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INVESTMENTINSIGHTS

GLOBAL INSURANCE SOLUTIONS

Buy and Maintain: A “smarter” approach to credit portfolio management

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SEPTEMBER 2014

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Effective fixed income management for liability-driven investorsBuy and Maintain strategies are designed to maintain high book yields relative to an investor’s credit risk budget, while minimizing portfolio turnover to reduce trading costs, tax charges and accounting volatility. To achieve these objectives, Buy and Maintain fund managers focus on actively selecting high quality bond securities that can be held to maturity, based primarily on the underlying financial strength of their issuers and their perceived remoteness from severe negative credit migration and default.

In many respects, the Buy and Maintain fund manager fulfills responsibilities more akin to a loan officer, making decisions based on the long-term absolute credit performance of a company, as opposed to quarterly relative value decisions based on what is expensive or cheap at any particular stage of the business cycle. Building and managing effective Buy and Maintain portfolios therefore requires a different way of thinking for investment departments of insurance companies and an entirely different fixed income investment process.

IN BRIEF• We believe Buy and Maintain is a highly effective way for insurers and other long-term

institutional investors to gain exposure to the income generated from a broad,representative universe of investment grade bonds.

• In this paper, we provide an investment framework that addresses the issues raised bythe credit crisis so that investors can benefit from more resilient portfolios. This isparticularly important in today’s low interest rate environment, when investors areagain reaching beyond their core fixed income competencies in search of moreattractive yield opportunities.

• Key to this investment framework is initial portfolio construction. We believe portfoliomanagement should reflect a customized benchmark rather than a public index, whilesecurity selection should be based on rigorous credit research rather than on publicratings. This means selecting Buy and Maintain fund managers with the resources tointelligently construct portfolios and to actively manage positions through economiccycles and turbulent markets.

• Our framework also allows for a more flexible sell discipline to be adopted, to avoidunnecessary losses, while we advocate measuring performance based on an investor’sindividual risk profile and the objectives of all stakeholders, rather than a simple focuson book yield maximization. We suggest insurers build a comprehensive performancescorecard to help fully evaluate the success of their investments over time.

Global Insurance Solutions

2 | Buy and Maintain: A “smarter” approach to credit portfolio management

INVESTMENTINSIGHTS Buy and Maintain: A “smarter” approach to credit portfolio management

Importantly, Buy and Maintain is not the same as the long espoused “buy and hold” passive approach to portfolio management. Although both strategies use a disciplined approach to construct portfolios that are designed to be resilient through any cycle and offer strong average performance over their lifetime, Buy and Maintain is an inherently active strategy that aims to achieve an insurance company’s objectives by continuously monitoring positions relative to a dynamic marketplace.

For some institutional investors—such as insurance companies—the more flexible Buy and Maintain approach can have advantages—not least the ability of Buy and Maintain fund managers to sell securities (and buy securities) if there is a significant change in their credit outlook, notwithstanding important accounting considerations in certain markets. The sell discipline can be just as crucial as the buy discipline in determining investment outcomes in a long-term portfolio, with good sell decisions often having a greater impact than good buy ideas.

Buy and Maintain can therefore be thought of as providing “security research to maturity,” by conveying the much stricter credit analysis required to provide stable cash flows throughout a market cycle. This is very different to a macro manager that needs liquidity to trade when its macro views change.

Learning the lessons of the credit crisisThe long-term funding nature of Buy and Maintain portfolios allows them to take advantage of liquidity premiums in the market to boost book yields. As a result, Buy and Maintain portfolios can help insurance companies and other liability-driven investors target an investment income that is matched closely to their balance sheet liabilities, while preserving that income over time and avoiding the need to realize losses—or gains—that could give rise to accounting volatility.

As with most other fixed income strategies, Buy and Maintain struggled in the credit crisis of 2007-09. There are many reasons why Buy and Maintain struggled during the crisis. Among the most important was that few institutional investors truly understood their funding profiles. As such, many insurance companies based their portfolio construction and security selection on public ratings and public benchmarks, while focusing on yield maximization at the expense of economics and abdicating their due diligence responsibilities to third parties in the process.

This combination proved toxic, as many investors faced a valuation squeeze when liquidity was demanded. For example, prior to the credit crisis, some Buy and Maintain fund managers added overweight exposure to structured products, such as non-agency residential mortgage-backed securities (RMBS), to boost performance relative to public benchmarks. These securities were deemed to be of a high quality by the rating agencies, but turned out to be anything but.

OBJECTIVES OF BUY AND MAINTAIN PORTFOLIO CONSTRUCTIONBuy and Maintain strategies use a portfolio construction methodology that weights holdings based on an investor’s own unique funding profile and risk budget, as well as the capacity of individual bond issuers to service their debt until maturity. The aim is to reduce volatility and improve credit quality by emphasizing companies with lower leverage, higher cash flow coverage and lower downgrade risk.

