Post on 26-Jun-2020
Portfolio Construction:Portfolio Construction: Considerations in Today’s Investment EnvironmentEnvironmentMarco Bravo CFAMarco Bravo, CFAPortfolio ManagerAAM Company
The 2014 Executive Education Roundtable Series
Portfolio Construction Considerationso t o o Co st uct o Co s de at o s
Objectives & Constraints Asset, Liability & Underwriting Expected Returns Tax Rates Capital Structurej
Regulatory
Returns, Tax Rates, Capital Structure
Applicable Insurance Laws
Capital Adequacy NAIC RBC, AM Best BCAR
Accounting
P C i
STAT & GAAP Financial Objectives
E l ti f P H ldiPeer Comparisons
Asset Allocation
Evaluation of Peer Holdings
Macro-Economic Environment, Expected Risk-Adjusted Returns, Yield Curve
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Risk Adjusted Returns, Yield Curve Structure 2
Portfolio Construction ConsiderationsPortfolio Construction Considerations
Key considerations in today’s investment environment:
Investment Policy Objectives & Constraints
Key Risk Measures
Asset & Liability Management
Taxabilityy
Asset Allocation
Fed PolicyFed Policy
Relative Value Assessment
Risk Assets
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Risk Assets3
Credit Risk Considerations
60Cumulative Default Rates (1983-2013)
Credit Risk Considerations
Low rate environment pushing i h f i ld b
40
50 5yr10yr15yr
insurers to search for yield by going down in credit qualityDefault rates and volatility of
20
30
5yDefault rates and volatility of default rates do not increase linearly as rating is decreased
0
10
20Set portfolio concentration limits that take into account default and recovery rates 0
AA A BBB BB B
Source: Moody’s Annual Default Study (Feb. 2014)
y
4
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Interest Rate (Duration) Risk ConsiderationsInterest Rate (Duration) Risk Considerations
Rate (%)Fear of rising rates has led i id h i
Implied Forward Rates
3.0
3.5
4.0( )
insurers to consider shortening portfolio duration Staying short has been costly
2.0
2.5
Staying short has been costly and forward yield curves pricing in higher rates
0 5
1.0
1.5
Current Yield Curve
3 year Forward Yield
Volatility of economic surplus a consideration when setting duration target for assets
0.0
0.5
1yr 2yr 3yr 5yr 7yr 10yrMaturity
3-year Forward Yield Curve
gLimit amount of duration mismatch to maintain i t t di i li
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investment discipline Source: Bloomberg, data as of 05/12/2014 5
Liquidity Risk ConsiderationsLiquidity Risk Considerations
Liquidity risk tends to be a bigger concern for P&C companies h if / l h C ithan Life/Health Companies
Increase in surrender activity for annuity writers is a concern if rates move above current crediting ratesrates move above current crediting rates
Manage liquidity risk through laddered maturity investment profile with ranking of liquid assetsprofile with ranking of liquid assets
Consider liquidity back-stop facility such as membership in Federal Loan Bank
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6
Asset & Liability Management ConsiderationsAsset & Liability Management Considerations
Risk of asset duration extending in a rising rate environmentIncreasing investment leverage increases importance of asset/liability duration matchCompare assets and liability cash flows under various interestCompare assets and liability cash flows under various interest rate scenariosInterest sensitive assets and liabilities requires the use of effective duration versus modified durationSegregating liabilities by product line imposes pricing discipline so that long term yields do not get used for pricingdiscipline so that long-term yields do not get used for pricing short-term liabilities
