With High Yield, Shorter May Be Better for Insurers’ Yields...and Capital Efficiency

20 April 2023

4 min read

With yield curves inverted in many parts of the world, investors no longer need to increase interest-rate risk to bolster yields. Instead, they can achieve the same end with shorter-duration high-yield bonds. For insurance investors that have typically shied away from high yield, we think this landscape—and the regulatory treatment—present a compelling opportunity.

Short-duration high-yield bonds may also help reduce the risk of the broader high-yield market: short-term bonds have less interest-rate and default risk, and higher quality issuers can provide a relatively defensive risk profile in exchange for a modest give-up in yield.

Insurers Are Underexposed to High-Yield Bonds

Insurers typically don’t invest much in high-yield bonds, given their conservative investment approach reinforced by risk-based capital (RBC) regulatory regimes. This has created a strong bias to investment-grade bonds in fixed-income portfolios, with high-yield bond allocations only a fraction of insurers’ total fixed-income portfolios (Display).

Insurers’ Bond Investments Are Mostly Investment Grade

High-Yield Allocation Is Just 3% Globally (Percent)

Globally, insurers allocate 80% of their fixed-income investments to investment-grade bonds and just 3% to high yield.

For informational purposes only. Historical analyses do not guarantee future results.
As of December 31, 2021
Source: International Association of Insurance Supervisors Sector-Wide Monitoring (IAIS SWM) 2022

It’s natural for insurers to be prudent but, in our analysis, a diversified mix of short-duration high-yield bonds may provide a highly efficient risk/reward profile. We think this is particularly true for dynamically managed portfolios that can respond to changes in relative value and adapt positioning to navigate both risk-on and risk-off markets.

But can increasing short-duration high-yield exposure be capital-efficient for insurance investors, given their solvency requirements under RBC rules? We think it can, based on the capital requirements for credit assets under two prominent insurance regulatory regimes.

Insurance Regulation Has Favored Investment-Grade Bonds

Solvency II has applied to European insurers since 2016, and was adopted fully by the UK post-Brexit. Current reviews may lead to some modifications (and a possible name change in the UK), but divergence between the regimes is likely to be marginal.

The International Association of Insurance Supervisors’ insurance capital standard 2.0 (ICS 2.0) is in a monitoring period before its planned adoption in 2025 as a prescribed capital requirement applying to internationally active insurance groups (IAIGs). A group-wide capital standard, ICS 2.0 doesn’t replace existing requirements for supervising insurance firms in any jurisdiction. But several jurisdictions, notably Japan and Korea, are considering ICS 2.0 when developing their own local frameworks.

Although the two regulatory regimes differ, both feature a similar steep jump upward in solvency capital requirements for any given level of duration when moving over the threshold from investment-grade BBB-rated bonds to BB-rated high-yield bonds (Display). This sharp increase in required capital is a key factor that has limited the size of insurers’ high-yield allocations.

Regulators Require More Capital for Longer and Lower-Rated Bonds

Under both Solvency II and ICS 2.0, capital charges rise progressively as bond duration increases and quality decreases.

For informational purposes only. Historical analyses do not guarantee future results.
Solvency capital requirement under Solvency II equates to the spread risk charge of a BB asset at each appropriate duration point under the standard formula. Solvency capital requirement under IAIS ICS 2.0 equates to NDSR charge, credit risk charge and hybrid subordinated charge of a BB asset at each appropriate duration point, assuming a portfolio consisting of 98% senior and 2% subordinated bonds.
As of April 20, 2023
Source: European Insurance and Occupational Pensions Authority (EIOPA), IAIS and AllianceBernstein (AB)

Inverted Yield Curves Create Capital-Efficient Opportunity in Short-Duration High Yield

An inverted yield curve introduces a different dimension to this calculus. It’s intuitive to have higher capital requirements for longer-duration bonds, given that they carry more risk. And in a typical upward-sloping yield-curve environment, that increased capital requirement comes with higher yield.

But when the yield curve is inverted, as it is today, insurers have a rare opportunity to earn a higher yield while holding bonds that actually carry a lower capital requirement. While the global high-yield bond yield curve was broadly flat in 2022, it has steeply inverted this year (Display), making short-duration high-yield bonds more attractive on a relative basis.

Global High-Yield Curve Is Now Downward-Sloping

Yield to Worst as of March 31, 2023, 2022 and 2021 (Percent)

From March 31, 2021, to March 31, 2023, the high-yield curve has moved from upward-sloping to flat to downward sloping.

For informational purposes only. Historical analyses do not guarantee future results.
As of March 31, 2023, 2022 and 2021
Source: Bloomberg Global High Yield Corporate Bond Index

Comparing the yield on BB-rated bonds relative to their capital requirement in the past three years, under Solvency II and ICS 2.0 standards, shows that short-duration high yield has become much more attractive in solvency capital efficiency terms. Of course, the higher-interest-rate environment has made high yield more solvency-efficient across the board, but short-term bonds have seen the biggest increase by far (Display).

One- to two-year BB-rated bonds yielded 0.95 times their Solvency II capital requirement at the end of the first quarter this year, nearly triple their 0.36 times ratio of two years ago. Five- to six-year BB bonds have higher solvency efficiency too, but less so, moving to 0.29 times from 0.15 times. In round numbers, that means one- to two-year BB bonds are currently three times more solvency-efficient than equivalent five- to six-year bonds.

It’s a similar story under the ICS 2.0 regime: one- to two-year BB bonds yield 0.72 times their ICS 2.0 capital requirement, up from 0.28 times. The same comparison for five- to six-year BB bonds shows a yield increase to 0.45 times from 0.24 times their ICS 2.0 capital requirement.

Yield-Curve Inversion Increases Short Bonds’ Solvency Capital Efficiency

Under both Solvency II and ICS 2.0, short-dated bonds are far more solvency-efficient than two years ago.

For informational purposes only. Past performance does not guarantee future results.
March 31, 2023, 2022 and 2021
Source: Bloomberg Global High Yield Corporate Bond Index, EIOPA, IAIS and AB

In today’s uncertain world, we think shorter-term, higher quality high-yield strategies could be particularly well suited to delivering attractive risk-adjusted returns for insurers while also representing a highly efficient use of solvency capital budgets.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

About the Author

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