Academic studies have singled out certain financial ratios that can guide investors as to the risk of downgrade and default. A recent report by Research Affiliates,* an indexing and asset allocation specialist, points to the following ratios: sales to assets, cash flow to assets, working capital to assets, and leverage.

Bonds issued by companies that perform poorly on these ratios are more likely to be downgraded and are also more sensitive to the credit cycle. This means they are more likely to be downgraded during an economic downturn and more likely to be upgraded in a time of strong economic growth—resulting in higher levels of volatility and below average returns.

In Buy and Maintain portfolio construction, by removing companies with higher susceptibility to downgrades, the portfolio’s sensitivity to the credit cycle, volatility and maximum drawdown risk can all be reduced, without harming potential returns.

* Shane Shepherd, “Smart Beta Investing in Corporate Bonds: Conceptualand Empirical Grounds,” Research Affiliates (February 2014).

J.P. Morgan Asset Management | 3

The subsequent sharp fall in credit quality of these structured products—and the substantial write-offs suffered by the Buy and Maintain portfolios that were holding them—has had far-reaching consequences, including a renewed focus on preserving regulatory capital.

Therefore, while we firmly believe that Buy and Maintain investing provides a highly effective way for investors to achieve an attractive yield from a resilient fixed income portfolio, we also recognize the importance of having a robust investment framework in place to construct Buy and Maintain portfolios that are durable enough to withstand all market environments.

THE LEGACY OF NON-AGENCY RESIDENTIAL MORTGAGE-BACKED SECURITIES (RMBS) EXPOSURE Prior to the credit crisis, some credit investors, including insurers, were attracted to non-agency RMBS by their higher yields and high quality credit ratings.

The credit crisis had a significant impact on the U.S. mortgage market. Billions of dollars of non-agency RMBS defaulted, forcing investors to absorb large losses in what had been considered low-risk investments.

According to the National Association of Insurance Commissioners, the U.S. insurance industry wrote down almost USD 27 billion in impairment costs and unrealized valuation decreases between January 1, 2008 and December 31, 2010. These write offs contributed to a 32% drop in the value of the industry’s non-agency RMBS holdings between December 2008 and December 2010 (Exhibit 1).

EXHIBIT 1: NON-AGENCY RMBS HOLDINGS (USD, MILLIONS) 2008-2010

Sector Dec 31, 2010 Dec 31, 2009 Dec 31, 2008

Fraternal $3,129 $3,720 $2,458

Health 787 1,250 2,244

Life 110,460 152,595 154,458

P&C 14,599 20,352 29,796

Title 3 4 23

Total 128,977 177,920 188,978

Source: National Association of Insurance Commissioners, July 2011.

An investment framework for Buy and MaintainBuy and Maintain struggled during the credit crisis because the paradigms used to construct portfolios and measure performance turned out to be false. In today’s low interest rate environment, when investors are again reaching beyond their core fixed income competencies in search of more attractive yield opportunities, it’s important that the lessons from the crisis are learned so that investors can build much more durable Buy and Maintain portfolios.

The three main lessons are to use customized benchmarks for asset allocation, choose fund managers with rigorous credit assessment resources that can make informed security selection decisions, and adopt a much broader measure of investment success rather than a simple focus on book yield maximization.

Taking these guiding principles into account, our investment framework for Buy and Maintain is built on the following five key rules:

1. Avoid using public benchmarks for beta management.

2. Use asset-liability management to guide asset allocation decisions.

3. Focus on independent credit analysis when buying securities.

4. Ensure fundamental credit views drive sell decisions.

5. Measure performance based on initial portfolio economics and credit migration.

1. Avoid using public benchmarks for beta management Buy and Maintain strategies will perform well, provided investors have exposure to the “correct” assets. However, many Buy and Maintain portfolios do not have an optimal asset mix because insurers tend to focus on public benchmark weightings when constructing portfolios. Public benchmarks have at least four major disadvantages when it comes to constructing Buy and Maintain portfolios:

Duration mismatch

A typical portfolio based on a public benchmark tends to hold duration within a narrow band closely linked to the duration of the benchmark itself. This gives the fund manager very little flexibility to manage the duration of a Buy and Maintain portfolio so that it matches an investor’s individual cash flow profile.



The duration mismatch between the benchmark and, in the case of the insurance investor, the liabilities, can be a magnitude of 10 or more years (Exhibit 2).

Concentration risk

Because public benchmarks tend to be market-capitalization weighted, the largest benchmark allocations are to the most indebted borrowers. Companies or countries that issue proportionally more debt will have a greater share in the index. Thus, an investor benchmarked to a traditional index may have the greatest exposure in the most indebted countries and corporations.1 Many insurers have implemented issuer limits to improve diversification, but the hundreds—if not thousands—of issuer limits and investment constraints contained in investment guidelines have actually made the problem worse, effectively tying the hands of fund managers and turning many risk management departments into de facto security selectors. Some have tried to address the problem by equally weighting issuers in the index, but we have found this approach does not go far enough for most insurance investors.

