Portfolio Construction: Portfolio Construction: Considerations in - - PowerPoint PPT Presentation

Portfolio Construction: Portfolio Construction: Considerations in Today’s Investment Environment Environment

Marco Bravo CFA Marco Bravo, CFA Portfolio Manager AAM Company

The 2014 Executive Education Roundtable Series

Portfolio Construction Considerations

• t o o Co st uct o

Co s de at o s

Objectives & Constraints

Asset, Liability & Underwriting Expected Returns Tax Rates Capital Structure

j Regulatory

Returns, Tax Rates, Capital Structure Applicable Insurance Laws

Capital Adequacy

NAIC RBC, AM Best BCAR

Accounting P C i

STAT & GAAP Financial Objectives E l ti f P H ldi

Peer Comparisons Asset Allocation

Evaluation of Peer Holdings Macro-Economic Environment, Expected Risk-Adjusted Returns, Yield Curve

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Risk Adjusted Returns, Yield Curve Structure

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Portfolio Construction Considerations Portfolio Construction Considerations

Key considerations in today’s investment environment: Investment Policy Objectives & Constraints Key Risk Measures Asset & Liability Management Taxability Asset Allocation Fed Policy Fed Policy Relative Value Assessment Risk Assets

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Risk Assets

3

Credit Risk Considerations

60

Cumulative Default Rates (1983-2013)

Credit Risk Considerations

Low rate environment pushing i h f i ld b

40 50

5yr 10yr 15yr

insurers to search for yield by going down in credit quality Default rates and volatility of

20 30

5y

Default rates and volatility of default rates do not increase linearly as rating is decreased

10 20

Set portfolio concentration limits that take into account default and recovery rates

AA A BBB BB B

Source: Moody’s Annual Default Study (Feb. 2014)

y

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Interest Rate (Duration) Risk Considerations Interest Rate (Duration) Risk Considerations

Rate (%)

Fear of rising rates has led i id h i

Implied Forward Rates

3.0 3.5 4.0

( )

insurers to consider shortening portfolio duration Staying short has been costly

2.0 2.5

Staying short has been costly and forward yield curves pricing in higher rates

0 5 1.0 1.5 Current Yield Curve 3 year Forward Yield

Volatility of economic surplus a consideration when setting duration target for assets

0.0 0.5

1yr 2yr 3yr 5yr 7yr 10yr

Maturity

3-year Forward Yield Curve

g Limit amount of duration mismatch to maintain i t t di i li

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investment discipline

Source: Bloomberg, data as of 05/12/2014

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Liquidity Risk Considerations Liquidity Risk Considerations

Liquidity risk tends to be a bigger concern for P&C companies h if / l h C i than Life/Health Companies Increase in surrender activity for annuity writers is a concern if rates move above current crediting rates rates move above current crediting rates Manage liquidity risk through laddered maturity investment profile with ranking of liquid assets profile with ranking of liquid assets Consider liquidity back-stop facility such as membership in Federal Loan Bank

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Asset & Liability Management Considerations Asset & Liability Management Considerations

Risk of asset duration extending in a rising rate environment Increasing investment leverage increases importance of asset/liability duration match Compare assets and liability cash flows under various interest Compare assets and liability cash flows under various interest rate scenarios Interest sensitive assets and liabilities requires the use of effective duration versus modified duration Segregating liabilities by product line imposes pricing discipline so that long term yields do not get used for pricing discipline so that long-term yields do not get used for pricing short-term liabilities

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Tax Considerations Tax Considerations

me Federal Tax > AMT Federal Tax = AMT AMT > Federal Tax

Objective:

After-Tax Incom

Objective: Establish Target Ranges for tax-exempt allocations

Municipal Allocation

250

Primary Consideration: Understanding of

150 200

• f Trials

Underwriting Profitability

50 100 # o

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0.88 0.89 0.90 0.91 0.92 0.93 0.94 0.95 Combined Ratio

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Why Consider Tax Exempt Municipals? Why Consider Tax-Exempt Municipals?

