The extended period of historically low U.S. interest rates has been a headache for yield-challenged fixed-income investors such as insurance companies. Yet one income-oriented asset that has benefited some investors remains an option that might benefit insurers as well, even in a rising-rate environment.
Dividend-paying equities have been a tempting income alternative in an era of low bond yields. Insurers can access these opportunities as well, although they would typically be drawn to higher quality issuers with a history of paying above-average and steadily increasing dividends. While the U.S. Federal Reserve is focused on raising its benchmark fed funds rate to 3% by the end of 2019, there is no guarantee this will occur or to what extent other market rates will follow. In the interim, higher quality income equities might remain an attractive and viable income option for insurers and, we think, will remain attractive should rates rise.
Equity strategies in general offer insurers other benefits both short- and long-term: diversification to a portfolio often heavy in fixed income, issuer diversification (not all issuers offer bonds), tax savings through ownership of other company's equity, equity's natural inflation hedging qualities and its long-term growth advantage over fixed income. These considerations can help offset some of the concerns equities may pose, namely higher risk-based capital charges and greater volatility.
While a market correction may be a concern with equity market indexes near all-time highs, higher quality companies with strong dividend histories tend to outperform the overall equity markets in down periods and may be a better fit for insurance company portfolios.
Lower bond yields raise appeal of equity dividends
Finding income in a low-yield environment has been a challenge for the insurance industry for many years. To generate greater income, some insurers increased credit risk by investing lower in the quality spectrum and/or increasing interest rate risk by extending duration.
Ignoring income equities as an alternative to riskier bond strategies has become harder to justify as bond yields have fallen, especially when it is equity of high quality companies.
As the examples in Figure 1 illustrate, there have been times recently where a high-quality company's equity dividend was competitive with its bond yield. Bond/equity yield comparisons are unique to each issuer, and the decision to invest depends on each insurer's portfolio strategy. However, there are times in this current market environment when an issuer's equity dividend yield presents itself as a viable alternative to its corresponding bond yield, providing selective opportunities to diversify portfolios to equity via higher quality names.
The compression of spread valuations through the fixed-income asset class overall has affected the risk-reward trade-off, as investors have found it harder to earn commensurate yields for greater investment risk.
At this point late in the credit cycle and in an environment of compressed spreads, investors with significant fixed-income allocations may want to consider the growing asymmetry between risk-reward profiles. Should interest rates rise or spreads widen, many may face unrealized losses in their bond portfolios as prices fall. An asset less correlated to these risks might be of great value to a portfolio, and equities might be strong candidates. In Conning's view, modestly improving economic growth, slowly rising interest rates and potential U.S. federal tax reform in 2017-2018 may create supportive conditions for equity markets. In this environment, an equity allocation may be of value to portfolios concerned about significant bond exposure.
Less volatile, better downside protection
Diversification and potential income may be valuable to insurers, but equity market valuations near historic levels may be a concern.
Higher quality equities, however, tend to outperform overall equities in down markets. For a representative comparison, we use the S&P 500 Dividend Aristocrats, an index subset of stocks of larger companies that have increased their dividends for at least 25 years. These firms tend to be high-quality, well-known names, mostly in consumer staples, industrials, health care, consumer discretionary, financials and materials; the index has few utility or real estate investment trust names.
According to Conning's study of S&P 500 data for the previous 20 years, $1 invested in the Aristocrats outperformed $1 invested in the S&P 500 (Figure 2). The key driver: the Aristocrats segment captured only 64% of the down market performance during the two decades. This loss-mitigating aspect did not cause it to miss gains, however, as the Aristocrats still captured 85% of the upside when markets were rising.
Investors with lower appetites for volatility but that want income might be more comfortable with high-quality income equity securities as their equity of choice. And while valuations for equity markets may currently be rich, timing the market for a "better" entry point is often difficult. High-quality dividend equities have tended to be consistent dividend payers over time, and delaying exposure to the asset class can also mean missing out on valuable portfolio income. Should equity markets continue to rise, though, equity owners' portfolios also participate in the valuation uptick.
A permanent place for equities
While no formula is in place for any asset category, we believe most insurers benefit from a diversified array of fixed-income and equity instruments to help meet their business needs over the short and long term.
When interest rates finally rise, conservatively focused investors such as insurers may want to take advantage of rising bond yields and return to more familiar-looking, bond-heavy portfolios. However, there are many reasons to consider some portfolio equity exposure. The income stream, relatively lower volatility and long-term benefits of income equities, especially from high quality companies with a long history of increasing dividend payments, make a compelling argument to make them a permanent part of many insurance portfolios.
Matthew Daly is a managing director and head of corporate credit research responsible for the corporate and sovereign research teams, and Donald Townswick is the director of equity strategies responsible for the development and implementation of equity investment strategies, at Conning in Hartford, Conn. This article represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.