Convexity mismatch

Some public benchmarks exhibit negative convexity due to prepayment and call risk. This is usually the case in benchmarks that maintain positions in certain types of municipal bonds, agency mortgage-backed securities and callable corporate debt. In contrast, insurance company liabilities typically exhibit positive convexity due to options-like minimum guarantees, surrender clauses, etc. As Exhibit 3 (next page) demonstrates, a life insurance company’s liabilities are more valuable than its assets when interest rates fall or rise sharply. This means that any Buy and Maintain portfolios linked to public benchmarks may underperform in periods when interest rates are volatile. As such, many insurance investors have actively sought to mitigate this risk by limiting or entirely eliminating these types of securities from their Buy and Maintain portfolios and substituting others with more favorable characteristics.2 However, the criteria for the benchmark can then become inconsistent with the underlying investor’s status and the mandate for portfolio management, rendering it ineffective for overseeing the prudent management of the assets.

1 Many investors will deem U.S. Treasuries and/or “core” European country sovereign debt (e.g., German Bunds, U.K. Gilts, French OATs, Dutch DSLs, etc.) as riskless from credit default perspective, and as such, not focus on concentration risk for these positions.

2 As examples, many in the industry have allocated to certain types of collateralized mortgage obligations (CMOs) that have prepayment tranches, such as planned amortization class and target amortization class bonds. These tranches receive prepayments according to a defined schedule. Some have also allocated to callable corporate debt with “make whole” provisions.

Rebalancing divergence

Buy and Maintain portfolios are designed to be more static in nature, with stable assets under management. Depending on the exact nature of the inflows, the composition of the portfolio and the public benchmark will tend to diverge considerably over time. The index will change each time it is rebalanced, whereas the Buy and Maintain portfolio will have lower turnover and will not necessarily be rebalanced in light of any change in the index. Exhibit 4 (next page) shows the potential performance of a public benchmark and a generic Buy and Maintain portfolio based on the liabilities and capital position of a hypothetical insurer. Importantly, in an environment with monotonically decreasing interest rates, one can see not just the yield differential (a yield pickup of 170 basis points—bps—currently) but also the effect of rebalancing on the yield of the index relative to the Buy and Maintain portfolio. Assuming yields stay at the current level, the evidence suggests that book yields will decrease much faster in the public benchmark due to higher portfolio turnover.

Insurance company liabilities are not well matched by public benchmark cash flows

EXHIBIT 2: BARCLAYS GLOBAL AGGREGATE CASH FLOWS VS. GENERIC LIABILITY REPLICATING PORTFOLIO

0%

2%

4%

6%

8%

10%

12%

2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2054 2058

Rela

tive

amou

nt o

f cas

h flo

w

Generic liability cashflows Barclays Agg

Source: J.P. Morgan; data as of May 31, 2014.


Life insurers are short volatility—when rates fall or rise quickly, liabilities are worth more than assets

EXHIBIT 3: LIABILITIES, ASSETS AND CONVEXITY FOR A TYPICAL LIFE INSURANCE COMPANY

Liabilities

Assets Worst case

interest down

Econ

omic

Val

ue

Interest Rate Level

Worst case interest up

Liability options like minimum guarantees

Liability options(surrender clauses, etc.)

Embedded options like

callables

Bestestimateeconomic

capital

Source: J.P. Morgan. For illustrative purposes only.

Smart beta benchmarks address some, but not all, of the issues

To address the disadvantages of market capitalization-weighted public benchmarks, smart beta benchmarks were developed. Although originally focused on equity indices, smart beta is now established in credit indices and is growing in popularity as a tool to assist with Buy and Maintain portfolio construction.

However, smart beta benchmarks only really address one of the problems related to public benchmarks—that the largest weightings belong to the largest borrowers. This issue has been dubbed the “bums” (or “deadbeats”) problem by Laurence Siegel.3 To address the problem, smart beta fixed income indices weight corporate securities by factors such as average annual cash flow or long-term assets, a proxy for collateral for long-term bondholders. For sovereigns, weightings might be determined by GDP rather than opposed to total debt outstanding.

Although addressing the deadbeats problem is important, smart beta does have its critics. In a recent interview for the online financial magazine, Advisor Perspectives,4 Stanford University economist Bill Sharpe—who won a Nobel Prize for his work defining the concept of beta—reasons that smart beta strategies are either factor bets, or an active attempt to beat the market (which would class them as alpha and not beta). Sharpe says smart beta providers cannot argue that their approach will work if everyone does it, and that the anomalies exploited by smart beta will also be eliminated over time.

