#208 | Taking Stock of the TNX
Although the public and the media are completely fixated by COVID-19 and the dramatic oscillations of the equity markets, we insurance folks are watching a different metric – the 10 Year Treasury yield (TNX). Since February 20th, the S&P has shaved off nearly 30% of its value, which is a steep and deep by any historical measure. But it pales in comparison to what happened to TNX. Over the same period of time, it lost 45% of its yield, falling from 1.52% to just 0.85%. The crazy part, though, is that TNX briefly touched levels just half of where it is right now during both normal trading hours and overnight. This set off a minor panic in our industry. We have all been conditioned to view the 10 Year Treasury as the health barometer of insurers and the products they sell. A sub-50bp TNX looks like the death knell of our industry, but is it? The reality is much more nuanced.
Let’s start with the simple fact that life insurers don’t invest a meaningful portion of their general account assets in Treasuries. There is no direct connection between the TNX and carrier general account yields. Instead, there are a multitude of indirect connections. We’ve been conditioned to watch the TNX because it serves as the reference risk-free rate for mid-maturity fixed income yields across the board. All else being equal, falling TNX will result in lower investment yields for other fixed income assets of similar maturities.
But all else is never equal. From 2/20 to 3/13 the Moody’s Aaa Index, which tracks the yield to maturity of highly rated corporate bonds, increased from 2.77% to 3.03%. Similarly, the Moody’s Baa Index, which tracks the same yield metric but for the bottom end of investment grade corporate bonds, has tacked nearly 70 basis points in yield, rising from 3.57% to 4.24%. Corporate bond yields have been stable, meaning that credit spreads are expanding as the TNX falls. This is generally a good thing for insurers, who have to capitalize for default risk anyway but now they’re actually going to be compensated for it with higher yields relative to TNX thanks to fatter credit spreads. It’s a better time to be putting money to work in fixed income today than it was a few weeks ago – assuming the floor doesn’t fall out on corporate debt.
However, times were already extremely tough for insurer investment yields. Both of the credit indices I referenced earlier are testing the historic lows of the late 1940s and sitting well below anything in recent history. For example, the lowest Moody’s Aaa reading in recent (40 year) history before the middle of last year was 3.2% in July of 2016. Life insurers were already in the jaws of an investment yield bear before the turmoil of the last couple of weeks, but at least things didn’t get significantly worse. At least, not yet. The big open question is what will happen when the COVID-19 crisis passes its peak and credit spreads normalize. If Treasury rates remain very low, investment yields will fall through the floor. Only time will tell.
Even this is too simplistic of a view. Over the past decade, companies have crept into increasingly esoteric corners of the credit market in their search for yield. Quick Take #8 discusses the growing use of Collateralized Loan Obligations (CLOs), which are securitized and structured corporate loans, in life insurer general account portfolios. These loans have two interesting angles. First, they pay floating rather than fixed rates, meaning that their payouts have decreased along with LIBOR over the past year. Second, they have a different credit risk profile than traditional high-quality corporate debt because the loans have non-standard covenant provisions and are generally sold to highly leveraged, small to medium sized businesses, many of which are owned by Private Equity firms. As a result, there is a distinct risk of the CLO market “cracking” if these levered businesses experience strain. The logic about CLOs has always been that there is no systemic risk in the same way that we saw with structured mortgage products like CMOs back in 2008 – except, you know, a global pandemic that grinds everything to a halt and jeopardizes the ability for these businesses to service their debt. Take a look at the value of the Palmer Square CLO Senior Debt Index (CLOSE) over the past 3 years.
Given the huge runup in CLO prices prior to the drop, it’s hard to say that this is a catastrophe, but the index is certainly reflecting a steeper drop in CLO values than is historically normal. We’ll have to wait and see if more credit contagion makes its way to CLOs. If the CLO market does crack, then the impact across insurers is going to be directly related to how much CLO exposure an insurer has and how well it is capitalized. A few of the insurers who are big in the CLO space, like Northwestern Mutual, have oceans of capital they can tap for events just like this. You can’t say the same many of the smaller, PE-backed, annuity-focused firms that shunt their capital off to their Bermuda reinsurer. That’s where things will get interesting. The same goes for all of these firms that have carved out niches in illiquid, specialty credit markets like railcar financing, solar farm financing and cellphone tower financing. When times get tough, liquidity counts. And if a carrier has been busy picking up pennies in super thin markets, then we’re about to see if they can dodge the bulldozer.
There are other implications of falling TNX yields as well but, again, without a direct connection. New accounting rules for long-term guarantees in life insurance and annuity products take effect at the end of this year (ASU 2018-12) that will require insurers to update the discount rate for valuing the embedded guarantees using “an upper-medium grade fixed-income instrument yield.” If that sentence had read “the applicable Treasury yield,” then some insurers would probably have gone into receivership last week if they were using the new accounting standards. Regardless, insurers are still sweating blood about these long-term guarantees because most of them use Treasuries as a baseline valuation rate, which means that they’re suddenly on the wrong side of the trade – and very much on the wrong side. We’re already starting to see them take action to stem flows into those products. AIG put in premium limitations for their GUL products last week and they’ll hardly be the only one. Other carriers are telling their sales folks to step off the gas and changing their compensation accordingly. And, of course, we’ll see even more dramatic moves – products being dropped, companies being spun off, you name it. My bet is that Guaranteed UL and VUL product inventory is about to get very, very tight.
In short, the sky was already falling for life insurer yields even before the last couple of weeks and the dramatic drop in the TNX put an exclamation mark on it. The question now is what will happen next. If credit spreads stay healthy, insurers will still have to grapple with historically low rates but they’ll be able to employ many of the tried-and-true investment and product strategies they’ve been using for years. If credit spreads tighten and move closer to the TNX, then carriers will have to find new strategies and make more dramatic product decisions. It’s just too early to tell. Will this regime last for 6 weeks or 6 months? Are we on the cusp of finally seeing rates turn the other direction or will they drop to zero? Will the CLO market crack and cause a contagion like in 2008? We’re going to find out soon enough. But no matter what way you look at it, things are going to get interesting.