Why Bank Loans for insurance companies?

Introduction

Bank loans, also referred to as senior secured loans (SSLs) are privately arranged loans issued to a consortium of institutional creditors that provide companies with access to debt capital. SSLs traditionally offer a fixed spread over an adjustable reference interest rate, making them ‘floating rate’ instruments. The fixed spreads over the reference rate reflect the credit risk of the issuer.

Generally, borrowers are companies, and the loans typically fund transactions related to mergers and acquisitions and leveraged buyouts by private equity sponsors. SSLs are typically rated below investment grade, but their special credit risk mitigation mechanisms rank them at the top of a company’s capital structure. These risk mitigation mechanisms can include comprehensive collateral packages, such as share pledges, seniority in the company’s capital structure and covenants. Seniority in the company’s capital structure means that SSL investors are effectively ranked first for any repayment in the event that the issuer defaults. For a deeper dive on SSLs as an asset class, please refer to Investment Insights Research by our Investment Analysis Team.

Why bank loans now?

In our view, SSLs offer three compelling reasons to invest:

1. Potential high level of current income
   Current income is comprised of two key components – base interest rates (which are expected to stay high) and credit spreads (which are historically wide). Coupon income for bank loans today is around 9%, which is near its highest level since 2009.¹ Market expectations are for rates to remain higher for longer, and well above pre-2022 levels, before the US Federal Reserve (Fed) started raising rates. Loans have proven to provide consistent, stable income through various market cycles, including recessionary periods and periods of falling interest rates. A loan's yield is based on coupon payments, which is the interest return, and principal return. The 9% average coupon on loans is above the average high yield coupon of 6.24%.² After yielding around 170 basis points less than high yield bonds over the past fifteen years, this is the first time the average loan coupon has surpassed the high yield coupon. Only three years ago, loans yielded 4.80%; they have recently yielded more than 400 basis points above that.³
2. Will rates be higher for longer?
   Loans have virtually no duration risk (average of around 45 days). The forward SOFR curve currently implies an average 3-month SOFR rate of approximately 5% over the course of 2024. This reflects the broadly accepted market view that the Fed will follow a cautious approach to easing interest rates further, following the 50 basis point interest rate cut in September. Recent economic data have been more supportive of a “higher-for-longer” interest rate environment, supporting higher loan coupons.
3. Compelling relative value
   Loans have offered one of the best yields in fixed income, while providing downside risk mitigation by being senior in the capital structure and being secured by companies’ assets. Loans have offered these high yields with virtually no duration risk.

For a deep dive into the sector and our latest outlook, read our paper ‘The Case for Senior Loans’.

An attractive asset class for insurers

SSLs are an attractive asset class for insurers, as they are a natural fit for most liabilities. SSLs provide insurers with the potential to improve returns, reduce capital charges and reduce overall risk, while maintaining portfolio liquidity.

In the recent environment of increased uncertainty and headwinds facing private market asset classes, we see a preference for liquid forms of alternative fixed income among our insurance clients. Indeed, most insurers have focused on investment grade bonds, which are relatively liquid and competitive in the current monetary context. This liquidity allows investors to implement asset allocation views and tactical plays without being constrained by the multi-year “lock-up” typical of many private debt strategies.

SSLs are on the frontier between private and public markets, since most of the loans are issued to privately held companies. But there is an active secondary market for the asset class, which gives investors access to liquidity.

In the section below, we focus on three key areas:

1. Where do SSLs sit on insurers’ balance sheets? 
2. Solvency II treatment of SSLs
3. Portfolio use case for SSLs by insurers and relative value analysis with comparable asset classes

Where do SSLs most naturally sit on insurers’ balance sheets?

As SSLs are short-dated, floating rate, sub-investment grade assets, they can be a meaningful addition to insurance companies’ participating businesses and surplus capital, as well as attractive to property and casualty companies.

A. Participating business

Depending upon the specific situation of each firm, SSLs could be used:

• to de-risk from equities
• to lower a firm’s volatility profile and capital requirements
• to improve a firm’s expected risk-adjusted portfolio return

Example: With Profits Fund

An insurer believed that equities were relatively expensive at prevailing levels. It switched a portion of its equity exposure to SSLs. SSLs’ lower volatility compared to equities was desirable for a portfolio in runoff, and the switch led to the portfolio’s improved risk-adjusted returns. SSLs required less capital than equities, boosting the free surplus position of the fund.

B.  Surplus capital, and property and casualty portfolios

Insurers have several objectives with these portfolios. Typically, firms do not seek to take interest rate risk exposure. They need access to liquidity, seek to deliver attractive risk-adjusted returns and may also have an overall capital budget. SSLs may tick some of these boxes.