3 Laurence B Siegel, the Ford Foundation, “Benchmarks and Investment Management,” the Research Foundation of the Association for Investment Management Research (August 2003).

4 Robert Huebscher, “Bill Sharpe: Smart beta makes me sick,” Advisor Perspectives (May 13, 2014).

Book yields will decrease much faster for portfolios linked to public benchmarks

EXHIBIT 4: BARCLAYS GLOBAL AGGREGATE BOOK YIELD VS. GENERIC REPLICATING PORTFOLIO

0

1

2

3

4

5

6

7

2000 2004 2008 2012 2016 2020 Yi

eld

in %

Yield to worst liability benchmark Yield to worst Global Agg Average yield liability benchmark Average yield Global Agg

Source: J.P. Morgan; data as at May 31, 2014.

In response to these concerns, smart beta providers are producing research showing their strategies are successful not because of factors such as value, that will be arbitraged away over time, but because of processes like rebalancing that take advantage of dynamics in the fixed income market, such as the tendency of credit spreads to mean revert on an annual horizon.

For example, in a recent paper, Research Affiliates5 looked at a smart beta index based on the BAML Global Corporate investment Grade Index, with constituents filtered using financial ratio screens and reweighted based on average cash flow and long-term assets. The smart beta index outperformed a market value weighted index by 39 bps with volatility more than 50 bps lower (for a Sharpe ratio 12 points higher and a comparable yield).

However, the smart beta index also had appreciably higher turnover, of 42% annualized, compared with just 28% for the market-weighted index. As such, on a stand-alone basis, smart beta benchmarks are far from ideal for use in Buy and Maintain portfolios. Frequent rebalancing is a tactic that Buy and Maintain strategies seek to avoid, as it incurs trading costs and taxes, and introduces accounting volatility with more rapidly changing book yields due to higher portfolio turnover.

5 Shane Shepherd, “Smart Beta Investing in Corporate Bonds: Conceptual and Empirical Grounds,” Research Affiliates (February 2014).



SMART BETA: HOW IT WORKS AND WHY IT’S NOT A PANACEA FOR INSURERSBeta is a coefficient that captures a security’s sensitivity to the market, as opposed to alpha, which is the variable that captures the changes in the price of a security arising from issuer-specific risk.

The Capital Asset Pricing Model (CAPM) breaks a security’s theoretical required rate of return into three components: beta—the return from exposure to systematic (non-diversifiable) market risk; alpha—the return from exposure to idiosyncratic (diversifiable) issuer-specific risk; and a residual term for the price change that cannot be explained by market movements and issuer specific risk.

As such, alpha is a measure of security selection skill and the so-called active return on investment, and so is difficult and expensive to obtain. In contrast, it is easy to gain beta exposure through index funds (such as exchange-traded funds), which give investors cheap access to market returns.

As we’ve already seen, replicating benchmarks based on market capitalization weightings carries several disadvantages for Buy and Maintain investors. Smart beta benchmarks were developed to address the shortcomings of traditional market-weighted benchmarks.

Smart beta works by weighting securities by factors such as earnings, dividends or risk rather than by market capitalization. This approach allows investors to exploit anomalies in security valuations while still offering low-cost index-like fund management.

However, by creating one-size-fits-all asset allocations, smart beta may not provide the smarter alternative to public benchmarks that its advocates suggest, especially for insurance companies, as smart beta benchmarks are not customized for their unique liability profiles and objectives.

Furthermore, smart beta indices (as with market-weighted indices) do not take into account insurers’ liabilities or their unique objectives, constraints and available capital. Different insurers have different investment strategies. In fact, based on differences in products, distributions channels and geographies among other factors, one might argue that no two insurance companies are the same and therefore individual insurers would ideally demand slightly different risk factor exposures for their portfolios.

The shortcomings of book yield benchmarks

To more effectively address the issues presented by public benchmarks, some Buy and Maintain investors have tried to reverse engineer public benchmarks to the objectives of their existing portfolios. This is done by matching the timing of historical portfolio purchases with index constituents at that time, so that the portfolio can be measured against a so-called “book-yield benchmark.”6 In 2005, Merrill Lynch & Co. launched its “Book Measured Asset Return Indices,” or “bookmark indices,” a service designed to meet the needs of investors who record their fixed income portfolios on a historical cost basis.

However, the data and analytics required to construct book yield benchmarks are complex and can be expensive to implement, making them prohibitive for many investors. The biggest issue in calculating a book yield for a benchmark is that the yield is dependent on the time horizon of the portfolio. For example, the book yield of today’s holdings in a portfolio constructed over the course of a 10-year period will depend on the buying and selling patterns over that period. Because yields are volatile, today’s yield may not reflect the portfolio’s book yield.

