How Capital Efficiency Drives Relative Value in Global Fixed Income

• We examine the global fixed income opportunity set for insurers through the lens of regulatory capital efficiency, which we define as the trade-off between risk-adjusted spread on fixed income assets and the Solvency II capital requirement for spread risk.

• Given the spread compression in the traded fixed income markets, direct lending stands out as the capital-efficient asset class for both UK and EU insurers. This is due to the combination of a persistent illiquidity premium in direct lending and the relatively benign spread risk capital charges.

• While the more capital-conscious insurers may appreciate the capital efficiency of high-rated, short-dated corporate debt, life insurers must balance higher capital requirements for longer-dated corporate debt against lower reinvestment risk and their asset-liability management requirements.

• CLOs and other securitized credit investments carry onerous capital charges under the Solvency II standard formula. However, high-quality CLO tranches can be attractive for insurers that choose to hold significant capital buffers or use internal models to better align Solvency II capital requirements with the economic risk profile of their investments.

Insurance investors think beyond yields and spreads when constructing their fixed income portfolios, with asset-liability management (ALM) considerations, liquidity needs, currency hedging costs, regulatory capital, and credit rating model capital all entering the equation. We focus on regulatory capital efficiency, defining insurers’ “return on capital” as the ratio of risk-adjusted, currency-hedged spread to the incremental amount of Solvency II standard formula spread risk capital that will be held against the new investment.

Within the corporate bond space, standard-formula firms are undercompensated for the higher capital charges on longer-dated or lower-rated credits. Higher capital efficiency of high-rated, short-dated corporates is good news for the more conservative general insurers; however, it presents a conundrum for life insurers that must balance higher capital requirements against lower reinvestment risk and more attractive duration profile of long-dated corporate bonds. For eurozone insurers (but generally not for their British peers), currency-hedged USD corporates can look more attractive than EUR-denominated bonds, which is largely down to subdued swap spreads on euro corporates across all term buckets and credit ratings.

Prohibitively high capital requirements for non-STS (simple, transparent, and standardized) securitizations make CLO tranches a capital-intensive investment under the Solvency II standard formula – unless the capital budget is “spent” on high-yielding sub-investment-grade CLO tranches. However, high-quality CLO tranches can be attractive for insurers that hold a significant buffer of excess capital or are able to better align the capital requirements of their investments with the economic risk profile using an internal-model approach – as well as for the overseas balance sheets of internationally active insurance groups and global reinsurers.1

Direct lending stands out as the capital-efficient asset class for insurers on both sides of the Channel. This is due to the combination of a material spread pickup over liquid fixed income and the relatively benign capital charges for non-rated corporate debt under the Solvency II standard formula approach.2 While an insurer’s decision to allocate to direct lending is informed by the interplay of ALM requirements, appetite for illiquidity, availability of reliable third-party valuations in the absence of tradeable market prices and many other considerations, the capital efficiency of direct lending is difficult to ignore.

Solvency II Capital Efficiency for Eurozone Insurers (EUR Hedged)

Solvency II Capital Efficiency for British Insurers (GBP Hedged)

Source: PineBridge Investments analysis based on LSEG LPC as of 30 June 2024; ICE Index Platform, JPMorgan Markets, Cliffwater, and Bloomberg as of 30 September 2024. IG – investment grade; HY – high yield; CLO – collateralized loan obligation, Lev Loan – leveraged loan, LMM – lower middle market, UMM – upper middle market. We define lower/upper middle market direct lending as loans to companies with EBITDA below/above $20 million.

Solvency II capital efficiency: methodology

We define “return on capital” as the ratio of spread to Solvency II capital.

“Spread” is the index spread (swap option-adjusted spread for bonds, discount margin for CLOs, and forward spread to maturity for leveraged loans), adjusted for:

Currency risk

• The adjustment aims to capture the spread impact of currency rates over the lifetime of the USD investment for a euro or GBP investor.

• It is calculated as the difference between the legs of a cross-currency swap for which the USD leg is set equal to SOFR plus the spread on the fixed income index.

Credit risk

• The adjustment aims to capture the average long-term loss on a buy-and-hold investment.

• It is calculated by PineBridge based on historical statistics reported by Moody’s and Cliffwater.

  • Bonds and loans: Adjustment is based on long-term historical average cumulative default rates for corporate obligors by credit rating (e.g., A vs. BBB) and recovery rates by instrument type (bonds vs. loans), as reported by Moody’s.3

  • CLOs: Adjustment is based on long-term historical multiyear cumulative loss rates on global CLOs by original credit rating, as reported by Moody’s.4

  • Direct lending: Credit risk adjustment is set at -1.03%, based on cumulative net realized losses since inception reported for the Cliffwater Direct Lending Index as of fourth-quarter 2023.5

“Solvency II capital” is the product of:

Solvency II standard formula spread risk capital requirement, based on index rating and spread duration (duration-to-maturity for CLO and loan indices)

• CLOs are treated as non-STS securitizations.

