High Yield Credit: An Evaluation for Prospective Insurance Company Investors

High Yield Credit: An Evaluation for Prospective Insurance Company Investors Low interest rates challenging traditional insurance company business model More insurance companies using high yield to mitigate book yield decline Higher quality credits less prone to price volatility and write-downs Credit fundamentals supportive of current valuations Bank loans offer attractive relative value versus high yield bonds According to the Federal Reserve, U.S. insurance companies hold approximately $6.5 trillion of financial assets, a significant majority invested in traditional fixed income assets and mortgage loans. 1 As the thirty year bond bull market continues with 10-year U.S. Treasury notes yielding a paltry 1.75% (as of 6/30/12) and investment grade corporate bond spreads compressing versus Treasuries, insurers are seeing a slow but steady erosion of book yield from their investment portfolios. Moreover, benign inflation forecasts and an accommodative Fed point to a likely extended period of low rates further stressing portfolio yields. Much like the recent soft market in the property & casualty industry, insurers today are accepting lower rates (this time, return on invested assets) for the same set of risks previously assumed. As a result, the thoughtful evaluation of duration, liquidity, and credit risk by insurance companies and their investment managers is of increasing importance in today s climate. In this article we will focus our attention on credit risk, specifically evaluating the complementary role that an allocation to high yield corporate bonds adds to an insurance company s core investment grade fixed income portfolio. An analysis of statutory financial transaction data indicates the severity of the yield decline in new money rates experienced by the industry (Exhibits 1 and 2). A sample of mid-sized property & casualty carriers purchased corporate bonds during the first half of 2012 at an average yield of 3.1%, a decline from nearly 5.75% during 2009. Similarly, corporate bond purchases made by a sample group of life insurance companies averaged 4.9% during the first half of 2012, a decline from 6.1% during 2009. Credit spreads have continued to narrow throughout the third quarter, pushing purchase yields to even lower levels. 1 Federal Reserve Flow of Funds Accounts of the United States: Flows and Outstandings, Second Quarter 2012, September 20, 2012, page 31. NOVEMBER 2012

Exhibit 1: Investment Grade Corporate Bond Yields Currently Below 3.0% Will Continue To Pressure Industry Book Yields 8.0 7.5 7.0 P&C Company Avg. Bond Yield Life Company Avg. Bond Yield Barclays Corporate Bond Yield 6.5 6.0 Yield (%) 5.5 5.0 4.5 4.0 3.5 3.0 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: SNL Financial, Inc., Barclays Capital Exhibit 2: New Money Yields Have Fallen Consistently, the Result of Declining Treasury Yields and Narrowing Risk Premiums Source: SNL Financial, Inc. Note: Based on purchase data from 15 randomly chosen Life and P&C insurers with assets between $100 million and $2 billion. Includes only corporate bond purchases with bullet maturities. NOVEMBER 2012 2

Despite a challenging trend, insurance companies willing and able to expand their opportunity set to include high yield corporate bonds and bank loans can mitigate a portion of the impact of low prevailing interest rates (Exhibit 3). While spreads and yields have compressed, below investment grade rated assets remain even at current levels one of the few sources of yield without sacrificing liquidity, with the U.S. broad market yielding approximately 6.5%. Exhibit 3: High Yield Credit Remains a Compelling Income Proposition Relative to High Grade Alternatives Source: BoA ML indices. All figures are yield to worst. As of September 30, 2012. In a portfolio setting, historical returns and correlations suggest that non-investment grade bonds offer diversification benefits and can increase expected return while modestly reducing portfolio volatility (Exhibit 4). Looking back to 1992, an investment grade portfolio (as measured by the Barclays Capital Aggregate Bond Index) has returned an average of 6.4% annually with approximately 3.7% annualized volatility. That high grade portfolio, when blended with 10% BB/B exposure averaged annual returns of 6.6% with slightly lower volatility. For the same level of volatility as the Aggregate Index portfolio, a 20% allocation to the BB/B portfolio would have returned 6.8% annually over the 20 year time period evaluated. NOVEMBER 2012 3

