By Matthew Daly
While the COVID-19 pandemic will likely impact the claims side of the insurance industry, it is also affecting another component: insurance company investment portfolios.
Many insurers invest most of their customers’ premium dollars in investment-grade securities (those rated AAA through BBB, which carry NAIC 1 or 2 designations). Insurers have a long history of investing in safer investments such as AAA-rated U.S. Treasuries, but the past decade’s historically low interest rates led insurers further into generally higher yielding assets, including IG corporate bonds.
However, Conning believes that the economic damage caused by social-distancing measures and business closures to slow the spread of COVID-19 has in turn damaged U.S. corporate credit profiles.
Conning currently expects corporate earnings to be dramatically impacted by higher unemployment, reduced consumer spending and weak business investment. Companies are also aggressively drawing on credit facilities and raising cash via record bond issuance, ensuring they have adequate financial flexibility to survive a potentially deep recession.
This increased debt, combined with expected lower earnings, should contribute to weaker credit metrics and a general deterioration of corporate credit profiles. This is of special concern for insurers, who face increased risk-based capital charges if securities in their portfolios are downgraded, especially should they fall to NAIC 3 or lower.
Despite expansive monetary and fiscal policy support, such as the financing programs enacted by the U.S. Federal Reserve, there remains a high degree of uncertainty surrounding the resumption of normal economic activity. Potential consumer behavioral changes and job loss could influence future spending and the resulting impact on corporate credit vitality.
Nonetheless, Conning believes valuations remain compelling for certain IG corporate issuers with durable balance sheets that can withstand a potentially prolonged economic downturn. Careful fundamental analysis can identify the credits best prepared to successfully manage through this environment.
The Rise Of BBB-Rated Debt
The rapid pace of downgrades as this credit cycle turned is due to the sheer velocity of the economic downturn. A complicating factor has been the tremendous growth in BBB-rated corporate bonds, a by-product of low borrowing costs, accommodative capital markets, a general shift by companies to more aggressive policies. This contributed to a general decapitalization of corporate balance sheets as approximately $3 trillion of corporate bonds, or nearly 50% of the Bloomberg Barclays U.S. Corporate Index, were rated BBB at the end of February before the economy began to deteriorate. (That is up from nearly $1 trillion, or 37% of the index, at the end of February 2010.)
The negative economic shock from COVID-19 will likely erode corporate earnings for the duration of the year and further pressure credit metrics that were already stretched heading into this downturn.
A Rise In “Fallen Angels”
A consequence of the dramatic rise in BBB-rated debt during this economic downturn are ratings downgrades known as “fallen angels,” IG credits that are downgraded to high yield. As noted, insurance companies face an exponential increase in capital charges on investments downgraded from NAIC 2 (IG) to NAIC 3 (below IG) or lower.
As of May 31, 2020, the “fallen angel” label had been applied to 24 issuers with approximately $148 billion of index-eligible debt. Several notable large capital structures have “fallen” including Ford Motor ($36 billion), Occidental Petroleum ($27 billion) and Kraft Heinz ($21 billion).
Many of the possible future fallen angels with larger capital structures are in the automotive industry, are heavily influenced by air travel and aircraft demand (Boeing, aircraft lessors), are exposed to potential lost advertising revenue or have highly leveraged balance sheets and cash flows may be negatively impacted by lack of consumer spending due to social distancing mandates. There are also more issuers at risk in the energy industry, as crude prices have been caught in the perfect storm of oversupply, evaporation of demand and limited storage capacity.
Conning believes that rating agencies may take a more patient approach to downgrades given the significant amount of monetary and fiscal support deployed to combat the economic fallout from the pandemic. However, uncertainty remains regarding the future trajectory of earnings and cash flow, which will be influenced by the reopening of global economies, the strength of the potential economic rebound and the resilience of the consumer.
Careful Analysis Can Identify Opportunities
We believe high-quality IG corporate issuers with durable balance sheets to help them withstand a prolonged economic downturn offer compelling value.
Many IG-issuer management teams have already begun taking prudent actions to defend credit profiles, including eliminating equity share repurchases, curbing dividends and reducing expenses and capital spending, all steps management teams take as a credit cycle migrates from Decline to “Repair.” Conning continues to anticipate an increasing number of issuers rotating into the Repair phase soon as they look to preserve and improve balance sheets and fortify liquidity profiles.
Conning’s favored issuers are often credits with more defensive attributes and good fundamentals that can continue to prosper in a weaker economic backdrop or those with solid balance sheets that are poised to benefit as economies reopen.
As corporate spreads have widened, there has been record-setting new issuance in the corporate bond market, creating compelling valuations for securities that have historically been either difficult to source or were only available at unattractive spreads.
Strong fundamental analysis can help identify these sector opportunities and specific names within them as we navigate through the Decline phase of the credit cycle and begin to enter the Repair phase and solidify balance sheets and credit profiles.
Matthew Daly, CFA is a managing director and head of corporate and municipal teams and a member of Conning’s Investment Policy Committee. Matthew may be contacted at [email protected].
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