How ‘Credit Barbell’ Approaches Can Help Insurers Ride Out the Inverted Yield Curve

Since last July, when the Treasury curve began to invert to the steepest degree since the early 1980s, readings of the economy have pointed to a range of possible outcomes – and insurers that have historically faced low yields across the curve are now grappling with how to position their portfolios for a yield curve inversion. Most hold long-dated assets in unrealized loss positions, which cannot be shed without pain, creating investment challenges.

The Steepest Curve Inversion Since the 1980s

10-year Treasury yield minus two-year yield. Source: Bloomberg. Data as of 28 February 2023. For illustrative purposes only.

Enter the ‘credit barbell’

One approach to optimize yield in this environment is a “credit barbell” strategy, which involves investing opportunistically at both the shorter and longer ends of the yield curve. Such an approach may be attractive for several reasons. For one, investors can benefit from higher income offered by the short end of the curve. The strategy also layers in longer-duration corporates and has the flexibility to permit insurers to adjust asset allocations to match their unique liability duration needs.

While market conditions can change swiftly, at the short end of the barbell, current pricing favors high-quality collateralized loan obligations (CLOs). These floating-rate instruments have a low historical impairment, offer a compelling potential return on regulatory capital, and in our view provide the best relative value among other corporate and securitized assets and the potential for greater income if short-term rates continue to rise. On the longer end of the duration spectrum, we favor corporate bonds, given that they are typically the core holdings of insurance asset portfolios. The credit barbell strategy could be implemented in an insurer’s opportunistic allocation or funded as an extension of its core portfolio, depending upon the level of risk tolerance and the liability profile.

A risk-based, capital-neutral approach

Insurers may seek a regulatory risk-based capital (RBC)-neutral barbell portfolio versus a standard corporate benchmark, such as the ICE BOA corporate indices (7-10 year), which have an average rating of A2-A3 and RBC of 0.92% for life insurers and 1.4% for property & casualty insurers. A barbell portfolio with 50% AA CLOs and 50% BBB corporate credit would be largely RBC neutral to the benchmark and would result in a potential yield and spread pickup of 86 basis points, while also benefiting from more limited interest rate sensitivity. For example, it would shorten portfolio duration to 3.4-4.7 years from 7.1 years for the index. In addition, the shorter asset profile may offer a better fit for non-life insurers (see table below).

Source: Bloomberg. Data as of 31 January 2023, ICE BOA corporate bond indices (7-10 year) and JPM CLO indices (for CLOs out of reinvestment period). *Portfolio duration calculation is based on effective duration for corporates and modified duration for CLOs. For illustrative purposes only.

An ‘enhanced’ credit barbell approach

Taking our credit barbell approach a step further out on the risk spectrum, below we show the spread and yield pickup versus the ICE BOA corporate index for an “enhanced” credit barbell portfolio under a handful of portfolio mixes of A rated CLOs and BB rated corporate bonds. Overall, insurers may potentially increase yield by as much as 2% in a blended barbell portfolio while maintaining a reasonable match to their liability duration profile.

An Enhanced Credit Barbell May Offer Yield and Spread Advantages

Source: Bloomberg. Data as of 31 January 2023, ICE BOA corporate bond indices (7-10 year) and JPM CLO indices (for CLOs out of reinvestment period). For illustrative purposes only.

ALM considerations

For insurers’ asset-liability matching (ALM) considerations, portfolio allocations between CLOs and corporates can vary to create a portfolio to match interest rate duration, modified, or effective duration of their liabilities. Greater allocation to seasoned CLOs would lead to a shorter portfolio profile, which tends to work well for non-life insurers. The chart below shows the duration profiles across four different hypothetical barbell portfolios.

An Enhanced Credit Barbell Offers Flexible Duration Positioning

Source: Bloomberg. Data as of 31 January 2023, ICE BOA corporate bond indices (7-10 year) and JPM CLO indices (for CLOs out of reinvestment period). *Portfolio duration calculation is based on effective duration for corporates and modified duration for CLOs. For illustrative purposes only.

Beyond the inversion

Critically, as active managers of credit barbell strategies incorporate market signals in the form of pricing and demand-supply changes, they have the flexibility to modify their projections about the emerging shape of the yield curve slope and position each end of the barbell accordingly. In these challenging times, the strategy’s dynamic attributes may be attractive.

A key question, of course, is what happens a year or two down the road, when the yield curve normalizes again. Insurers employing credit barbell strategies may want to consider transitioning some of the shorter-duration seasoned CLOs into longer recent-vintage CLOs as the curve regains its normal shape. It’s an active and dynamic approach that can adapt to changing conditions and provide optionality – and may help insurers ride out the inversion and beyond.

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