ASSET SIDE

Evaluating the Case for US High Yield for Insurance Companies

By Jason Chen, Bernie Ryan, and Katherine Klein

Historically, insurance companies have tilted their fixed income portfolios toward higher-credit-quality asset classes, helping avoid credit default loss potential and providing a longer duration profile that helps with asset-liability management.

Over the past decade, as yields were suppressed by disinflationary pressures and corresponding dovish monetary policy, insurers—among other investor groups—were gently guided toward riskier segments of capital markets in an effort to generate sufficient returns on their float. The most obviously incremental yield extension of the fixed income has been the US high yield universe, which has seen significant inflows from insurers since the global financial crisis.

Despite the move higher in both nominal and risk-free rates over the past year, high yield seems to have established a permanent strategic and tactical allocation in insurers’ asset allocations. As high yield has gained prevalence in insurers’ investment portfolios, the complexity and nuance of high yield bond investments has also evolved. While some insurance companies may elect only to invest in the upper-tier ratings of the high yield universe as a way to increase portfolio yield on a hold-to-maturity basis, other insurers may seek greater potential opportunities in more speculative segments of the market, and more tactically minded insurers may look to rotate their high yield risk to reflect current market conditions.

Historical Risk and Return

When examining the empirical returns of various segments of the high yield market, a couple of observations can be made as seen in Figure 1:

Figure 1

Risk-adjusted returns have generally been more favorable for the higher quality segment of the high yield market and correspondingly less favorable for the lower-end cohort.
Unsurprisingly, there is considerably more return volatility among CCC and lower-rated securities relative to BB and B names.

Figure 2 shows the return, volatility, and Sharpe ratios for different ratings segments of the high yield market dating back to 1996.

Figure 2

Looking at returns and Sharpe ratios by calendar year, it’s apparent that seldom does the CCC and lower segment of the high yield market generate superior risk-adjusted returns relative to BB/B-rated credits. Only in very strong credit market rallies has the risk-adjusted return of the CCC and lower-rated securities exceeded the broader high yield index as shown in Figure 3. In just seven of the 27 calendar years (1999, 2003, 2006, 2013, 2018, 2021, and 2023) was the Sharpe ratio of the CCC and lower superior to the BB-B index, with an average spread tightening in US High Yield of 117bps across those calendar years.

Figure 3

Spread Betas Across Ratings

Historically, spread movements have been understandably more pronounced in the lower-rated segments of the high yield market. Figure 4 shows the option-adjusted spread for the respective high yield rankings cohort. The sensitivity of different-rated credits to moves in broad high yield market spreads can vary at different points in time due to factors such as industry exposure. Aside from idiosyncratic single-issue risks or other point-in-time factors, the historical beta of the upper tier high yield to the broad market is relatively stable, with BB and B historically realizing 0.66 and 0.92 betas to the broader high yield universe, respectively. The lower-rated CCC segment has historically realized less stable spread betas, given higher issue concentration and default risk associated with higher spread levels. Figure 5 shows the options-adjusted spread betas across different high yield ratings.

Figure 4 Figure 5

Issuance Across Ratings

In periods of financial and credit distress, lower-rated issuers often bear the brunt of waning demand for new corporate bond issuance. This can potentially compound the risk associated with shorter-maturity borrowing windows that often characterize lower-rated corporates. Figure 6 shows CCC and lower bond issuance as a percentage of the total high yield issuance and its relationship with high yield spreads the previous year.

Figure 6

As you can observe, in years where spreads reached distressed levels, the subsequent year’s CCC and lower issuance was, in many cases, quite limited. Following the tech bubble in 2000, the financial crisis in 2008, and the energy crisis from 2014-2016, issuance volumes for lower-rated corporates were well below long-term averages.

Spread Behavior Around Ratings Upgrades/Downgrades

The interaction between spreads and changes in credit ratings is a dynamic worth noting. Following the experience with mortgage credit ratings during the 2008 global financial crisis, investors have observed that ratings agencies may not always upgrade or downgrade bonds before the fundamental deterioration or improvement of the issuer can be observed by market participants.

