Bonds: A Solution for Yield-Starved Insurance Companies?

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1 August 2015 A Solution for Yield-Starved Insurance Companies: Dividend Equities Federal Reserve efforts to normalize monetary policy are unlikely to provide meaningful relief for yield-starved insurance companies. Elusive domestic inflation and ongoing reflation efforts around the world are likely to continue weighing down intermediate and long yields. With insurers unlikely to experience material improvement in income from core bond strategies, we believe equity income strategies are an attractive complement to fixed income given the combination of income and return potential. W. Charles Cook, CFA Director, Portfolio Strategist James Kaniclides, CFA Senior Portfolio Manager, Fixed Income Strategist

2 Core Bonds and Low Yields Central banks around the world have implemented extreme policy measures to foster liquidity and promote capital deployment in efforts to fuel growth and employment. The Federal Reserve has been at the forefront of this movement by maintaining a target policy rate of zero since 2008 and by pursuing several massive bond-purchase programs over this period. Growth and inflation have been slow to respond, which has depressed yield curves worldwide to low - and even negative - levels of real and nominal interest rates. This environment has been challenging for insurance companies that have experienced falling investment yields, given their large allocation to core bonds. Exhibit 1: Property and Casualty Companies - Gross Bond Yield (%) at the historical volatility of bonds relative to other asset classes, which serves as a reminder of the appeal of core bonds in supporting claims reserves and the rationale for the favorable capital treatment. The Fed s march toward normalization is unlikely to cause a departure from this pattern of remarkable stability in core bonds. Forward rate curves and the central tendency projections by the Fed suggest a slow pace of rate hikes over the next few years with core inflation projections remaining well within the Fed s comfort zone of 2%-2.5%. As a result, forward yields reflect a bearish flattening in which intermediate and long yields are contained. With the pace and magnitude of rate hikes suggested by forward curves offering only modest optimism for improvement in investment income, the search for yield beyond fixed income will continue. Equities can be Exhibit 3: Forward Yield Curves (YTM %) Source: SNL Financial as of 12/31/2014 Core bonds have been a funding source for higher-risk strategies in an effort to increase yield and return potential. Nevertheless, core bond strategies remain the dominant exposure in insurers allocations. The important role that core bonds have in strategic allocations is evident in looking Exhibit 2: Annual Return (%) - Bonds and Equities Source: Bloomberg as of 8/14/2015 Source: Barclays, Bloomberg as of

3 important elements in strategic asset allocations given the attractive risk-adjusted returns and the low correlations with fixed income. We believe an equity income strategy within the strategic allocation can help achieve portfolio efficiencies while also offering incremental yield. Income Opportunities of Dividend Equities With global bond yields at historic lows, equities now offer yields that are as compelling relative to fixed income as they have been in several decades. Since the inflation-induced spike in bond yields in the early 1980s, bond yields have been attractive relative to equity yields. Over the past 50 years, the dividend yield of the Standard & Poor s 500 Index has generally been below that of the 10-year U.S. Treasury. Investors have been rewarded for owning bonds over the past 30 years, benefiting from high coupon income and a long period of disinflation in the U.S. and abroad. Exhibit 4: U.S. Treasury Yield Less Dividend Yield More recently, however, quantitative easing in the U.S. and overseas has driven bond yields below those of equities. This is a global phenomenon, and in most developed equity markets, dividend yields are close to or higher than bond yields. In the U.S., the current percentage of companies with dividend yields above the 10-year U.S. Treasury bond is approximately 33%, one of the highest levels in more than 30 years (Exhibit 5). Dividends as a source of yield have not been as competitive relative to bonds in a generation. With a significant portion of the equity market trading at greater yields than the 10-year U.S. Treasury, opportunities for income-oriented investors abound. It is possible to build a well-diversified portfolio of large, liquid equities with yields that are above those of bond indices. Another key benefit is that the income stream of dividends typically increases over time and has risen approximately 7% a year over the past 35 years. 1 As economies grow, so too will the earnings and dividends of equities, enabling them to offer attractive prospective returns should the economy experience periods of rising interest rates, whether precipitated by stronger growth or rising inflation. Dividends Drive Returns Source: Wolfe Research as of 7/31/2015 Dividends have historically represented nearly half of the return to equities over a long time horizon. Emphasizing dividend equities, particularly those with high dividend yields or growing dividends, has historically contributed to excess returns relative to the broad market. In addition, these dividend cohorts have tended to exhibit similar or slightly lower volatility, which has led to better risk-adjusted returns. Exhibit 5: Dividend Stocks Yielding More than 10-Year U.S. Treasury (%) Source: Wolfe Research as of 7/31/ largest market cap companies

