By Jason Pratt
Insurers have time to wait for better valuations.
Our bias for insurance portfolios favors shorter-tenor fixed income currently, ideally taking advantage of enhanced carry and providing insulation from the evolution of the credit cycle.
However, assuming we are nearing peak policy tightening, it’s only natural to ask when easing could begin and whether, with the U.S. 10-year Treasury above 4%, it’s time to adjust duration. Between increased rate volatility at the long end and tight credit spreads, we believe the answer may be “not so fast.”
Although inflation has trended lower, equities have boosted household net worth while employment remains resilient. This combination presents a conundrum in that target inflation may still be difficult to achieve next year, even as markets are pricing in cuts beginning in the second quarter.
Is there a danger of missing an opportunity to lock in quality positions with yields in the high 5 to 6% range? With few signs of credit crisis (despite flareups in banking and commercial mortgages), it’s hard to discern an event that would require meaningful policy reversal and thus reduce rates.
Moreover, we believe that we are past peak credit market fundamentals, spreads are at their tightest levels in 36 months, while the “maturity wall” in high yield won’t reach critical mass until 2025.
Any effort to lock in high longer-term yields should also take into account two insurer-specific concerns: First, the credit cycle could last longer than many expect, and credit spreads continue to reflect limited risk of deterioration.
Second, there’s no set policy timetable for achieving inflation goals, which remain out of range. Is the carry available at the front end of the curve more durable as a result?
If you are biased toward owning duration to support liabilities, today’s yields will look attractive. However, you can also insulate against credit deterioration by tilting up in quality, as well as focusing on better terms and conditions through covenants and structural protections.
Today’s elevated yields may not get much higher from here, but they may be with us for a while.
In sum, today’s yield levels do not appear to be fleeting and we recognize that investors generally are being paid well in high-quality markets such as private placement debt, European private loans and, more broadly, public fixed income.
That said, we expect more volatility further out on the yield curve, which could present challenges for insurers. In light of the Federal Reserve’s still hawkish tone coming out of Jackson Hole, elevated yields could remain in the coming quarters but could come with better valuations as we gain more clarity on the credit cycle.
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