Reverse engineering a public benchmark into a book yield benchmark requires investors to recognize the unique buying patterns of their individual portfolios. If the historical trading patterns are not accounted for, the portfolio’s unique characteristics will not be captured, so the benchmark will not allow a fair judgment to be made. To do this successfully, therefore, investors will need to select a start date and obtain all the relevant portfolio data for that date—a full list of securities with their book values and purchase dates. The portfolio’s book value can then be divided into purchase date segments, which can be used to buy the current sub-indices of the total return index in the appropriate allocations.

This process is challenging and requires complex analysis to implement accurately. We believe a better approach is to use an asset-liability management (ALM) process that generates custom reference portfolios and summary attributes to enable direct construction of bespoke investment benchmarks for each individual mandate.

6 Wells, Canning & Associates Inc. “True Book Yield BenchmarkingSM: A New Approach for Insurance Companies.”


2. Use asset-liability management to guide customized asset allocation decisionsBuy and Maintain portfolios require benchmarks that are customized to individual aims and objectives. Instead of being based on some set of market algorithms agnostic to funding sources (as is the case with a smart beta benchmark), customized “investment benchmarks” focus on constructing portfolios to meet the obligations of an investor’s individual liability profile, risk appetite and capital position.

Companies that followed such an approach performed much better through the credit crisis. Zurich Insurance Group, for example, recorded positive net investment results and net income during the extremely turbulent capital market years of 2008 and 2009. As Exhibit 5 shows, the minimum risk portfolio “matches” Zurich’s liabilities and provides a low risk reference point. Insurance companies will try to enhance surplus returns with riskier investment strategies designed to outperform liabilities. By monitoring its surplus exposure to market risk factors, Zurich avoided much of the market turbulence of 2008 and 2009.

INSURANCE GAIN/LOSS MANAGEMENT MOTIVATES LOW TURNOVER PORTFOLIOSInsurers seek to avoid realizing capital gains so that they do not incur taxes and trading costs or trigger several negative accounting consequences—both under statutory accounting principles (SAP) and generally accepted accounting principles (GAAP). Also, a company that realizes gains will generally be selling fixed income securities that have appreciated in value due to a drop in rates. Therefore, the proceeds will be reinvested at lower book yields.

Under SAP, an accounting regime established by insurance regulators that is closely tied to regulatory solvency, life insurers must establish a so-called “interest maintenance reserve” (IMR) for realized capital gains and losses. The purpose of the IMR is to capture realized gains (and losses) that result from changes in the overall level of interest rates and amortize them into income over the approximate remaining life of the investment. As such, under SAP, while the insurer will have lower book yields, it will not receive any benefit to its statutory solvency from realizing the gain (unless it is in a negative IMR position, where the realized gains will offset the negative reserve).

From a US GAAP perspective, while operating income includes ordinary investment income (a product of book yield and book value), it specifically excludes realized gains and losses. These are accounted for “below the line,” in net income. The rationale for doing so is that realized capital gains and losses may vary significantly from period to period and are generally driven by business decisions and external economic developments, such as capital market conditions, the timing

of which is unrelated to underlying operations. As such, insurance managers often use operating income to assess performance and establish incentive compensation.

Most importantly, investors, financial analysts, financial and business media, and rating agencies look at operating income results “above the line” when assessing a company’s financial performance. The price-to-earnings multiple is commonly used by sell-side analysts as a forward-looking valuation technique using operating income (loss) as the denominator.

Insurance companies are already employing this methodology when accounting for gains and losses, whether using GAAP or non-GAAP measures. The Allstate Corporation,* for example, notes that operating income provides a reliable, representative and consistent measure of the company’s and management’s performance.

It is worth noting that insurance companies can control operating income through gain/loss management. When securities are sold at a capital loss (such as risk-free fixed income in a rising rate environment), the loss goes “below the line” and can disappear from a sell-side analyst valuation model. Higher yields from reinvestment improve the net interest spread and give the appearance of better asset management. The opposite is true for capital gains. Thus in most public companies, capital losses are preferred to capital gains.

* The Allstate Corporation, “Definitions and Reconciliations of GAAP and Non-GAAP Measures,” (First Quarter 2013).



Source: Company websites, financial reports. Note: Peer universe defined as DJ Global Insurance Titans. Some peers were not included in the analysis due to availability and quality issues. The analysis performed is based on quarterly returns 2007-2011. Modified information ratio is used to account for negative returns. Prior data not available in required quality. 1 Return = cumulative excess return (chain linked). 2 Risk = standard deviation of excess return.

While the insurance industry usually thinks of asset-liability management (ALM) as a tool or process for duration management, ALM also gives insurance investors detailed information on their funding profiles so they can know their yield targets, liquidity and risk budget capacity for building longer maturity credit portfolios. In many instances, an insurance company’s funding profile remains ideally positioned relative to other institutional investors for building and managing Buy and Maintain portfolios.