Example: Property and casualty insurance company

In the current monetary context, insurance companies have been allocating increasing amounts to high quality global credit and low duration senior secured loans to benefit from higher short-term global interest rates. This additional yield helps them secure a low capital consumption going forward. After 10 years of depressed interest rates, interest rate normalization has allowed insurers to resume their traditional asset allocation in their general accounts, without the need to extend duration or invest in illiquid asset classes. 

Solvency II treatment of SSLs

The most significant element of the capital requirement for SSLs is credit spread risk. Under the Solvency II Standard Formula, the capital requirement for spread risk is a function of the rating and duration of the loan. In this way, the spread risk capital requirement for SSLs is the same as that for high yield corporate bonds with the same rating and credit modified duration. For example, SSLs with a five-year maturity and BB rating would have a spread risk capital charge of around 18.5%, compared to 39.0% for Tier 1 Equity, such as European equity, and 49.0% for private equity.

Figure 1 provides the 10-year expected return for SSLs compared to real estate, European equity and private equity. SSLs’ expected return of 6.90% is significantly higher than the expected return for European equities, real estate and almost on par with expected private equity returns. 

Portfolio use case for SSLs by insurers and relative value analysis versus comparable asset classes

In the current market environment, few fixed income investments offer attractive current income with short duration and historically low volatility. SSLs combine these features while offering potentially attractive diversification benefits due to their historically low correlation to other asset classes. These factors provide three compelling use cases for SSL allocation by insurers:

1. Return on capital: Replacement of equities. SSL volatility is lower compared to equities. Capital requirements are halved compared to Type 1 or Type 2 equities as defined under Solvency II.
2. Risk and reward arbitrage: SSLs offer diversification relative to equities, high yield bonds and emerging market credit in the below-investment grade category. Hence, SSLs can potentially improve the portfolio’s expected risk-adjusted return, , reduce its volatility and reduce the volatility of the eligible own funds in the economic balance sheet.
3. Access to liquidity and reduce cash drag: Investing in bank loans can reduce the “cash drag” that results during the waiting period associated with private market allocations.

SSLs benefit from certain credit risk mitigation measures that guarantee seniority to creditors in the case of default. This has historically resulted in lower default rates and higher recovery rates compared to unsecured non-investment grade securities, such as high yield bonds. Additionally, during some periods, SSLs can offer higher yields than high yield bonds due to their different market dynamics.

In figures 2 and 3 we show the impact on return/risk and return/Solvency Capital Requirement (SCR) by adding 3% of European SSLs to a European general account (GA) portfolio and a UK general insurance portfolio.

• In Portfolio 1, we have sourced the reallocation via a pro-rated reduction in baseline portfolio holdings
• In Portfolio 2, we have sourced the reallocation from the portfolio’s equity and private equity holdings
• We observe a sizeable positive impact in both portfolios in terms of return/risk, while for return/SCR, we observe a sizeable positive impact when the SSL allocation is funded from equity allocations, thus reinforcing the case for replacing equities with SSLs.

Asset liability management (ALM) considerations

Many European life insurers and UK general insurers use an 80% fixed income and 20% total return allocation to back their liabilities. Nevertheless, the objectives are very different:

• European with-profits policies must deliver a competitive yield for their policyholders in a competitive environment. Financial risks are shared between the insurance companies and the policyholders.
• General insurers seek to keep a safe and liquid asset allocation to reimburse claims. In actuarial theory, the investment income is used to finance expenses.

Hence the asset allocation of European life insurers is more capital-intensive, which explains why both return/risk and return/SCR are improved when one substitutes either all portfolio asset classes or the equity and real estate portions only with SSLs.

In the case of the general insurer, return/SCR is improved only if SSLs replace the equity and real estate asset allocation, showing that this asset class is a competitive alternative when it comes to surplus/excess own fund portfolio management.

In each case, SSLs improve the portfolios’ return/risk measures, reinforcing the stability of our clients’ eligible own funds or reducing the cost of options and guarantees.

Conclusion

SSLs offer attractive risk-adjusted and capital-adjusted return potential, along with a record of low volatility of investment returns (compared to traditional asset classes), low duration and a potential source of diversification for an insurer’s investment portfolio.

In the current interest rate and macroeconomic environment, we believe SSLs are attractive compared to high yield and equities, offering a higher potential income, a lower exposure to interest rate volatility and a source of portfolio diversification. These features make SSLs a good match for the with-profits, general insurance and surplus assets of an insurance balance sheet.