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7
Tax ConsiderationsTax Considerations
me Federal Tax > AMT
Federal Tax = AMT
AMT > Federal Tax
Objective:
Afte
r-Ta
x In
comObjective:
Establish Target Ranges for tax-exempt allocations
Municipal Allocation
250
Primary Consideration: Understanding of 150
200of
Tria
ls
Underwriting Profitability
0
50
100# o
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0.88 0.89 0.90 0.91 0.92 0.93 0.94 0.95
Combined Ratio 8
Why Consider Tax Exempt Municipals?Why Consider Tax-Exempt Municipals? 170
180
130
140
150
160
asur
ies
100
110
120
130
10 Y
ear S
prea
d to
Trea
70
80
90
Tax A
djuste
d 1
50
60
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10yr Municipal Spread
Source: Bloomberg, Thomson Municipal Market Data as of 4/8/20149
Fed Policy ConsiderationsFed Policy ConsiderationsTiming Balance Sheet
Short and Long Term Interest Rates
Fed Funds Rate (%)5 000
Fed Balance Sheet
Asset Class Returns
Fed Funds Futures
1.40
1.60
1.80
2.00
3,500
4,000
4,500
5,000Fed Agency MBS Purchases
Liquidity to Key Credit Markets
Lending to Financial Institutions
Long Term Treasury Purchases
Traditional Security Holdings
Fed Funds Futures
0.60
0.80
1.00
1.20
1 500
2,000
2,500
3,000
Bill
ion
s
0.00
0.20
0.40
Jun
Sep
Dec
Mar Jun
Sep
Dec
Mar Jun
Sep
Dec
2014 2015 2016
0
500
1,000
1,500
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2014 2015 2016
Source: Bloomberg, Cleveland Fed, Chicago Board of Trade10
Tighter Monetary Policy and Interest RatesTighter Monetary Policy and Interest Rates
Yield curve usually flattens when Fed is raising rates
8
9Rate (%)
Fed Funds2yr10yr
y g
5
6
7 10yr30yr
2
3
4
0
1
Source: Bloomberg, US Treasury 11
10yr Treasury Rates and Asset Returns10yr Treasury Rates and Asset Returns
Comparison of various asset returns during periods of rising p g p g10yr Treasury Rates
09/93 thru 12/95 thru 9/98 thru 5/03 thru 6/05 thru 12/08 thru11/94 3/97 1/00 5/04 6/06 12/09
Period
10yr TSY Yield +252 bps +131 bps +224 bps +124 bps +123 bps +163 bpsBank Loans S&P 500 S&P 500 S&P 500 S&P 500 High Yield
+9.63% +30.41% +43.19% +18.31% +8.62% +58.21%S&P 500 Convertibles Convertibles High Yield Bank Loans S&P 5002.14% +14.97% +25.45% +11.89% +7.49% +26.45%
High Yield High Yield Bank Loans Bank Loans Convertibles Convertibles1.97% +12.59% +7.91% +6.95% +5.88% +23.88%
1-3Y Gov/Credit Bank Loans High Yield Convertibles High Yield IG Corp Bonds1.03% +11.04% +4.12% +5.99% +4.80% +18.68%
Convertibles 1-3Y Gov/Credit 1-3Y Gov/Credit 1-3Y Gov/Credit 1-3Y Gov/Credit Bank Loans-3.11% +5.82% +3.98% +0.96% +1.92% +13.65%
Barclays Agg Barclays Agg Barclays Agg Barclays Agg Barclays Agg Barclays Agg-3.53% +3.05% -0.81% -0.44% -0.80% +5.93%
IG Corp Bonds IG Corp Bonds IG Corp Bonds IG Corp Bonds IG Corp Bonds 1-3Y Gov/Credit-4.86% +2.25% -1.71% -0.44% -2.22% +3.82%
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Source: Barclays, Bloomberg, CSFB Loan Index12
Asset Classes Relative ValueAsset Classes Relative Value
OAS bps
5-year Historical Option-Adjusted-Spreads
d
1,000
1,200OAS, bps
Recent
Asset spreads at or near 5-year lowsPrices seem to be pricing in
600
800AveragePrices seem to be pricing in
a benign credit environmentIncreased risk of a pullback
200
400due to a change in investor sentiment towards riskYield focused investors need
0
200
IG Corporate
CMBS Taxable Muni
HY Corporate
Yield focused investors need to be careful
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Corporate Muni CorporateSource: Barclays 13
Considering Risk AssetsConsidering Risk Assets
Is this the right time?
P&C Investments in Alternative Investments
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Source: SNL, 12/31/201314