(February 24, 2014) — The challenges facing fixed income assets have been well-documented over the past two years, but how does it affect you when 85% of your $200 billion portfolio is invested in them?
aiCIO caught up with Zurich’s head of alternative investments Urban Angehern to find out.
aiCIO: What view do you take on current government bond allocations? Should investors retain some exposure at a strategic level?
Urban Angehrn: With any asset allocation you always need to know the minimum risk investment you could make whilst covering your liabilities.
Government bonds have an important role, and will continue to do so; they are basically the anchor in our asset allocation. If we took no investment risk relative to our liabilities, then we would have a portfolio of top quality government bonds with the right duration for our liabilities. That’s not how we allocate but it’s certainly the starting point of an investment approach relative to liabilities.
Government bonds are a very large asset class. We’re very heavily invested in fixed income, about 85% of our total assets, and within the fixed income universe it is a very important sector. You wouldn’t choose to exclude government bonds because it is one of the largest sectors in fixed income and is the lowest credit risk choice available in most markets.
The other important point for us is that at least some of our portfolio has to be liquid and within the fixed income spectrum. Government bonds continue to be the most liquid part of the bond market.
Our total holdings of government and government related bonds in group investments are approximately 37%. I don’t foresee this changing very significantly.
aiCIO: I spoke with Zurich a couple of months ago on its decision to consider impact investing more and more, with one of the decisions being to move a billion dollars away from government bonds into green bonds.
Angehrn: That’s interesting in the sense that these green bonds are not issued by national governments but by supranational organisations. From a default risk point of view these supranational organisations have the support of multiple governments and are in that regard comparable to government bonds. Although to some degree they are a substitute for government bonds it’s fair to say that they are much less liquid. Zurich has set out to contribute to the development of the green bond market as part of our responsible investment strategy.
We have an allocation between 30% and 40% of our portfolio in government and government related bonds and that moving a billion is half a percentage point. It’s a very significant amount of course for the green bond market, but it’s not a significant asset allocation change for Zurich.
aiCIO: What else do you consider to be the best practice alternative to government bonds if you’re looking to keep that fixed income exposure?
Angehrn: If you replace a material allocation to government bonds with corporate credit, real estate, or with equities you are in essence comparing a lower risk and a higher risk asset allocation; that’s not how we work. We always consider that a certain amount of capital has been allocated to investment risk taking. We then need to find the best way to allocate that capital with a diversified investment strategy. It’s more about substituting risky asset classes—corporate credit, real estate, equities, hedge funds—within that universe.
If we run a wholesale replacement of government bonds then we are in effect significantly re-risking the investment portfolio. This isn’t an ordinary course for us because the capital is allocated and so we think about a fixed quantity. That’s how much risk Zurich wants to take investing against liabilities; the issue is more about alternative possible allocations within the risky spectrums, the non-government spectrum.
I am aware the Eurozone crisis has created a lot of debate about the risk embedded in government bonds. Government bonds are not completely risk free but they still constitute a minimum risk investment to cover liabilities.
As we evolve the investment strategy the question for us is more within the non-government space. What changes will support an optimal asset allocation.
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aiCIO: Has anything in that non-government space caught your eye over the last few months?
Angehrn: There is some room to make the asset allocation less liquid by having a greater portion of illiquid investments and a smaller portion of liquid investments.
I’ve talked about the liquidity advantages of government bonds before; large cap equities are also very liquid, cash is of course liquid by definition. We have all these investments but feel there might be further room for us to have slightly less liquid allocations and earn a premium for taking that illiquidity risk. I suspect it’s widespread in our peer group of insurance investors. We are looking to increase our real estate allocation and are exploring non-bond fixed income investments, which would be private debt as opposed to publicly traded debt.
We are not talking about wholesale changes in the strategy but rather gradual movements into somewhat less liquid investments.
aiCIO: Are there any specific considerations or risks that insurers must take into account before switching allocations within the fixed income space?
Angehrn: Top of the list is regulation. Differences of regulation drive important differences in strategy. In the development of the investment strategy, the first consideration will always be an economic one: how do we best invest for the risk capital that we have? Then we explore the possibilities of economically optimal allocations and look at the ones that work from a regulatory point of view.
The good news is that regulation has been evolving in recent years to become more economically based. Modern solvency tests consider assets versus liabilities and look at the actual risk of asset classes. These are welcome developments because it means regulation is more aligned with our thinking.
aiCIO: In response to Solvency II there are growing demands that governments should increase the number of long-term bonds to assist insurers in matching their liabilities, would you agree?
Angehrn: Solvency II certainly supports life insurance investors to invest in long-dated government bonds. But maybe we’re giving Solvency II slightly too much credit. The issuance by governments of very long dated bonds is an older phenomenon. The Swiss government issued 50-year bonds maturing in 2049 in 1999 already and at that point nobody was talking about the Swiss Solvency Test or Solvency II. This was two financial crises ago.
The French government issued their 2055 bond in 2005 as a 50-year bond. Again at that point we didn’t have Solvency II but the debt management offices have listened to investors. Investors like us made the point that we should manage against liabilities a long time ago, prior to regulation moving in that direction.
The impact of Solvency II is a reinforcement of this need for insurance investors, with their capital requirements and capital frameworks, to hold long dated government bonds. I can’t speak for the UK Treasury, but looking for instance at recent issuance, they have issued a 55-year bond for 2068 last year for about £10 billion, which demonstrates that we have ongoing issuance at the very long end of the yield curve. As life insurers we need that.
Somehow we have to talk about our demand and let issuers know via asset managers or the underwriting banks or maybe directly, so that the supply side of the market knows what the demand side needs.
aiCIO: Are you looking at collateralised loan obligations (CLO) as an option?
Angehrn: We have some investments in collateralised loan obligations, the higher rated tranches. We have been exploring various routes for increased private debt and equally, how some more of our debt can be less liquid but earning more return. However, we are not busily buying CLOs. They are useful from the point of view of the credits within the CLO structure. The underlying loans that sit in the CLO are often names that don’t trade in the bond market and so can provide good issuer diversification.
If one is looking for even more diversification by issuer, then CLOs or private debt are certainly routes you could take.
This interview was first published by ClearPath Analysis. For the full version, plus the wider report on Insurance Asset Management, click here.