Multi-asset credit investing in volatile times: Low rates and ESG

In the third part of this Insurance Asset Risk / CSAM roundtable, insurers discuss their views on low rates, the influence of RBC on credit investing and how they are looking to integrate environmental, social and governance factors into their investments.

Sarfraz Thind: Examining the theme of low rates—how long do you think this rate environment will persist and what are your tactics to try and mitigate against it?

Sean Collins: In general, low rates, even if we see the Fed begin hiking and even if we get this inflation—you can't let them run forever. We could be in a place where we have lower rates for a very long time. And we've started to see that for the last few years. Right now we are trying to diversify our investments. So that could be more in the private markets where you can get some yield pickup over the public markets. We're looking at other geographies where you can maybe go outside the US for opportunities and that could be cross-currency or that can be in US dollar. And part of it is that you balance the risk that if you're trying to get more yield, you're going to take more risks. That could be liquidity that could be down in quality, that could be longer duration. But we are looking for those opportunities that may be less understood, that may be more niche parts of the market.

Brendan White: Our firm is a little different than others in that historically we've been incredibly liquid. In our ALM processes, we have relied on BBB corporates and high yield corporates. We've not been big in the private placement markets and we've been small in the illiquids and alternatives markets. We are in the process of trying to broaden our toolkit and add some creativity to our portfolios and have more in illiquids.
Certainly, I don't know that I want to take more fundamental risk in these markets. I'm willing to take liquidity risk which is probably the cheapest risk out there right now. The way we have invested the last 10 years is not going to work for the next 10 years. We need to be open to new ideas. We need to be open to risk that is other than fundamental risk.

Todd Hedtke: I would double down on that—creativity, complexity, whatever you call it, that's an important point. And so that's clearly where we're looking to take advantage of our strengths. As insurers, we can take more liquidity risk and we hopefully can take more complexity risk. But the one thing that concerns me is people taking that complexity risk who don't have the ability to really understand it. So, yes, certain assets are a good fit but if you don't understand that risk, how does that play out? And then if you extrapolate that to smaller investors that that gives me pause here.

Randy Brown: We've always had a large allocation to non-public assets and we're increasing it, both in property and in non-public debt. It is hard to make it up on volume when you're earning a negative rate of return, even on high quality single A, BBB assets in credit, for instance. So, we are increasing our allocation to real assets.

Sarfraz Thind: Are you comfortable with the complexity risk that you're taking? Do you think the industry as a whole is in a place where it actually understands the underlying risks of some of the more complex or illiquid assets?

Randy Brown: Typically, nothing happens quickly and we have ALM involved, we have risk involved, we have compliance involved. These are thoroughly vetted well before they get onto a balance sheet. So yes, by and large, insurance companies understand the risks they're taking, including liquidity risk, model risk, structure risk, complexity risk.

Xiaowei Han: We do a lot of complex analysis. We look at the balance sheet from different perspective. We look at tails, stress, volatility, and market expectations. We look at reporting to see how things come through with different accounting rules and we look at mark to market view. So we really do comprehensive analysis. And obviously we also have the risk management function. We have a very strong liquidity position and a very strong capital position. Overall, the industry is pretty much well capitalized. So if one has the capital and liquidity, then one is in a position to take advantage of potential opportunities.

Brendan White: It's really important to know what you can do and what you can't do. Play to your strengths and where you are weak find a partner. Does everyone do that? I'm not sure. Some people get blinded by things that are highly rated for example, and that's a little dangerous.

Sean Collins: That's where insurers or investors in general can get themselves into trouble, when you start to push the boundaries of your core competencies. You assume what works here in the US works in Europe or Latin America. You have to understand them in your general account, but you really need to make sure the manager understands the risk that they're taking as well. And if it's outside your core competencies—there's only so far, you can push the boundaries on that.

Vincent Huck: In the context of understanding the risk, how do you work out capital charges for multi-asset credit strategies and where there is a bit of tactical play how do you work that out?

Brendan White: We do pay attention to regulatory capital efficiency. That said, we're very fortunate in that we are one of the most well capitalised insurance companies, which is one of the reasons we have a large equity portfolio. Generally, our goal is to find the best investment from a risk-return standpoint and allocate capital accordingly. If we can get regulatory capital efficiency for free, a rated structure, for example, we'll take that. But our capital position allows us to focus purely on risk and return and secondarily on regulatory capital efficiency.

Todd Hedtke: For me it is more of a focus than Brendan is saying. Capital efficiency is key, but for me it's looking at that capital from multiple perspectives. The point was made earlier on about the NAIC. You can see what charges are changing now.
This is a global situation as well. I don't have to deal with just the NAIC, but I have to look at it from S&P ratings, from Solvency II and from economic risk capital. We're looking at it from a multi factor lens.
It does create more complexity—but it does hold us in check a little bit as well.