4 Exhibit 6: Average Annualized Returns of S&P 500 Stocks by Dividend Cohort Source: Ned Davis Research. Monthly Data 1/31/79 1/31/15 Importantly, dividend equities generally outperform the broad market during times of equity-market stress. The downside capture of equities declines for companies with high yields or growing dividends. This is an attractive characteristic for investors concerned about the potential for capital losses. Exhibit 7: Downside Capture of Stocks by Dividend Cohort proxies, which tend to perform well as bond yields fall and perform poorly as bond yields rise, led the equity market in 2014 as global bond yields declined. Exhibit 8: Relative Returns in a Rising Yield Environment Begin Date End Date Barclays Aggregate Index Return 3/1986 6/ / / /1988 3/ /1989 4/ /1991 3/ / / /1995 7/ /1998 1/ /2001 4/ /2003 6/ /2008 4/ /2010 2/ / / % All Dividend- Paying Stocks % Source: TBCAM, Bloomberg, Barclays, Ned Davis Research. Periods based on 10-Yr Yield increases of 100 BPS or greater Fortunately, dividend opportunities come in several flavors, and strategies can adopt approaches that emphasize cyclical yield instead of defensive yield, such as that exhibited by the bond proxies. We believe high-yielding dividend portfolios can be constructed to produce returns that are competitive with the broad market by incorporating valuation criteria and dividend growth in the investment process. These portfolios offer the advantage of a competitive yield relative to bond alternatives, with the protection of equities if yields or inflation rise. Conclusion Source: Ned Davis Research. January 1979 January 2015 Navigating the Risks of Rising Yields Equities may be impacted by the process of normalizing interest rates, which arguably supported both bond and equity valuations. Generally, equities have outperformed bonds during periods of rising interest rates. If bond yields rise over the next few years, equities will likely provide meaningful diversification benefits to portfolios. The recent period of unprecedented low interest rates, combined with bouts of risk aversion caused by global growth concerns or geopolitical worries, resulted in relatively high valuations of some dividend investments, such as utilities and real estate investment trusts. These bond As insurance companies continue to search for strategies to improve investment yield and return, we believe it is critical to partner with an investment manager that can help design and implement custom solutions to meet these investment needs. In our view, the manager should have experience and expertise in managing core bond strategies that address the liability, regulatory and tax needs of insurers while also offering counsel and capabilities that extend beyond fixed income. While core bonds will likely continue to be a large and essential component of insurers asset allocations, diversifying into strategies beyond core fixed income can enhance income and return potential. We believe equity income strategies are an attractive complement to core fixed income and should be considered in an insurance company s strategic asset allocation

5 End Notes 1. Wolfe Research Disclosure Any statements of opinion constitute only current opinions of The Boston Company Asset Management, LLC (TBCAM) and Standish Mellon Asset Management Company LLC (Standish), which are subject to change and which TBCAM and Standish do not undertake to update. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. This publication or any portion thereof may not be copied or distributed without prior written approval from TBCAM and Standish. Statements are correct as of the date of the material only. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorised. The information in this publication is for general information only and is not intended to provide specific investment advice or recommendations for any purchase or sale of any specific security. Some information contained herein has been obtained from third party sources that are believed to be reliable, but the information has not been independently verified by TBCAM and Standish. TBCAM and Standish make no representations as to the accuracy or the completeness of such information. Listed securities are being presented for illustrative purposes only. This is not a recommendation to buy, sell, or hold these securities. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. CFA and Chartered Financial Analyst are registered trademarks owned by CFA Institute. About Standish Standish is one of the largest fixed income firms dedicated to serving the needs of sophisticated institutional investors. Our investment process strives to capture relative value opportunities created by market inefficiencies. We use both proprietary research to seek new and changing sources of excess return and a mix of qualitative judgment and quantitative tools to formulate and implement our investment views. Our strategies reflect expertise in specific market sectors and also span the global fixed income markets. We can design innovative solutions to satisfy the most pressing needs of investors in today s difficult market environment. About The Boston Company The Boston Company Asset Management, LLC, is a performance-driven active equity manager. We build portfolios that are rooted in fundamental research, bottom-up stock selection, macro perspectives and risk controls appropriate for our client base. We are dedicated to fostering long-term, solutions-based relationships with our clients and earning their confidence through the consistent delivery of alpha across a wide range of equity offerings. All of our strategies, including traditional long-only and alternatives, are implemented with consistency and discipline, leveraging more than 40 years of history in equity investing. Our investment performance is based on a time-tested approach, coupled with the deep, broad-based experience of our investment professionals

6 About the Authors W. Charles Cook, CFA Director, Portfolio Strategist - The Boston Company Asset Management, LLC Chuck is a Portfolio Strategist for The Boston Company, primarily focused on communicating the firm s strategies from an investment perspective to the BNY Mellon Wealth Management group. Before joining The Boston Company, Chuck spent 21 years at Standish Mellon Asset Management, where he served both as Senior Global Strategist and Director, Global/International Fixed Income. Previously at the firm, he held positions of increasing responsibility while gaining experience in global fixed income portfolio management, derivative strategies and currencies. Prior to that, he worked at State Street Bank & Trust Co. as a portfolio accountant. Chuck earned a B.S. in Business from Lehigh University and an M.B.A. with a concentration in Finance from Northeastern University. He holds the CFA designation. James Kaniclides, CFA Senior Portfolio Manager, Fixed Income Strategist - Standish Jim is a Senior Portfolio Manager and Fixed Income Strategist responsible for managing high grade multi-sector fixed income portfolios for insurance clients. Jim is also a Co Chairman of the Crossover Investment Committee that seeks to optimize returns for tax sensitive clients. He joined the company in 1998 from Citizens Bank, where he conducted quantitative research in the Treasury Group and managed the Bank s liquidity positions. Prior to that Jim was a Bank Examiner at the Federal Reserve Bank of Boston, where he specialized in reviewing asset/ liability management and capital markets activities of banks and bank holding companies. Jim has an M.B.A. from Northeastern University, a B.A. from Ohio University, holds the CFA designation and has 21 years of investment experience. For more market perspectives and insights from our teams, please visit