• Direct lending is treated as unrated corporate debt with a five-year duration.

• Other asset classes are treated as rated corporate debt.

Target solvency ratio, set at 200% in line with large European insurers’ published target solvency ratios.

Diversification adjustment, which captures the diversification benefit of imperfect correlation between market risk and insurance risk in an insurers’ aggregate capital requirement.

• Based on our analysis of individual firms’ Solvency and Financial Condition Reports, large European life insurers typically carry about-equal capital requirements for insurance and market risk.

• Assuming an equal split between insurance and market risk and given the 25% correlation between life/general insurance and market capital requirements, we set the diversification adjustment at 80% (i.e., a €1.00 increase in market risk capital requirement translates into a €0.80 increase in post-diversification capital requirement).

Insurers’ capital remains stable amid recent flux

In 2022, global central banks acted decisively to curtail runaway post-Covid inflation, triggering a sharp rise in interest rates across major economies. Tumbling bond prices left insurers saddled with double-digit unrealized losses on their fixed income investments.6

10-Year Government Bond Yields

Source: ICE Data Platform as of 30 September 2024

Median EEA Life Insurer’s Investment Return

Source: EIOPA July 2024 Insurance Risk Dashboard. Returns excluding unrealised gains and losses are reported by EIOPA for 2020 onward.

Yet despite the recent patch of turbulence, insurers’ capital adequacy remains healthy, buttressed by robust asset-liability management. The typical European insurance group ran a nearly five-year asset-liability duration gap at the end of 2021, putting them in a solid position as rates began to surge in 2022.7 For many insurers, unrealized losses on fixed income investments were more than offset by the mark-to-market on longer-dated liabilities, resulting in stronger solvency ratios

While several life insurers struggled and one ultimately failed,8 the broader industry remains well capitalized: as of first-quarter 2024, EIOPA reported a healthy 214% median solvency ratio for insurance groups, down from the mid-2021 peak of 235% but still well within (or even above) most insurers’ comfort zones. Most large insurers reported strong immunity to future interest rate shocks in their 2023 Solvency and Financial Condition Reports.9

Europe and UK Insurers’ Solvency Ratios Are Positioned to Weather Rate Shocks

EEA and UK Insurers’ Solvency Ratios

EEA – European Economic Area. Source: EIOPA July 2024 Insurance Risk Dashboard, Bank of England Insurance Aggregate Data Quarterly Report (accessed 30 August 2024)

EEA and UK Insurers’ Solvency Ratio Sensitivity to +50 bps Interest Rate Shock

Source: PineBridge Investments’ interpretation and analysis of 50 largest EEA insurance groups’ Solvency and Financial Condition Reports, investor presentations, and annual reports

EEA and UK insurers’ Solvency Ratio Sensitivity to -50 bps Interest Rate Shock

Source: PineBridge Investments’ interpretation and analysis of 50 largest EEA insurance groups’ Solvency and Financial Condition Reports, investor presentations, and annual reports

Public fixed income spreads have compressed, while direct lending shows more resilience

With government bond yields edging closer to their long-term averages and central banks at a tipping point, does corporate debt look attractive for insurers? As rates shot up in 2022, spreads compressed across most markets. Current US dollar and euro investment grade (IG) spreads are in line with their long-term averages, while sterling IG spreads are at the lower end of their long-term (interquartile) range.

Bond and Loan Spreads: Current Levels vs. Long-Term Ranges (2014-2024)

Sources: ICE Data Platform for bond index statistics (USD IG Corporates: ICE BofA US Corporate Index, EUR IG Corporates: ICE BofA Euro Corporate Index, GBP IG Corporates: ICE BofA Sterling Corporate Index, USD HY Corporates: ICE BofA US High Yield Index, EUR HY Corporates: ICE BofA Euro High Yield Index, GBP HY Corporates: ICE BofA Sterling High Yield Index), JPMorgan for CLO and leveraged loan index statistics (JPMorgan Leveraged Loan Index and JPMorgan European Loan Index), LSEG LPC’s direct lending statistics (2Q24 Middle Market Sponsored Private Deal Analysis, as of June 2024). Bond, loan, and CLO spreads are monthly levels over January 2014 – September 2024. Direct lending spreads are quarterly levels over 2015 Q1 to 2024 Q2.

With the resilient economy pushing default rates and upgrade/downgrade ratios in the right direction, spreads on high yield bonds and leveraged loans have also tightened materially – but with higher rates, all-in yields on high yield fixed income remain attractive.10 While CLO spreads have compressed toward the lower end of their long-term range, IG CLO tranches continue to offer a spread pickup over same-rated corporate bonds. And finally, direct lending spreads have remained stable relative to liquid comparables, with a material pickup over leveraged loans and high yield bonds (as of the second quarter of 2024) – standing out as an especially effective capital-efficient asset class for insurers.