Issues & Answers Special Advertising Section:
“At AAM, we believe in working with our clients to establish a duration target based off of their line of business and/or their risk tolerance.”
We think inflation has likely peaked at this point, and we would expect to see it moderate in the coming months but remain at historically elevated levels through year-end. Interest rates have risen quickly in anticipation of the Fed hiking short-term rates this year. The futures market is pricing in a 2.8% Fed funds rate by year-end. With the curve so flat, market participants fear that the Fed will raise rates to the point of pushing the economy into a recession. The biggest impacts that fixed-income investors are facing today are rising interest rates as well as a possible deterioration in fundamentals of corporate issuers should recession possibilities increase. As for mitigating the risk of rising interest rates, we’re advising our clients to explore opportunities in alternative asset classes, particularly those offering floating rate debt, as well as downside equity market protection.Which alternative asset classes are most advantageous given the current environment?
On the debt side of the market, asset classes like high-yield bank loans and direct lending offer floating rates with coupons that reset as interest rates rise. These debt instruments have a shorter duration profile than we typically see with traditional fixed income and help cushion the impact of rising rates and, hence, income. They are a great complement to an investment-grade fixed income portfolio, and offer higher yields than a traditional bond portfolio given the illiquidity. Turning to the equity side of the market, we prefer the equity-like asset class of convertible bonds. A convertible bond offers an equity-like return with a lot less risk than a direct equity investment. Downside risk is limited and defined, but the convertible bond still has the ability to capture upside performance if the underlying equity appreciates. They are a great complement to a fixed-income portfolio in that they have a low correlation with traditional fixed income and they outperform fixed income over the long run, particularly in a rising rate environment.
How does the Fed-tightening cycle affect an insurer’s portfolio, and what are the corresponding actions you advise in response?
Insurance companies are very highly regulated on both the state level as well as by the NAIC. The vast majority of their portfolio holdings are required to be invested in investment-grade bonds. The biggest downside an insurer faces during a Fed-tightening cycle is the negative impact of rising interest rates. Luckily, due to the statutory accounting treatment that insurers’ portfolios receive, a large number, if not all of the bonds, are carried at amortized cost, and they’re not mark-to-market, meaning as long as these bonds are not sold, the unrealized loss will not affect the insurer’s income statement or surplus. We maintain a disciplined duration management style and do not try to turn interest rates. Instead, we have added these high-quality floating rate debt securities to enhance income in our clients’ portfolios. For those clients whose risk tolerance allows for an allocation to the equity markets, we’ve added convertible bonds to provide downside equity market protection.<!###CONTENT:END###>