Basing asset allocation on liabilities and capital consumption by market factor exposures paid off for Zurich Insurance Group during the credit crisis

EXHIBIT 5: INVESTMENT PERFORMANCE AND RISK ANALYSIS, ZURICH INSURANCE

Peer Benchmarking Q1 2007 - HY 2011Ranking based on information ratio

1 Peer 1 -0.092 Zurich -0.113 Peer 2 -0.124 Peer 3 -0.135 Peer 4 -0.186 Peer 5 -0.237 Peer 6 -0.298 Peer 7 -0.329 Peer 8 -0.3710 Peer 9 -0.3811 Peer 10 -0.4412 Peer 11 -0.4713 Peer 12 -0.4814 Peer 13 -0.5015 Peer 14 -0.6516 Peer 15 -0.6817 Peer 16 -0.6918 Peer 17 -0.8619 Peer 18 -1.39

0%

Q1

03

Q4

03

Q3

04

Q2

05

Q1

06

Q4

06

Q3

07

Q2

08

Q1

09

Q4

09

Q3

10

Q2

11

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

46.1%

41.0%

Total return on minimum risk investment strategy

Total return on investment strategy

Cumulative total investment return against the minimum risk investment strategy Performance based on return and risk

0% Return1

1st on volatility of excess return basis

3rd onexcess returnbasis

Risk

2

-5%

-10%

Zurich

Peer 3

Peer 1

Peer 2Peer 4 Peer 5

Peer 8

Peer 7

Peer 11

Peer 15Peer 16

Peer 17

Peer 18

Peer 12

Peer 13Peer 14

Peer 9

Peer 6Peer 10

-15%

-20%

-25%

-30% 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0

To build an effective customized investment benchmark for a Buy and Maintain portfolio, we advocate using ALM before making any decisions (Exhibit 6). Because an insurer’s liabilities (L) are generally less liquid or tradable than its invested assets (A), the ALM process should begin with an estimate of liability cash flows by constructing a liability benchmark (Lb).

The ALM process analyzes an insurer’s business objectives and constraints as well as their liabilities

EXHIBIT 6: USING ASSET LIABILITY MANAGEMENT TO CREATE A CUSTOMIZED LIABILITY BENCHMARK

E = A - L

A = Actual assets; Ab = Asset benchmark (strategic asset allocation); Lb = Liability benchmark (replicating portfolio); L = Liabilities

Risk & Return:Tactical investment

decisions

Risk & Return:Strategic investment

decisions

Risk & Return:Insurance operations

Alpha: Relative return of each liquid asset class strategy to its custom benchmark based on sector and security selection; for non-liquid strategies, ranking relative to manager dispersion

Beta: Absolute return from asset allocation exposure to market risk factors such as credit spreads and migration, interest rates, equity and real asset returns

Rf: Risk minimizing rate of return from liability benchmark portfolio

AssetManagement

InvestmentManagement

InsuranceUnderwriting

E = (A - Ab) + +(Ab - Lb) (Lb - L)



Only then can investors decide how best to tailor their strategic asset allocation so that their asset benchmarks (Ab) for each asset class are constructed taking their individual liability profiles, available capital and other constraints, as well as their commercial objectives, into account.

The liability benchmark is often constructed as a so-called “replicating portfolio.” It is called a replicating portfolio because it is a portfolio of market instruments that replicates as closely as possible the liability cash flows under a diverse set of economic scenarios.7

UNDERSTANDING INVESTMENT RISK: THE IMPORTANCE OF ASSET- LIABILITY MANAGEMENTInvestment risk is different for insurance companies than for the typical fund manager. Fund managers focus on the absolute risk that the market value of their underlying investments will rise or fall in a particular time period, and on the relative risk of outperforming or underperforming a benchmark. Both of these risk measures are focused solely on the asset side of the balance sheet.

However, for an insurance company, investment strategy and risk are linked to its liabilities and the capital held by its shareholders. The insurer’s absolute return will depend on strategic asset allocation decisions, which should be tailored to the insurer’s unique objectives, constraints and available capital.

Return and risk will depend on exposure to market factors such as interest rates, credit spreads, equity returns and liquidity, as well as security-specific factors. Typically, insurers use an absolute return approach to measure overall performance for their alternatives allocation and evaluate managers based on performance relative to overall dispersion.

For more liquid strategies, such as fixed income, insurers will develop custom benchmarks to measure the relative performance of their fund manager directly.

7 This can be further broken out into a theoretical replicating portfolio, realistic replicating portfolio and commercial replicating portfolio. The first is a portfolio of hypothetical instruments that matches the liability payoff pattern as closely as possible whether the instruments are available in the market or not. The second is based on what is constructed using available instruments in the market, with the difference noted as “unhedgeable” risks. The third is used as a negotiated transfer pricing mechanism back to the insurance lines of business to support commercial objectives.