170 180 130 140 150 160 asuries 100 110 120 130 10 Year Spread to Trea 70 80 90 Tax Adjusted 1 50 60

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10yr Municipal Spread

Source: Bloomberg, Thomson Municipal Market Data as of 4/8/2014

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Fed Policy Considerations Fed Policy Considerations

• Timing
• Balance Sheet
• Short and Long Term Interest Rates

Fed Funds Rate (%) 5 000

Fed Balance Sheet

• Asset Class Returns

Fed Funds Futures

1.40 1.60 1.80 2.00 3,500 4,000 4,500 5,000 Fed Agency MBS Purchases Liquidity to Key Credit Markets Lending to Financial Institutions Long Term Treasury Purchases Traditional Security Holdings

Fed Funds Futures

0.60 0.80 1.00 1.20 1 500 2,000 2,500 3,000 Billions 0.00 0.20 0.40 Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec 2014 2015 2016 500 1,000 1,500

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2014 2015 2016

Source: Bloomberg, Cleveland Fed, Chicago Board of Trade

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Tighter Monetary Policy and Interest Rates Tighter Monetary Policy and Interest Rates

Yield curve usually flattens when Fed is raising rates

8 9 Rate (%)

Fed Funds 2yr 10yr

y g

5 6 7

10yr 30yr

2 3 4 1

Source: Bloomberg, US Treasury

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10yr Treasury Rates and Asset Returns 10yr Treasury Rates and Asset Returns

Comparison of various asset returns during periods of rising p g p g 10yr Treasury Rates

09/93 thru 12/95 thru 9/98 thru 5/03 thru 6/05 thru 12/08 thru 11/94 3/97 1/00 5/04 6/06 12/09 Period 10yr TSY Yield +252 bps +131 bps +224 bps +124 bps +123 bps +163 bps Bank Loans S&P 500 S&P 500 S&P 500 S&P 500 High Yield +9.63% +30.41% +43.19% +18.31% +8.62% +58.21% S&P 500 Convertibles Convertibles High Yield Bank Loans S&P 500 2.14% +14.97% +25.45% +11.89% +7.49% +26.45% High Yield High Yield Bank Loans Bank Loans Convertibles Convertibles 1.97% +12.59% +7.91% +6.95% +5.88% +23.88% 1-3Y Gov/Credit Bank Loans High Yield Convertibles High Yield IG Corp Bonds 1.03% +11.04% +4.12% +5.99% +4.80% +18.68% Convertibles 1-3Y Gov/Credit 1-3Y Gov/Credit 1-3Y Gov/Credit 1-3Y Gov/Credit Bank Loans

• 3.11%

+5.82% +3.98% +0.96% +1.92% +13.65% Barclays Agg Barclays Agg Barclays Agg Barclays Agg Barclays Agg Barclays Agg

• 3.53%

+3.05%

• 0.81%
• 0.44%
• 0.80%

+5.93% IG Corp Bonds IG Corp Bonds IG Corp Bonds IG Corp Bonds IG Corp Bonds 1-3Y Gov/Credit

• 4.86%

+2.25%

• 1.71%
• 0.44%
• 2.22%

+3.82%

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Source: Barclays, Bloomberg, CSFB Loan Index

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Asset Classes Relative Value Asset Classes Relative Value

OAS bps

5-year Historical Option-Adjusted-Spreads

d

1,000 1,200

OAS, bps

Recent

Asset spreads at or near 5- year lows Prices seem to be pricing in

600 800

Average

Prices seem to be pricing in a benign credit environment Increased risk of a pullback

200 400

due to a change in investor sentiment towards risk Yield focused investors need

200

IG Corporate CMBS Taxable Muni HY Corporate

Yield focused investors need to be careful

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Corporate Muni Corporate

Source: Barclays

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Considering Risk Assets Considering Risk Assets

Is this the right time?

P&C Investments in Alternative Investments

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Source: SNL, 12/31/2013

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Questions?

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