Brendan White: We actually come about it from a different angle because I think there's a danger of being too focused on regulatory capital efficiency. For instance, there are a lot of private debt funds out there that might be rated NAIC 2 but they're not NAIC 2 risk. When we model that, we model it as a high yield risk. And when we stress our portfolios, we stress it as a high yield risk. So we pay attention to regulatory capital efficiency, but we're more focused on stressing our portfolio daily on what we think the right risk is.

Randy Brown: I agree with Brendan in the sense that I look at economics first and foremost. This is what I feel like I've brought to this side of the world from when I started as a bond trader, then a portfolio manager, now an asset owner. I always start with the economics as opposed to letting accounting or risk capital or ALM drive the decision. It's got to start with economics. In the long run, that wins.There are a lot of asset classes that you would say purely on a capital perspective you wouldn't buy.

Xiaowei Han: As mentioned we're not just looking at the RBC, we also consider capital views from S&P and other rating agencies. Furthermore, we have our internal capital model. We need to look at economic capital. We need to understand through our internal modelling what is our real economics here. The NAIC may change their risk factors but S&P or other rating agencies haven't necessarily changed their models yet. So it's probably a calibration process going forward as we learn companies' new capital ratios and their ratings.

Sean Collins: When we talk to the rating agencies, there's a lot of time spent educating them on how we think about risk as well. When you think about the NAIC framework, yes, the factors are changing. But overall, it's a simplistic view of risk. And RBC ratios are kind of a simplified view of probably what everyone's internal capital models are. So capital efficiency is useful, but maybe it's not the whole picture and it's useful on the margin. Here are opportunities on the margin of our portfolio where we can make a capital efficient decision. But you still have to understand the risks of those investments. If those risks differ from what the capital charges say, we're going to have that view of what those risks are. If you just look to capital efficiency, everyone will be buying triple-A structured tranches, because the charges are so low under the new framework.

Sarfraz Thind: ESG is now intrinsic to insurer investments. How that has been playing into your asset allocation choices in the recent past and how do you see it doing so in the future.

Randy Brown: As an institution we have been quite focused on ESG for a long time. With respect to asset allocation, we are considering some changes, and that would be to invest in asset classes that we traditionally didn't invest in and doing it in a smart way. We're considering investing much further down the lifecycle chain. So venture and early stage growth and mid stage growth to make sure that we get a front row seat at innovation that's coming into the market. A lot of the time that was focused on defense. Now it's time to play offence.

Todd Hedtke: On a personal side this has been a huge topic for me. We've been trying to be at the forefront of this, especially on the E portion. What's really been a bigger topic naturally over the last 12, 18 months is the S portion. The role of regulation is going to be played more and more in the US. We see so many different activities in Europe but that's now coming ashore in the US. But when it hits, it's going to hit hard.
And regulators are going to play a role in many different ways. You're going to see disparate things in the US, where, for example, Texas is going to have rules that will look a lot different than what California has.

I think ESG, ultimately, is something we are all going to have to be fluent in. It's going to be a language topic.

Sean Collins: ESG is a constant topic at Prudential. It's quickly escalated over the last 12 months, probably faster than most other things we've seen in recent years. And, a huge part of it is on communication—being able to communicate what your strategy is and what your company's beliefs are and not succumbing to kind of the lowest common denominator of the activist, shareholder or stakeholder who says, why have you not taken action on some project that is not even in your portfolio, that you're loosely tied to.

Randy Brown: The most important thing right now is the misalignment of expectations. Politicians and activists have an expectation that you're going to be able to stop quickly and turn on a dime. And it's just not realistic, given the nature of our portfolios. Uou have to have a core set of beliefs. You have to communicate them effectively and you cannot respond and engage with everybody who comes across with an opposing point of view. If you did that, then there is virtually nothing you can own in your portfolio that somebody somewhere doesn't deeply and passionately feel is bad.

Alex Chan: What do you expect from your debt managers from an ESG perspective?

Todd Hedtke: To be honest, it's been an evolution. Being a PRI signatories is not good enough today. Now you want to know how are you integrating all the various elements? How do you score your portfolio, how do you make a decision? And it's not to say you can't buy this, you can't buy that.
I want to know what are you doing? How are you marking your portfolio? Do you have your own ESG model? Are you relying on MSCI?

Sean Collins: It's definitely working closer with the manager, it's definitely having that two-way dialogue to understand how they're thinking about the risks and the negatives in the portfolio and understanding how the asset manager thinks about those issues or those risks that are credit material.

Part I is available here
Part II is available here