3 highlights the difference between the average and widest 10-year BBB bonds. The timeframe of Exhibits 2 and 3 begins before cracks in the market and economy became widely noticed. During this time period, there was only a modest spread difference between the bonds with spreads that were wider relative to the average. In the period since the recession began, the relationship between these groups of bonds has not yet rallied back to their pre-recession levels.
Source: Merrill Lynch U.S. Corporate Index, BBB rated; AAM
From a statutory accounting perspective, the spread volatility makes little difference. These bonds were all NAIC 2 as of December 31, 2006 and were therefore carried at amortized cost with very modest capital charges. If the spreads and prices fluctuate, all else being equal, there is very little statutory statement impact. However, of those 11 bonds that had the widest spreads before the recession, six are now rated below investment grade (NAIC 3 and 4), and none have been upgraded. In comparison, there were 39 securities with spreads in the average spread group. Of those 39 bonds, six have been downgraded to below investment grade while five have been upgraded to A or better. Exhibit 4 summarizes the ratings changes for each of the three bond groups.
Source: Bank of America Merrill Lynch, AAM
On an investment of $1 million, investors would have captured $4,300 of extra income by investing evenly in the wide spread group relative to the average group. However, by holding the $1 million investment, companies would have had increased risk based capital requirements of $23,000 for Life and Health companies[note]Bank of America Merrill Lynch index data as of 12/31/05; S 7.375% 8/1/15 vs. T 7% 7/1/15[/note] or $7,700 for Property & Casualty companies[note]Bank of America Merrill Lynch index data as of 12/31/05; WM 5.125% 1/15/15 vs. JPM 4.75% 3/1/1[/note].
While the example provided here is specific to BBB 10-year Industrial bonds, the same experience can be observed across sectors and ratings categories. There continue to be opportunities to add risk-adjusted yield in portfolios, and we do not believe that significant selling of risk is necessary in our clients’ portfolios. However, we would advise investors to be careful “reaching for yield.” While a particular security may offer a few extra basis points of yield, even in the same rating category, investors should be cognizant of the extra risk being taken for the incremental yield and ask themselves whether the potential risk is worth the reward.
Daniel C. Byrnes, CFA
Principal and Senior Portfolio Manager
For more information about AAM or any of the information in the AAM Newsletter, please contact:
Colin Dowdall, CFA, Director of Marketing and Business Development
30 North LaSalle Street
Chicago, IL 60602
Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.
This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.