The Benefits of UK Insurers Investing in USD-denominated Corporate Bonds
UK insurers may be tempted to invest in sterling corporate bonds in order to capture some extra yield over gilts. Alan Cubbon suggests they should not overlook the far more diverse dollar market: if currency exposure is hedged out then the capital requirements of investing in either market, under Solvency II, are exactly the same.
The benefit of investing in fixed income markets for UK insurers is that bonds provide a known schedule of cashflows that can be used to service their liabilities. The gilt market is particularly attractive in that the cashflows come with a low level of credit risk and can be as long as fifty years or more. Unfortunately gilt yields are now at all-time lows, and have recently turned negative on shorter maturity bonds. This makes it hard to generate income sufficient to cover the size of an insurers’ liabilities. In an effort to obtain higher yields several insurers are buying GBP-denominated corporate bonds. However, this course of action suffers from two principal drawbacks. The first is that investing in such bonds, especially those with low credit ratings or long maturities, comes with a higher requirement for capital to be set aside, under Solvency II regulations. The second is that the sterling corporate bond market is not very extensive or diverse, being dominated by bonds issued by banks and other financials.
In contrast, the US dollar corporate bond market is much larger and more diverse and offers far more opportunities for capturing some extra yield, even when the currency risk is hedged out. It is important to note that when this is done the capital requirements of dollar bond investments are exactly the same as for sterling bonds.
As mentioned, these capital requirements increase quickly under Solvency II for longer-maturity and lower-rated bonds. The chart below shows the spread risk solvency capital requirements (SCR) for bonds of modified durations up to twenty-five years, by broad rating category.
Spread risk capital requirements for corporate bonds
Source: legislation.gov.uk
These onerous requirements firmly push insurers towards buying short-dated, high quality bonds, which further restricts the choices available within the sterling market. Focusing on the more attractive short-maturity ends of the markets, the tables below compare the 1-5 year GBP and USD investment grade corporate bond markets as depicted by the JP Morgan GBP Credit Index and JP Morgan US Liquid Bond Index (JULI) at the end of September. ABS have been excluded, as have bonds issued by sovereigns, agencies and other public bodies. Issuers may be from countries other than the UK and US. Dollar market values have been converted into sterling. Yields are market value-weighted and dollar yields have been converted to sterling equivalents by subtracting the cost of currency hedging, which I’ve taken as simply the difference in 12-month USD and GBP libor rates.
In order to explore the diversity of each market the bonds have been divided into categories according to both industry sector and broad credit rating as published within the indices. Where bonds exist in the same categories the average yields are often in the same ball-park, but the much broader opportunity set offered by the USD market is evident. More of the categories are populated, there are bonds from more issuers to choose from, and the overall USD market is about ten times larger than its GBP counterpart.
A comparison of the 1-5 year GBP and USD corporate bond markets
Source: JP Morgan. Actually the JP Morgan GBP Credit Index makes use of a greater number of industry sectors than the US dollar JULI: I mapped the GBP sectors to their JULI equivalents (any errors obviously mine). $/£ exchange rate from the Bank of England; libor rates from global-rates.com. Data as of 30th September 2020.
Often the average yields in the USD categories are lower than the corresponding GBP yields. However, the USD market offers far more opportunities to access yields higher than the average. The extent of these opportunities is illustrated in the tables below. These show the number of issuers of bonds – both GBP and USD – offering yields higher than the average yield available in the sterling category. Note that even for USD bonds the threshold for inclusion in the tables here is the average sterling yield in the respective category. The total market values of such bonds are shown and the average excess yields. That is, of all the bonds in the category offering a yield higher than the sterling average yield for that category, the excess yield is the difference between their market value-weighted average yield and the category’s sterling average. If there are no GBP bonds in a category then the average sterling yield is just taken as zero: the point is to emphasise the extra investment opportunities that exist in the USD market over the GBP market alone.
The picture restricted to bonds offering more than the average £ yields in each category
Source: JP Morgan
Of course, this isn’t an either/or choice for an investor. Ideally an investor would be allowed to choose from the union of GBP and USD bond universes to have access to the best of both markets. This affords a greater range of investment possibilities and makes it easier to build a more diverse and less volatile portfolio. For that matter why not also look at EUR-denominated bonds? Again: if the currency exposure is hedged out then the capital requirements under Solvency II are exactly the same as if investing in sterling bonds.
The views, opinions and positions expressed within this guest post are those of the author alone and do not represent those of Moorgate Benchmarks Limited. The accuracy, completeness and validity of any statements made within this article are not guaranteed. Moorgate Benchmarks and the author accept no liability for any errors, omissions or representations. The copyright of this content belongs to the author and any liability with regards to infringement of intellectual property rights remains with them.
Previous posts by Alan Cubbon:
Assessing risk in today’s US$ corporate bond market – updated