Build a reference portfolio for the fund manager to follow

Constructing a liability benchmark is only the first step to effective Buy and Maintain portfolio construction. The key factor is to plug the liability benchmark into a strategic asset allocation tool based on models that faithfully reflect historical asset risks while incorporating the many constraints that are relevant to insurers (such as book yield, regulatory capital, gain/loss, etc.). Importantly, the model should include forward-looking return, volatility and correlation estimates over the time horizon relevant to the insurer, and the return estimates should include market forecasts of credit migration and default.

The aim is to produce a range of optimal asset allocation portfolios at the constituent level for given degrees of risk (annual capital surplus/shortfall) and expected returns (see Exhibit 7). So investors require an expected return of 2.5% to match their liability benchmark and earn a target return on budgeted risk capital, they will select the corresponding asset allocation sleeve for each asset class strategy based on this level of expected return.8

Asset allocation is optimized against the investor’s risk budget

EXHIBIT 7: PORTFOLIO OPTIMIZATION BASED ON EXPECTED RETURN AND ANNUAL SURPLUS/SHORTFALL

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

0 200 400 600 800 1000 1200 1400 1600

Expe

cted

ret

urn

(%)

Annual surplus expected shortfall (USD MM)

E�cient frontier Sample portfolio

0 10 20 30 40 50 60 70 80 90

100

2.00

2.25

2.50

2.75

3.00

3.25

3.50

3.75

4.00

4.25

4.35

Asse

t allo

catio

n (%

)

Portfolios by expected asset return (%)

EQ

EMD

CorpHY

Alts

Struct

Corp

Muni

Govt

Cash


8 As the approach of setting a target yield (or return) and minimizing risk given that target got many companies into trouble in the credit crisis, some leading insurance companies implemented the ALM process from Exhibit 6 and instead now strive to maximize yield (or return) subject to their risk bearing capacity budget. As such, their investment departments are represented at their respective product approval committees with proactive roles in underwriting and pricing new insurance products.



Because a significant part of an insurer’s portfolio is non discretionary, this needs to be reflected in the customized benchmark.

EXHIBIT 8: CREATING A CUSTOMIZED BENCHMARK WITH BUSINESS PORTFOLIO OBJECTIVES AND CONSTRAINTS

Block D

Company portfolio

Block ND

Benchmark

Shor

tCr

edit

Med

ium

Cr

edit

Long

Gov’

t

Cash

&Eq

uity

Med

ium

Gov’

t

Shor

tGo

v’t

Block ND

Unch

ange

d

Wei

ghts

chos

en b

yop

timiz

atio

n

A major stumbling point within benchmark creation is that the mandates of the benchmark must match the mandates of the portfolio; this issue is often raised when a portion of the portfolio is Buy and Maintain.


The model portfolios will include weightings of individual asset class strategies, including the individual constituents and summary attributes of those strategies that can be used to create reference indices for each asset class. This allows each asset allocation sleeve to be translated into index “buckets” that can be used to build the customized asset benchmark (Ab), or reference portfolio, for the Buy and Maintain fund manager to follow.

Essentially, an insurance company’s sector and security selection within each asset class sleeve of its strategic asset allocation is more akin to the fund manager’s risk relative to a market benchmark. However, in the case of the insurance company, the benchmark for each sleeve is a custom benchmark based on liabilities and available capital.

Crucially, because a significant part of an insurer’s investment portfolio is Buy and Maintain, this also needs to be reflected in the asset benchmark (Exhibit 8). Investors should therefore partition their investment assets into two blocks. Block ND is non-discretionary, or non-tradable. The fund manager’s performance in managing these assets should be measured based on credit migration and default of the ND portfolio relative to market average credit statistics rather than relative value measurement. Block D is the portion of the portfolio that is discretionary, or traded. Its performance measurement should be based on relative value decisions.

Block ND assets can be moved to the asset benchmark as they are—the effect of this is that changes in the value of any non-discretionary assets are realized identically in both the asset benchmark and the portfolio.

The resulting asset benchmark (Ab) will provide a highly customized investment benchmark based on an insurer’s bespoke corporate objectives, right down to the constituent level. It can then be loaded into a performance attribution system in order to measure the relative performance of the fund manager.

Importantly, the investor’s liability profile and investment objectives are already “baked in,” so fund managers are able to focus on building portfolios that can meet or outperform the insurer’s investment objectives while ensuring that the risks being taken do not exceed stakeholders’ expectations. With the Buy and Maintain assets netted out, the relative performance can be measured more effectively for the discretionary portion of the portfolio. And, most importantly, the absolute performance of the Buy and Maintain fund manager can be transparently measured based on long-term credit migration and default of the constructed non-discretionary portfolio.

3. Focus on independent credit analysis when buying securitiesChoose managers with strong credit research capabilities

Once the strategic asset allocation is determined, security selection for the Buy and Maintain portfolio should be based on rigorous credit research rather than solely on public ratings, with an emphasis on identifying and buying cheap cash flows. This is especially important given that such a large portion of the portfolio is constructed as non-discretionary in anticipation of holding to maturity.

