Investing in the Time of COVID-19–The Importance of High Quality and Stable Income

The first half of 2020 has been a rollercoaster ride so far, with 10-year U.S. Treasury yields that began the year around 2%, now yielding a paltry .65-.70%. Equity markets started on a positive note, only to take a nosedive when the entire global economy virtually shut down in March as a result of COVD-19. In the second quarter, they dramatically rallied back through mid-July. This wild ride has insurance companies struggling with multiple issues: the impact of COVID-19 itself; the historic downward slide in fixed income yields and its adverse effects on income; and the highly volatile equity markets that are stressing surplus. The challenges to achieve budgeted investment income targets are looming large and growing. This uncharted territory is forcing insurers and their investment managers to explore other sources to fill the expanding investment income void—this all while maintaining appropriate balance within their enterprise risk budgets.

Navigating tumultuous markets

During this confusing and critical time, it’s important for insurers to spend time reassessing their specific circumstances given the vastly different investment landscape. Depending on the specific situation, it could be appropriate for an insurer to maintain previous market positions with marginal changes to their operational risk outlooks or capital and surplus strength. In other situations, an insurer may prefer to batten down the hatches somewhat and focus on near-term liquidity accumulation until the uncertainties surrounding future liabilities, surplus pressures, and non-budgeted capital needs abate.

This challenging environment may require a two-fold approach: playing defense to mitigate risk, while seeking opportunities to generate income and growth.

For example, one approach for risk-appropriate yield in a traditional insurance company asset class is municipal bonds in state and local housing finance agency bonds (HFAs), a generally atypical structure. On the surface, these securities are issued as a municipal bond. However, when you lift the hood, the underlying structure is fundamentally similar to a mortgage-backed security with their monthly paydowns of principal and interest, and maturity characteristics. Possibilities for insurers looking to limit portfolio risk, duration or credit, include the HFA Planned Amortization Class (“PAC”) tranches that can provide a more stable duration profile, and issues collateralized by U.S. agency mortgage-backed security (MBS) issuers, ranging from FNMA, FHLMC, FHA, VA, and GNMA, which include enhanced U.S. Government guarantees.

It is also important to focus on those states and local issuers with historically strong credit fundamentals. With the current fiscal pressures COVID-19 is placing on the budgets of many municipal bond issuers, these structures provide multiple layers of cover and collateral in the event things go wrong. These diamonds in the rough finds are allowing investors comfortable with modestly increased risk to pick-up .40% to .60% over a traditional municipal bond, and 1.5% to almost 2.0% over a 10-year U.S. Treasury. An approach such as this in the HFA municipal bond space, with a focus on AAA and AA-rated issuers and given the inherent monthly paydown characteristics these structures, can reduce an insurer’s exposer to credit and interest rate risk.

Benefits of dividend-generating equities

Another strategy could be a focus on high-quality, dividend income equities, which help bridge the investment income gap created by the ultra-low yield environment. Through careful security selection, investors can find consistent dividend yield well above U.S. Treasuries that are currently yielding less than 1% out to 10 years. These types of equities can provide an alternative income stream that supplements the deficits in fixed income.

This approach is especially productive because when looking broadly at the stock market as a whole, it becomes clear that dividends have been a key component of long-term success for investors. Figure 1 reveals that with the S&P 500 Index the reinvestment of dividends accounts for more than 40% of the returns of that index from January 1995 through May 2020. Adding a dividend focused portfolio can create a material difference that contributes to an insurer’s growth of surplus.

Careful security selection can help insurers avoid dividend cuts in an era where they are all too common as companies rush to shore up capital in the face of COVID-19 rating downgrades. In fact, in the S&P 500, 40 companies have announced dividend suspensions1, and 18 companies cut their payouts.1

However, even in this environment, selected companies are increasing their dividends due to strong balance sheets and continued growth. A dividend income strategy may be suitable for some insurers that have the capacity in their risk budgets. Because current equity valuations are somewhat stretched, it can be a challenge to gain exposure at reasonable pricing levels. In this environment, it can make sense to use market weakness to find appropriate entry points for specific dividend-income equities.

Gaining additional yield in a challenging environment

Low yields will likely persist for some time as a result of this profound economic shock, even after the immediate ravages of COVID-19 abate, as the economy struggles to regain its footing with the historic ground lost in employment, earnings, and global growth. Insurers may have to look to nontraditional investments on the margin to fill income gaps if they wish to avoid negative real yields (yield – inflation) going forward. And, if surplus strength and risk tolerance allows, companies could find sources of income and surplus growth in a higher allocation to equities. Whether fixed income or equity, high-quality investments are important in this time of COVID-19, given extreme headwinds for corporations, and concerns about market liquidity that has resulted in unprecedented monetary policy. For example, investing in assets outside of extremely low yielding U.S. Treasuries that offer some safe-haven protection, yet still provide some semblance of investment income can help fill the income void. With a bit more effort, strategic thinking, and marginally incremental credit risk, companies can find income. And in such an extremely low-income environment, every little bit helps.

1. As of 5/31/2020 according to S&P Dow Jones Indices: announced-cuts-51590944530

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”), which also includes the Madison Scottsdale office. MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

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