Credit downgrades caused by Covid-19 could spur a wave of high-risk corporate bond sales by Asian insurers who need to maintain solvency ratios and avoid capital charges.
Insurers are likely to be reluctant to hold on to sub-investment grade debt, as capital charges calculated against the increased risk would offset the extra returns available, said Frank Yuen, a senior analyst in the financial institutions’ group at rating agency Moody’s in Hong Kong.
The average credit rating of Asian insurers’ bond holdings was between high Baa and A, and they would be keen to maintain this, he told AsianInvestor. “So if large portions got downgraded to high yield, insurers would follow a proactive asset allocation [to rebalance portfolios].”
Thanks in part to the falling credit quality of investment-grade bond portfolios, European insurers have seen solvency ratios fall by about 25% in the first quarter of 2020, according to a June report from JP Morgan. Based on observations from the financial crisis, the report predicted that solvency ratios were likely to fall between 10% and 20% further. The bank declined to provide figures for Asia.
“As the crisis unfolds, downgrades and defaults in the corporate bond portfolio may lead to further increases in market risk, putting additional strain on the insurers’ solvency ratios,” the report said.
Capital requirements for bonds downgraded from investment grade to junk increase from 2.2% to 3.9% in Hong Kong and 2.4% to 3.8% in Singapore, assuming underlying bonds with a maturity between five and 10 years, said Sam Manchanda, the head of Asia Pacific insurance coverage and institutional sales for Southeast Asia at DWS Investments.
Jethro Goodchild, Hong Kong chief investment officer (CIO) at insurer FWD, said during a June 4 webinar hosted by AsianInvestor and HSBC Global Asset Management that his firm’s relatively low allocation to US credit had limited the number of so-called fallen angels it was exposed to. But he added that some of the bonds it owned had seen ratings fall from investment grade to junk status, and in some cases the Hong Kong-based insurer had sold them to avoid the higher capital charges the rating drop entailed.
According to a report by Moody’s in May, about 75 issuers with roughly $1.1 trillion of rated debt have Baa3 ratings, the lowest investment-grade bond category before high yield. Many of these are currently either under review for downgrades or to have a negative outlook.
In the first quarter, a little over $150 billion worth of bonds fell from investment grade to high yield, roughly half of it outside the US, according to the report.
Yuen estimates that bonds rated BAA3, currently account for slightly less than 5% of total investments by the Asian insurance companies that he rates. He said the majority of these allocations were government bonds in emerging markets, which insurers needed to hold for currency matching in countries where insurers have obligations.
According to Moody’s, 85% of the value of global fallen angels sit in the oil & gas, automotive and retail sectors.
Sectors hit hardest by Covid-19 include travel, tourism and hotels. However, some insurers may have failed to identify the weaker credits in these areas before the start of the Covid-19 outbreak and may still need to cut these from their portfolios, said Bryan Wallace, London-based senior fixed income portfolio manager at JP Morgan Asset Management.
In general, though, he said insurers divested much of their lower-quality credit holdings last year to reduce risk.
Many insurers have become more conservative in their bond allocations in recent years, making them less likely to retain downgraded bonds arising as a result of Covid-19 than they would have been previously, said Singapore-based Manchanda.
However, Kunal Chavda, director of public markets at investment consultancy Bfinance, said none of the company’s insurance clients in Asia had experienced increased capital charges as a result of holding fallen angels.
“In the subset that we have spoken to, we haven’t come across this. Some of them had portfolios that have sold out of risky exposure already, and some have sold since,” she said. The poor liquidity in the market during late March would have seen losses taken, but market liquidity has improved considerably since then, she added.
FWD’s Goodchild said in the AI webinar that a credit downgrade was not a cause for an automatic sale.
Similarly, Manchanda said downgrades would lead to negotiation between managers and insurers rather than automatic sales.
“Mandates have room for customisation; their investment guidelines are an ongoing collaborative discussion. If there are downgrades, it’s possible to discuss a short-term waiver [on requirements to sell] until there is some clarity in the market,” he said.
Please click here to listen to the webinar, "A new investment era: will Asian and Hong Kong bonds win the race for resilience?", co-hosted by AsianInvestor and HSBC Global Asset Management, which took place on June 5.