Thinking outside the box: Using insurance-linked securities (ILS) to complement fixed income

Zeba Ahmad

Zeba Ahmad

CFA, Alternatives Director

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Beat Holliger

Beat Holliger

Head of Product Management, ILS

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Executive summary

  • Fixed income investors have been boxed in for several years, forced to accept increasingly lower yields
  • That box has gotten smaller as the portion of the global bond market trading with negative yields grows
  • Falling yields have affected fixed income portfolios of all types, from traditional Barclays Aggregate strategies to income-oriented portfolios
  • By thinking outside the box and incorporating insurance-linked securities (“ILS”) in fixed income portfolios, we believe investors could potentially see higher returns and lower risk

Boxed in: The problem with fixed income today

Over the last several years, fixed income investors have been forced to accept increasingly lower yields. The opportunity set has recently gotten even smaller. $17 trillion, or over 15% of the global bond market, now trades with negative yields. The trend is most noticeable in the global sovereign bond market, where almost 35% of all debt trades with negative yields.

Thinking_outside_the_box_Using_insurance-linked_securities_(ILS)_to_complement_fixed_income.jpgMuch of Europe has been leading this trend. Driven by a slowing global economy and an active central bank, US rates are still positive, but at or near all-time lows. As shown in Figure 1, as the stock of negative-yielding debt has increased over the course of 2019, yields on risk assets such as high yield bonds have also fallen.

As global growth slows, allocators face a tough choice. Do they chase declining yields in lower-quality corporate debt? Or do they think outside the toolbox of traditional fixed income assets? We believe a look at the corporate debt market since 2008 can serve as a guide.

Outstanding global investment grade corporate bonds have ballooned from less than $5 trillion in 2008 to over $11.5 trillion today. At the same time, the composition of the corporate debt market has changed. BBB-rated bonds, the lowest-rated portion of the investment grade universe, now make up half of the Barclays Corporate Index, from 24% in 2008. Yields have fallen from over 7.2% in 2008 to under 2.2% today. Interest rate risk, or duration, has also risen. The duration of the US Barclays Aggregate increased from 3.7 years to 5.8 years over the same timeframe.

Should the economy rebound, the lower income provided by traditional fixed income may be erased by rising rates. Conversely, if slowing global growth results in a recession, the declining credit characteristics of traditional fixed income portfolios could result in defaults, causing unexpected volatility and losses. As a result, we believe that investors can benefit from considering non-traditional fixed income options...

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