Exhibit 4: Historical Returns (12/31/1992 to 9/30/2012) Suggest an Incremental Allocation to High Yield Improves the Return Profile with a Modest Reduction in Volatility 8.5% 8.0% 8.01% Average Annualized Return 7.5% 7.0% 6.5% 6.41% 6.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% Annualized Standard Deviation of Returns Source: Barclays index series data. Incrementally adds high yield to high grade (Barclays Capital BB-B Index, 2% Issuer Cap and Barclays Capital Aggregate bond index). Insurance Company Exposure and Risk/Regulatory Considerations Filing data provides evidence that insurers are attracted to the high yield market by the yield benefits and return potential as described above. Not surprisingly, investment activity differs based on industry and insurance company size. Larger property & casualty companies are more likely to have a measureable allocation to below investment grade rated securities, and those companies are more heavily invested in the sector than their smaller peers (Exhibit 5). What is consistent among P&C companies regardless of size is the increasing frequency and weighting to non-investment grade bonds since 2008. Interestingly across all mid-sized P&C companies, while roughly 20% reported a measureable allocation to high yield, nearly 80% of these same companies had an allocation to non-affiliated common stocks (with an average of approximately 10.5% of invested assets in equities). We believe that P&C insurers should take a balanced approach to risk assets and consider the role of both equities and high yield in an investment portfolio context. NOVEMBER 2012 4

Exhibit 5: Property & Casualty Company Invested Asset History (2003 2011) Invested Assets: $100 - $500 million % of Companies with High Yield Avg. High Yield Exposure (% of bonds) % of Companies with Equity Avg. Equity Exposure (% of Invested Assets) 2003 11.61% 5.45% 73.45% 12.61% 2004 8.37% 4.78% 73.57% 12.91% 2005 13.97% 4.75% 73.91% 13.20% 2006 9.48% 4.78% 69.36% 14.46% 2007 10.21% 4.82% 70.17% 13.55% 2008 9.79% 4.44% 72.27% 10.11% 2009 12.24% 4.86% 71.55% 11.32% 2010 15.90% 5.07% 73.64% 11.80% 2011 14.88% 5.50% 75.21% 11.72% Source: SNL Financial, Inc. Measureable sub-investment grade exposure defined as > 2% of fixed income investments. A greater reliance on yield and more favorable accounting treatment likely explain a more frequent use of high yield among life insurance companies roughly 50% of life companies with assets of $100 million - $2 billion have a measureable allocation to non-investment grade bonds with an average weighting of approximately 6% of bond investments (Exhibit 6). Filing data suggests that life companies, like their P&C peers, have modestly increased exposure to the sector relative to precrisis levels. Moreover, those yield and regulatory considerations are a cause for life insurance companies limited investment in common stocks. Exhibit 6: Life Insurance Company Invested Asset History (2003 2011) Invested Assets: $100 - $500 million Invested Assets: $500 million - $2 billion % of Companies with High Yield Avg. High Yield Exposure (% of bonds) % of Companies with High Yield Avg. High Yield Exposure (% of bonds) 2003 42.37% 5.84% 56.14% 5.83% 2004 20.00% 8.19% 38.60% 5.27% 2005 33.33% 7.93% 45.61% 4.50% 2006 33.33% 7.75% 38.60% 4.84% 2007 31.67% 7.23% 38.60% 4.83% 2008 36.67% 6.77% 49.12% 5.30% 2009 56.67% 6.62% 54.39% 6.33% 2010 53.33% 7.18% 56.14% 5.38% 2011 53.33% 6.26% 50.88% 5.52% Source: SNL Financial, Inc. Measureable sub-investment grade exposure defined as > 2% of fixed income investments. Life insurance companies carry debt investments at amortized cost, except for those considered to be at or near default (NAIC 6 rated investments). Absent credit events, a life insurance investor will realize the income statement benefit of high yield with virtually no statutory balance sheet NOVEMBER 2012 5

