Optimizing Asian US Dollar Credit Portfolios for Hong Kong Risk-Based Capital Efficiency

• The new Hong Kong RBC (risk-based capital) regime introduces additional complexity to fixed income portfolio management for Hong Kong insurers.

• Asian USD bonds remain attractive for long-term investors, offering a strong risk-reward profile, and are an important building block for Hong Kong insurers’ portfolios.

• We demonstrate how integrating RBC requirements into active portfolio construction can boost regulatory capital efficiency for Hong Kong insurers’ Asian USD credit investments without compromising performance or resilience.

• Supplementing active, fundamentals-driven portfolio management with quantitative capital optimization could help insurers enhance return on capital under new and emerging risk-based capital frameworks in Hong Kong and beyond.

The new Hong Kong RBC regime, effective 1 July 2024, aims to enhance financial stability and risk management of insurance companies operating in Hong Kong by mandating insurers to hold adequate capital against insurance, default, and market risk. For many of these insurers, credit spread risk is one of the main drivers of market risk capital requirement. This risk captures the effect of credit spread changes on insurers’ assets and liabilities.

Under the new regime, insurance fixed income portfolio managers will need to incorporate spread risk capital requirements in their portfolio construction process to help insurers deliver attractive returns on capital for shareholders while meeting their policyholder expectations. In this paper, we consider the impact of new RBC requirements on portfolio construction in Asia US dollar-denominated (USD) bonds, a major asset class for insurers in Hong Kong and across Asia more broadly.

Asia USD bonds remain an attractive asset class for insurers

Asian credit – and investment grade (IG) bonds in particular – is an attractive asset class for long-term investors, including insurance companies, for the following reasons:

• Strong fundamentals. Asian IG corporates demonstrate stronger credit profiles compared to developed market peers with lower leverage ratios.

• A favorable macroeconomic backdrop. Inflation in Asia is broadly in control, and economies continue to expand at a healthy clip.

• Attractive valuations. Asian IG credit offers attractive all-in yields with better risk-adjusted returns. They provide additional credit spread against developed market countries, while exhibiting shorter duration and lower volatility.

• Positive supply-demand dynamics. We believe reinvestment demand is currently exceeding USD bond issuance from Asian issuers. Local investors’ home bias, coupled with demand from international asset owners, help anchor volatility of Asian bonds.

For a more detailed discussion, please refer to the additional PineBridge insights listed at the end of the article.

Solving for regulatory capital efficiency under Hong Kong RBC

Under Hong Kong RBC, the capital requirement for a debt instrument is defined as the change in fair value under a spread stress scenario prescribed by the regulator. Spread stresses vary across credit rating bands and remaining term to maturity buckets. Thus, the capital requirement for a corporate bond investment is determined by its rating, remaining term, and spread duration, while its yield is determined by a wide range of fundamental, technical, and quantitative factors.

For portfolio managers, this opens an opportunity to supplement active security selection with numerical optimization aimed at maximizing portfolio spread (or yield) for a given RBC budget, while meeting the client-specific portfolio diversification requirements and constraints. The output of this augmented process is a set of capital-efficient portfolios that enhance return on capital for insurance investors while staying true to portfolio manager’s active views.

This approach can be implemented in two steps:

Step 1: Identify the subset of bonds reflecting active sector, issuer, and instrument views.

Step 2: Construct the frontier of capital-efficient portfolios by maximizing average portfolio option-adjusted spread (OAS) for a given regulatory capital budget, subject to:

• Sector, country, and issuer outlook

• Duration and credit quality targets, as well as additional investment key performance indicators (KPIs), such as ESG metrics

• Diversification requirements, such as portfolio weight limits and/or desired number of countries, sectors, issuers, and instruments.

The process generates an efficient portfolio frontier, which incorporates both forward-looking fundamental credit views and capital efficiency requirements. Using the capital-efficient frontier, investors can quantify the trade-off between portfolio spread, capital requirements, and diversification and arrive at a fully implementable portfolio tailored to the insurance client’s requirements.

For illustration, let’s consider two Asian US Dollar corporate bond investment strategies. One (“APAC IG”) is fully allocated to investment-grade bonds and the other (“APAC IG+”) allows allocating up to 15% to high-yield bonds. For both strategies, the capital efficient frontiers sit above the JACI IG index and US IG index1 (see figure 3) – in other words, the combination of active security selection and capital optimization delivers a more attractive return on capital than the index. APAC IG+ frontier sits above that for the IG-only strategy: allowing for a modest allocation to high-yield bonds enables higher portfolio spreads for the same capital budget.

Figure 3: Capital-Efficient Portfolio Frontiers for APAC IG and APAC IG+ Strategies

Source: JP Morgan, Bloomberg, PineBridge Investments, Hong Kong Insurance Authority as of 6 September 2024. Portfolio OAS/YTW is calculated as the market value weighted average of the option adjusted spread/ yield to worst of all the bonds. Portfolio HK RBC is calculated as the market value weighted average of the HK RBC credit spread risk capital amount estimated by PineBridge for each bond in the portfolio based on its ratings and duration.

Figure 4 compares the OAS and return on capital (i.e., the ratio of OAS to RBC) for two optimized model portfolios to that of the broad market indices. The model portfolios increased return on required capital relative to the benchmark by 0.6x to 24%.

Figure 4: Spread OAS and HK RBC Capital Efficiency (Ratio of OAS to Spread RBC) for Optimized Portfolios and Broad Indices

Source: JP Morgan, Bloomberg, PineBridge Investments, Hong Kong Insurance Authority as of 6 September 2024. Portfolio OAS/YTW is calculated as the market value weighted average of the option adjusted spread/ yield to worst of all the bonds. Portfolio HK RBC is calculated as the market value weighted average of the HK RBC credit spread risk capital amount estimated by PineBridge for all the bonds based on their ratings and duration.

Helping insurers navigate investment complexity

Supplementing an active, forward-looking fundamental approach with a quantitative capital optimization can enhance return on insurers’ capital under the new Hong Kong RBC. The capital-efficient portfolio construction approach can also be extended to address the needs of multi-national APAC insurers operating under different sets of RBC charges across multiple jurisdictions.