Investing in an environment of high and unpredictable inflation presents challenges for investors in all asset classes, and insurers are no exception. Equities and real estate are two traditional areas that offer some inflation protection. But in the current environment, the mainstay of insurance investing – fixed income – may offer the potential for higher returns. Bonds can offer attractive levels of risk- and inflation-adjusted yields in some sub-sectors and they can offer some protection against the risk of higher-than-expected inflation.
We see some interesting opportunities in private credit, such as fund financing, private placements, commercial real estate loans, and infrastructure debt. Each offers different opportunities in an inflationary environment, while also offering meaningful diversification to a portfolio.
In an environment of high and unpredictable inflation, unstable interest rates and an uncertain macroeconomic outlook, there has been increasing interest in fund financing. This sub-sector offers short-term loans to private market investment funds to support operating activities. For those parts of the balance sheet where an insurer doesn’t require fixed-asset cashflows, the variable interest rate available on fund-financing assets can offer some protection against the risk of inflation and interest rates in the future. Additionally, the very low correlation between the performance of fund financing and other markets, and the very low historical losses, makes fund financing an ideal asset class to consider in periods of macroeconomic uncertainty.
Commercial real estate loans
Commercial real estate loans (CREL) are secured against commercial real estate assets and have long been favoured by insurance investors. CREL was the most affected area of private credit in the fourth quarter of 2022, partly because of a rapid correction in real estate values and increasing yields on investment-grade credit assets. That led to certain insurers turning their attention to public credit rather than private credit assets. For example, when yields were hovering around 4.75-5.5% on BBB five-year public credit, the merits of tying up governance and investment committee resource for CREL assets – yielding, on average, 6-8% for an equivalent five-year loan – had been more difficult to justify. But this started to change as we moved into 2023, as public spreads began to compress (largely due to supply and demand dynamics).
CREL is starting to look particularly attractive again on a risk-adjusted return basis, given the sharp correction in real estate equity values in late-2022. This means that higher spreads can be achieved at lower leverage levels on deals. While not historically the norm, we have seen more interest for inflation-linked CREL, which offers more direct protection against uncertain future inflation.
Private placements are bonds issued to a specific group of investors in a non-public offering and are frequently held by insurance investors as a complement to their public credit assets. Supply is an ever-increasing challenge, especially in sterling public markets. Issuance tends to be taken-up rapidly by a small number of large players and sector diversification is limited. This supply shortage has led to more interest in private placement bonds, to supplement holdings in public credit over 2022. This trend is likely to continue in 2023, because of significant demand from bulk purchase annuity (BPA) insurers. We also see insurers expressing interest in broadening private placement exposure to US and European credit. For insurers looking for direct protection from the risk of higher-than-expected future inflation, a small but significant proportion of private placements are structured with links to inflation.
Infrastructure assets – such as transport and energy – have been popular for many years, and we believe 2023 will be no different. This asset class is attractive because it allows insurers to tick three important boxes: capital efficiency; matching adjustment eligibility; and strong environmental, social and governance credentials.
Two key outcomes of the Solvency II review might make this asset class even more desirable in the future. The first is the removal of the ‘cliff edge’ of capital efficiency for assets that are below investment grade. This could allow insurers to invest further up the risk curve more easily, such as in early stage projects that have some construction risk. The second is the small but potentially mighty wording change to cashflow characteristics from ‘fixed’ to ‘highly predictable’, which should allow further flexibility around financing structures, such as prepayments. Furthermore, infrastructure assets are often structured with links to inflation, which provides some direct protection from rising inflation.
Was 2022 the year of the black swan for rates and inflation? Or will the 2020s be the decade for them? Only time will tell. But whatever paths rates and inflation take, private credit will present attractive opportunities for navigating that path.