volatility. However, where accounting treatment accommodates high yield credit, regulatory risk based capital requirements and rating agency treatment (Best s Capital Adequacy Requirement) are more punitive and quality biased and should be contemplated. Moreover, balance sheet leverage is typically elevated in the life insurance industry placing a greater importance on asset quality and loss avoidance. Statutory accounting treatment for property & casualty companies is more stringent with all speculative grade rated debt investments (NAIC 3 or below) carried at lower of cost or market value much like equity investments. Whereas life insurance companies reap the benefits of higher investment income with limited balance sheet risk, property & casualty companies will realize price volatility through surplus, rewarding those investors that can control downside risk. These factors suggest a risk budgeting approach to high yield credit viewing the appropriate allocation in the construct of surplus at risk, similar to the approach taken with equity investments. The NAIC has not written authoritative guidance on the treatment of bank loans for statutory accounting purposes. Should an insurance company categorize these investments as bonds under SSAP 26, similar rating related implications as described above are pertinent. Alternatively, if an insurance investor treats bank loans as Schedule BA other invested assets, capital requirements are increased and mark-to-market risk emerges for life companies (Exhibit 7). We are aware of insurance companies using both interpretations of guidance for the asset class. To alleviate the capital pressure, loan-level price volatility, and accounting burden, we have seen a trend towards utilization vehicles which are rated by the NAIC and thus subject to reduced RBC for life insurance investors. A Moody s analysis of historical default experience since 1920 shows a peak one-year default rate for speculative grade rated companies of 15.6% in 1933 with the recent 2009 default rate of 13.1% a close second. However experience by issuer quality varied greatly during both periods. Over the measurement period, BB rated issuers defaulted at an average 1.07% rate, B rated issuers at a 3.4% rate, while those CCC or below averaged a 13.8% default rate. Looking ahead, while base case speculative grade default rates are expected to be below average at around 3%, stress case default estimates are upwards of 8%. 2 We believe that historical and projected default costs coupled with heavier capital requirements for NAIC 5 and 6 rated investments support an upper-tier high yield bias for insurance company investors. 2 Moody's Global Credit Research: "Annual Default Study: Corporate Default and Recovery Rates, 1920-2011," Feb 29, 2012, http://www.alacrastore.com/research/moodys-global-credit-research- Annual_Default_Study_Corporate_Default_and_Recovery_Rates_1920_2011-PBC_140015 NOVEMBER 2012 6

Exhibit 7: Regulatory and Rating Agency Capital Requirements by Investment Type Unaffiliated Asset Type P&C RBC P&C BCAR Life RBC Life BCAR #1 Highest Quality 0.30% 1.00% 0.40% 0.80% #2 High Quality 1.00% 2.00% 1.30% 2.50% #3 Medium Quality 2.00% 4.00% 4.60% 6.00% #4 Low Quality 4.50% 4.50% 10.00% 12.00% #5 Lower Quality 10.00% 10.00% 23.00% 25.00% #6 In or near Default 30.00% 30.00% 30.00% 37.50% Common Stocks 15.00% 15.00% >22.5% 30.00% Other Invested Assets 20.00% 20.00% 30.0% or Rating Source: NAIC and A.M. Best >36.0% AAM s Partnership with Muzinich & Co. In our over thirty years of providing investment management expertise to the insurance industry, we understand that insurance companies seek a high level of risk-adjusted income with a constant focus on the avoidance of realized credit losses. These objectives, coupled with the insurance regulatory framework, led us to partner with Muzinich & Company to offer quality high yield bond portfolios and bank loans to the insurance industry. With assets under management in excess of $17 billion and a deep team of supporting credit analysts, Muzinich s approach to managing high yield credit is well suited to meet the needs of the insurance industry: BB/B focused portfolios Low historical annualized default rate a fraction of the high yield market default rate Rigorous fundamental credit evaluation Ability to tactically rotate between the bond and loan market Outlook includes consideration of high yield indicators The High Yield Market Outlook Credit fundamentals within the high yield market are stable today and significantly improved from pre-crisis levels as companies have been diligently focused on strengthening balance sheets. This means aggressively reducing debt, pushing out maturities and increasing cash balances (Exhibit 8). Net leverage has declined to below trend levels, interest coverage ratios have increased to above historical averages and the majority of new issuance has been utilized for refinancing. The resulting backdrop creates a marketplace with limited refinancing needs prior to 2020. NOVEMBER 2012 7