By measuring the average issuer spread behavior prior to and following rates downgrades, we can illustrate this strong bias: on average, issuer options-adjusted spreads have widened by roughly 550bps three months prior to ratings downgrade and have rallied nearly 450bps in the three months following. Interestingly, the same analysis of ratings upgrades yields much more neutral results in terms of spread behavior before and after the ratings upgrade. Figure 7 shows the average high yield issuers change in OAS in the three months before and after ratings upgrade and downgrades.

Figure 7

High Yield Industries Breakdown

The industry composition of the high yield universe has changed over the past three decades, where energy has grown to now exceed 11% of the high yield index even after the energy default cycle in 2016. On the contrary, retail has shrunk from just about 10% in 1996 to barely 5% of the current index, and media, once representing over 22% of the index, is now just 9% of the high yield universe.

Generally, macroeconomic trends have driven the shifts in the industry composition across the high yield universe, although the size and the creditworthiness of companies has also influenced the breakdown between investment grade and high yield composite indices. Telecommunications and media companies such as Nextel and Adelphia, once sizeable issuers within the high yield universe, are now either merged with other firms or no longer operating. The boom in US energy production has made Houston-based Occidental Petroleum one of the largest high yield issues in recent years. Figure 8 shows the historical changes in the industry composition of the broad high yield index.

Figure 8

Industry Tilts Resulting from Quality Bias

Although constraining a high yield allocation to upper tier BB-B rated bonds only effectively removes about 10% of the index—see ratings composition in Figure 1—there are, at times, not insignificant deviations in industry composition. The CCC-and-lower segment of the market can, at times, be dominated by single issuer downgrades or industry-specific turmoil, which can drive significant differentials in industry composition between higher quality and lower quality indices. Figure 9 shows the most recent industry weightings for the BB-B segment of the high yield market as compared to the CCC and lower segment.

Figure 9

Financial Industries

For some insurance companies, there is a desire to mitigate industry or sector-specific risks that more closely align with their areas of business. An obvious starting point is financially oriented industries, which constitute roughly slightly more than 12% of the high yield universe. The four financial industries—banking, financial services, insurance, and real estate—have fluctuated in their market values over the past three decades, with real estate having gradually grown at the expense of banking. Figure 10 shows the composition of financial industries within high yield.

Figure 10

Historically, high yield industries have realized different levels of market risk as well. When measuring the beta of the spread relative to the broad high yield index, more defensive sectors such as healthcare and utilities have realized the lowest betas whereas financially-oriented industries have historically realized among the highest market betas of high yield industries. Figure 11 shows the historical spread betas across high yield industries, illustrating the empirically higher beta of financial industries.

Figure 11

The higher spread beta nature of financial industries is predominantly driven by elevated risk during the financial crisis, with post-global financial crisis betas looking for in line with the broader high yield market. Figure 12 shows how the beta in the post global financial crisis regime was significantly lower and more in line with the broad universe.

Figure 12

As with the risk profile, risk-adjusted returns are also a tale of two regimes. While the average BB-B returns were modestly higher than the BB-B index since 1996, the significantly higher volatility outweighed the higher returns, resulting in a lower empirical Sharpe ratio. However, simply measuring the risk-adjusted returns in the post-GFC period puts financials more on par with the broader BB-B universe, exhibiting slightly higher volatility but also slightly higher average returns. Figure 13 shows the risk and return across the full period, prior to the GFC, and from the GFC to the end of 2023.

Figure 13

Market Timing: Returns in Distressed Credit

Markets In a distressed market environment, the extent to which high yield spreads can widen is not uniform across historical bear markets. The average option-adjusted spread experience in distressed markets was heavily skewed by the global financial crisis when high yield spreads reached nearly 2000bps, implying a nearly 40% default rate based on our previous assumptions. Those assumptions are a 325bps credit risk premium and 40% recovery rate.

While high yield total returns were quite challenging during this period of market turmoil, the realized default rate was significantly lower, and the subsequent returns to the asset class were quite favorable for investors. Figure 15 shows the options-adjusted spreads of both the high yield index and the BB-B segment, highlighting periods where spreads exceeded 1 standard deviation above the historical average.

