U.S. High Yield for Insurance Companies

High yield serves an important role in income generation for insurance portfolios, providing diversified income streams versus traditional core fixed income.
Insurers’ general aversion to default losses has resulted in higher quality biases, which can affect portfolio risk and return as well as industry exposure. Historically, changes in spreads have been, on average, more timely indicators of credit deterioration than agency downgrades.
When combining high yield with other corporation investments, industry beta and overlap should be an important consideration for portfolio construction.
For investors looking to be more tactical, measuring market distress and implied default rates or risk premia have been a useful time for capturing beta rallies.

Historically, insurance companies have tilted their fixed income portfolios toward higher credit quality asset classes, helping to avoid credit default loss potential and providing a longer duration profile that helps with asset-liability management. Over the past decade, as yields were suppressed by disinflationary pressures and corresponding dovish monetary policy, insurers, among other investor groups, were gently guided toward riskier segments of capital markets in an effort to generate sufficient returns on their float. The most obvious incremental yield extension segment of the fixed income universe has been the U.S. High Yield universe, which has seen significant flows from insurers since the Global Financial Crisis (GFC).

Despite the move higher in both nominal and real risk-free rates over the past year, High Yield seems to have established a permanent strategic and tactical allocation in insurers’ asset allocations. As High Yield has gained prevalence in insurers’ investment portfolios, the complexity and nuance of high yield bond investments has also evolved. Where some insurance companies may elect to only invest in the upper-tier ratings of the high yield universe as a way to increase portfolio yield on a hold-to-maturity basis, other insurers may seek greater potential opportunities in more speculative segments of the market, and more tactically minded insurers may look to rotate their high yield risk to reflect current market conditions.

This paper seeks to provide a general outline for insurers on the different risk levers that exist within the High Yield universe and how utilizing these levers changes the risk and return characteristics of a high yield portfolio. To do so, we address three main questions that often arise:

How do risk and return look for segments of the high yield market? Does quality bias (either in ratings or in spread terms) detract from investment returns or introduce any other unforeseen risks?
How does the industry composition of the high yield market bias? What have been the riskier and less risky industries within high yield, and how might constraining industry weights impact risk and return?
How has high yield performed in periods of market distress? What is the subsequent recovery performance experience across segments of the high yield market?