Exhibit 8: The Debt Maturity Wall Has Been Pushed Out by Recently Heavy Issuance Source: JP Morgan, Market. As of June 2012 We are generally comfortable with credit risk, particularly with the BB/B names within our client portfolios. However, the last five years have most certainly been dominated by increased tail risk as demonstrated in Exhibit 9. The red line highlights returns since 2007 while the blue line highlights returns from 1991 to 2007. The tails have clearly become fatter in the last 5 years. Exhibit 9: High Yield Returns Have Exhibited More Volatility Compared to Pre-Crisis Monthly Return Distribution for US HY Cash Pay 1991 to 2007 vs. US HY Cash Pay Last Five Years (through July 31, 2012) US HY Cash Pay 1991 to 2007 US HY Cash Pay since 2007 Fatter Tail 20% 15% 10% 5% 0% 5% 10% 15% 20% Monthly Returns Source: BofA ML US High Yield Cash Pay Index (J0A0) NOVEMBER 2012 8

While tail risk certainly persists, pull-backs in the high yield market have been markedly shallower and shorter since 2009 with no two consecutive negative months (one exception being August and September 2011). We would attribute these more modest pull-backs to improving credit trends, low default rates, and investors understanding that company fundamentals remain sound. As such, we have found that pull-backs have represented attractive buying opportunities for investors. For investors considering an allocation to high yield credit, we cannot stress enough the importance of coupon income (book yield). Returns for high yield bonds are generated by two components: income generation and capital appreciation. High yield bonds generate a steady stream of income based on a contractual obligation to pay the stated coupon, assuming no defaults. Over time, most returns in the high yield space are driven by the income generation component. Only a restructuring event or declaration of bankruptcy will terminate this obligation to pay the stated coupon and return of principal at maturity. From a coupon perspective, matters have not changed significantly over the last few years as the average coupon for the broad U.S. high yield market has ranged from 8.4% to 8.0% since the beginning of 2008 (Exhibit 10). Exhibit 10: High Yield Coupons Will Continue to Offer Compelling Carry for Investors BofA ML US High Yield Cash Pay (J0A0) Par Weighted Coupon and YTW 2008 to August 31, 2012 Coupons (%) 8.40 8.30 8.20 8.10 8.00 7.90 Coupon YTW 25 20 15 10 5 7.80 0 12/1/2007 3/1/2008 6/1/2008 9/1/2008 12/1/2008 3/1/2009 6/1/2009 9/1/2009 12/1/2009 3/1/2010 6/1/2010 9/1/2010 12/1/2010 3/1/2011 6/1/2011 9/1/2011 12/1/2011 3/1/2012 6/1/2012 Yield to Worst (%) Source: BofA ML US High Yield Cash Pay Index (J0A0) Nevertheless, in the search for yield, high yield managers may be tempted to reach down in quality to CCC and distressed credits. We believe this is a risky strategy given the recent run in the market. Markets, while buoyant these last three months, remain highly sensitive to macro news, particularly events out of Europe. Tail risk remains high given the variety of negative currents that need to be navigated in a short period of time. A pull-back in the market could cause poorer quality credits, NOVEMBER 2012 9

particularly those with refinancing needs, to suffer sharp declines. We believe it is important to invest in companies that can withstand economic hardship and respect their commitments to pay us our coupon and pay us back at maturity. For tactically driven investors, we believe our bank loan strategy offers modestly better risk / return characteristics at current valuations. In summary, yields are lower now but spreads are still above their historic median. As we say often, we do not know if or when markets will correct it is very difficult to time markets. If markets do pull-back, we do not expect it to be significant given the strong underlying company fundamentals. When we compare the current environment to the previous 20 years, we are comfortable with our portfolios and believe our focus on risk management will continue to reward long-term investors. Written by: Timothy J. Senechalle, CFA Principal Vice President, Senior Portfolio Manager For more information, contact: Colin T. Dowdall, CFA, Director of Marketing and Business Development colin.dowdall@aamcompany.com 30 North LaSalle Street Suite 3500 Chicago, IL 60602 312.263.2900 www.aamcompany.com Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as AAM ), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. NOVEMBER 2012 10