Figure 14 Figure 15

The widening in credit risk premia has spurred the creation of risk rotation strategies from asset allocations that are looking to take advantage of wide credit spreads. If the peak in spreads can be estimated with any accuracy, monetizing temporarily high credit risk premia following these market selloffs can help generate quite favorable investment returns. Figure 16 and Figure 17 show the rolling 12-month returns of segments of the high-yield market; average twelve-month returns have been far more favorable following periods of market distress.

Figure 16 and 17

Approach High-Yield Market Strategically

The need for nominal and real income generation by insurance companies in the decade and a half following the financial crisis has pushed insurers out on the risk curve, with allocations to the high yield now making up an important allocation within strategic investment portfolios. As interest rates have moved higher, the yield provided by high yield markets, particularly with lesser interest rate and spread duration as compared to other sovereign and credit asset classes, continues to look quite attractive for insurance investors and other asset-liability plans.

Understanding the risks and access points within the high yield market remains integral for insurers who may be looking to either supplement yield or express more tactical views on the market. By approaching high yield investments through a thoughtful strategic lens, yield objectives can be potentially achieved with consideration for spread volatility and drawdown risk, ratings quality, and industry concentration. Furthermore, insurance investors looking to be more opportunistic during more distressed market conditions can also utilize different segments of the high yield market such as spread beta, duration, and industry tilts to help achieve their tactical objectives.

Disclosures

Please note certain information in this presentation contains forward-looking statements. Due to various risks, uncertainties, and assumptions made in our analysis, actual events or results or the actual performance of the markets covered in this presentation report may differ materially from those described. The information herein reflects our current views only, is subject to change, and is not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. Assumptions, estimates, and opinions contained in this document constitute our judgements as of the date of the document and are subject to change without notice. Past performance is not a guarantee of future results. There is no assurance provided that investment objectives will be achieved. Bond investments are subject to interest rate, credit, liquidity, and market risks to varying degrees. When interest rates rise, bond prices generally fall.

Important Definitions

Bond investments are subject to interest rate, credit, liquidity, and market risks to varying degrees. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest.

Bond and loan investments are subject to interest-rate, credit, liquidity, and market risks to varying degrees. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Floating rate loans tend to be rated below-investment-grade and may be more vulnerable to economic or business changes than issuers with investment-grade credit. Bond investments are subject to interest-rate, credit, liquidity, and market risks to varying degrees. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest.

Loan investments are subject to interest-rate, credit, liquidity, and market risks to varying degrees. Floating rate loans tend to be rated below-investment grade and may be more vulnerable to economic or business changes than issuers with investment-grade credit.

Investments in lower-quality ("junk bonds") and non-rated securities present greater risk of loss than investments in higher-quality securities.

Credit risk refers to the ability of an issuer to make timely payments of principal and interest. The Credit quality represents the credit worthiness of corporate or government bonds.

Mortgage-backed securities represent interests in “pools” of mortgages and often involve risks that are different from or possibly more acute than risks associated with other types of debt instruments. When market interest rates increase, the market values of mortgage-backed securities decline, and volatility of the fund may increase. When market interest rates decline, the value of mortgage-backed securities may increase, but could expose the fund to a lower rate of return on investment.

Municipal securities are subject to the risk that litigation, legislation, or other political events, local business or economic conditions, or the bankruptcy of the issuer could have a significant effect on an issuer’s ability to make payments of principal and/or interest. The market for municipal bonds may be less liquid than for taxable bonds and there may be less information available on the financial condition of issuers of municipal securities than for public corporations.

Index performance is shown for illustrative purposes only and is not intended to represent historical or to predict future performance of any specific investment or Deutsche Bank’s Asset Management strategy. Deutsche Asset Management products may have experienced negative performance over these time periods. Past performance is not indicative of future results. Investments are subject to risk, including possible loss of investment capital.

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Jason Chen, Senior Research Analyst, DWS Research Institute.

Bernie Ryan, Head of Insurance Business Development, Americas, DWS.

Katherine Klein, Insurance Coverage, DWS.

Understanding the risks and access points within the high yield market remains integral for insurers who may be looking to either supplement yield or express more tactical views on the market.

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