A visit to the Harley-Davidson Museum ignited the idea of how munis may help insurers navigate new regulations and late-cycle investing.
Laurie King: I’m Laurie King, and you are listening to On the Trading Desk®.
This conversation features highlights from an Investment Perspective created by Wells Fargo Asset Management [WFAM] called Of munis and motorcycles: How insurers can navigate new regulations and late-cycle investing.
Today, we’re talking with its authors, Ed Martin, Senior Solutions Manager of the Multi-Asset Solutions team, and Gabe Diederich, Portfolio Manager of the WFAM Global Fixed Income team. Welcome to the program, Ed.
Ed Martin: Thanks, Laurie. It’s great to be here.
Laurie: And thank you for joining, Gabe.
Gabe Diederich: Thanks for having me, Laurie.
Laurie: So a visit to the Harley-Davidson Museum in Milwaukee starts off your paper. Could you explain the details why you were there and how it lead to you writing about this topic?
Ed: Sure. Wells Fargo Asset Management had a conference in Milwaukee. Being new to Wells Fargo, it was a real treat for me to meet so many of my colleagues face-to-face.
For entertainment one night, we went to the Harley-Davidson Museum. I’m not really a motorcycle guy, but the museum is well worth the trip.
Gabe and I had a chance to talk during the day but also were able to catch up later at night and talk about some of the exhibits, as well as some of the investment ideas we talked about during the day.
Gabe: Yeah, it certainly was a wonderful conference to bring through not only all different asset classes into one place, but clearly someone like Ed that’s focused on insurance, to sit down and really talk with people like myself who focus on balance sheet asset management for insurance companies.
Laurie: And talking about the museum, there was a specific motorcycle called Night Train that had an interesting story behind it. And in the paper, it said it really ignited your conversation. Can you talk more about that?
Gabe: Yeah, Laurie, it was really an interesting exhibit, in that this is a motorcycle that drifted 4,000 miles across the Pacific, was washed out of a container following the tsunami that had hit Japan in 2011, and the bike’s owner actually donated it to the museum as a memorial to those who had died or had lost belongings in that tragic event.
To me, it really kind of brings full circle back the work that our insurance company clients are doing, whether if it’s property, casualty, life, or even health. The insurance company’s job is to be there during a time of distress or a time of loss, and it really helps us think about how we can be there for the insurance company to have a balance sheet well-protected to fulfill those needs.
Laurie: Well, what are the main challenges that insurance companies are facing in this environment?
Ed: From a market’s point of view, insurers are being challenged on multiple fronts.
The yield on the Barclays Corporate Bond Index, which is a good proxy for what insurers invest in, has fallen from 437 in November down to 292 today. So lower yields by themselves are a big problem and spreads on those bonds are not rising enough to keep up with the falling treasury yields.
Another thing people are concerned about is the late cycle. We keep wondering if the economy is finally starting to deteriorate, which can result in credit losses or other problems in bond portfolios.
And a final thing is new RBC rules that are going to come into effect in 2020. RBC stands for risk-based capital, and risk-based capital is an amount that an insurance company needs to hold to ensure its financial strength, to make sure it has enough surplus set aside to be a sound financial institution.
Because of changes in the math behind those rules, the amount of capital attributed to higher quality fixed-income investments, particularly single-A and BBB bonds, is increasing. Because of the increased capital requirements, they become more expensive for insurance companies to hold.
Laurie: So in particular, focusing on investment-grade portfolios, you guys have, in this paper, talked about ideas to help compensate for that. Is that right?
Ed: Exactly. The hardest hit credit quality is single-A bonds where the factors will be increasing the most. Also, most BBB bonds will see an increase, too.
Laurie: So how can muni bonds help insurance companies navigate this challenge?
Gabe: Well, I certainly think insurance companies have had to rethink their approach to not only the municipal market but I think all fixed income with this changing yield climate, the changing spread climate, and even the changing regulatory climate and tax reform.
We try to be as proactive as we can with ideas.
I think that one that comes to mind for me is certainly integrating taxable municipals into a balance sheet, looking at bonds subject to the alternative minimum tax, ways to generate additional income.
When I think about this asset class relative to other fixed income, municipals certainly do have favorable credit metrics. This is an asset class that on average is AA-minus rated and has generally shown low levels of spread volatility and ratings migration over an investment cycle.
It’s also a low volatility asset class and that certainly speaks to me today. We’ve seen the bond markets move around quite a bit here in recent weeks, and this is an asset class that has shown much lower volatility than the U.S. corporate bond market or Treasury bond market.
I think the other big component is diversification, too. This is an asset class that offers different sectors and these different dynamics that I’ve already discussed.
If you take it and put it all together, we certainly analyze some numbers of what this really means for an investor and for this balance sheet. You can look at something like a AA-rated taxable municipal and ,net of risk adjustments, the spread on that security is actually going to be better than going down a rating notch within the corporate market.
So I think looking beyond the surface of the spread on a security or the rating on the security to really adjust it to the insurance company’s specific operating environment is really key in understanding what asset class and what asset allocation is going to be optimal.
Laurie: These are great insights for investors to consider. Any final thoughts for our audience?
Ed: I think Gabe hit the nail on the head. Insurance companies need to relook at all aspects of their investment policy, given the low yield environment that we’re in today.
Gabe: I think for me, Laurie, the big topic here to bring this full circle is if you look back to this item that we talked about earlier with Night Train at the museum.
For us, trying to put ourselves in the place of the insurance company that’s trying to prepare itself for these situations of loss and what that means is trying to have an efficient balance sheet.
To me, looking at this museum, we saw some of the oldest motorcycles, which almost looked like bicycles, and then you see the new modern motorcycles of today, and it shows how even in that industry, you have to evolve. You have to modernize. And I think that same evolution also applies to balance sheet management for insurance companies.
Laurie: Well, thank you for your comments, Ed and Gabe. To our listeners, I would like to say that you can find this full Investment Perspectives paper by visiting www.wellsfargoassetmanagement.com. But for now, let’s wrap things up for today. We appreciate your time on the program, Gabe and Ed.
Gabe: Thanks, Laurie.
Ed: Thanks for having me.
Laurie: Until next time, I’m Laurie King; take care.