Strong credit research resources are particularly important for Buy and Maintain portfolios because the longer one holds fixed income securities, the more time there is for things to go wrong. The fund manager’s initial credit analysis needs to be as strong as possible to try to lessen the chances of an issuer suffering a significant deterioration in its credit rating over security life cycles (Exhibit 9, next page).

This is particularly important with corporate bonds because the price impact on a corporate bond from a change in credit rating is asymmetric. Bonds pay a steady stream of income, so the price gain from a credit rating upgrade is often not very large—after all, the bond’s income stream remains the same. However, because a rating downgrade could eventually lead to default and a total loss of income, a bond’s price can fall significantly on downgrade to reflect the chances of a much reduced future return.


As fund managers are penalized much more for selecting bonds that are downgraded than they are rewarded for selecting bonds that are upgraded, it’s crucial that they undertake rigorous proprietary credit analysis to try to minimize the chances of selecting bonds that are downgraded—particularly if bonds with a lower credit rating are included in the portfolio.

Identify the most stable investments at the sector and issuer level

To confidently pick securities that can be held to maturity, Buy and Maintain fund managers require a rigorous, statistically valid investment process that is focused on fundamental credit research at the sector and individual issuer level, so that all the key drivers of credit performance can be fully understood across the economic cycle.

Typical fixed income sectors include, but are not limited to, cohorts such as investment grade credit; U.S., European and Asian high yield debt; government and inflation-protected securities; municipals; emerging market debt; real estate and other asset-backed securities; covered bonds; liquid loans; mezzanine debt; commercial mortgage loans; and private placements. Each cohort will behave slightly differently in various economic growth, interest rate and inflationary environments. Importantly, some fixed income sectors will be more or less sensitive to business cycle factors.

These cyclical factors are important when driving sector allocations, but a Buy and Maintain fund manager also needs to have additional long-term visibility into the corporate debt sectors, where issuing companies operate. For example, regulated utilities will lend themselves more naturally to a Buy and Maintain portfolio than will the more volatile technology sector. This is because every business cycle is different, and so are the relative performance

patterns among sectors. Using a disciplined approach, it is possible to construct a resilient portfolio in each environment, through every phase of every business cycle, that offers strong full phase average performance over its lifetime.

• Sector selection. There are four main phases to a normal market cycle:

– The recovery phase often sees strong growth, low interest rates and increasing corporate profits. Sectors sensitive to interest rates and to economic growth—such as financials, industrials, information technology, and materials—should do well.

– In the middle phase of the cycle, positive GDP growth, strong credit growth and healthy corporate profitability still tend to favor more economically sensitive sectors, such as information technology and industrials. In contrast, later in the cycle, building inflationary pressures often favor the energy and materials sectors, which benefit from rising commodity prices. Defensive sectors, such as health care, consumer staples and utilities, also generally perform well as the economy begins to slow, while economically sensitive sectors such as information technology, begin to struggle.

– Finally, in a recession the most defensive sectors, such as consumer staples and regulated utilities, should maintain credit ratings better than economically sensitive technology companies. Obviously “risk free” proxies such as various government securities are also preferred.

• Issuer analysis

– All issuers should be thoroughly analyzed using a common and disciplined process to assess creditworthiness, the relative value of an issuer within its sector and the concentration limit (or maximum position size) for each issuer. Issuer limits should be based on the relative size of the issuer compared with the reference portfolio, as well as on credit analysis and the issuer’s potential volatility. Creditworthiness should be assessed through a rigorous due diligence examination and detailed financial modeling. Credit analysts should focus on the current and future ability of a company to service its debt from cash flows by analyzing leverage and cash flow coverage, while also assessing the probability of a credit downgrade through financial ratio screening.

• Leverage and cash flow coverage

– Using cash flow and long-term assets as weighting factors when constructing Buy and Maintain portfolios can be beneficial, as they can provide higher exposure to companies with better capacity to service their debts and give a generally higher exposure to more liquid bonds. As cash flow rises, a company can afford larger interest payments.

Over any given year, the probability of default or negative credit migration is low, but the cumulative default risk can be high over long holding periods.

EXHIBIT 9: TEN YEAR CUMULATIVE DEFAULT PROBABILITY FOR TWO U.S. FINANCIAL INSTITUTIONS

Model 1M (%)

3M (%)

6M (%)

1Yr (%)

2Yr (%)

3Yr (%)

4Yr (%)

5Yr (%)

7Yr (%)

10Yr (%)

0

5

10

15

20

25

30

35

AA- BBB

cum

ulat

ive

prob

abili

ty o

f def

ault

Source: J.P. Morgan, Kamakura Corporation.



As assets rise, a company has more collateral available to pledge against its debt. Additionally, larger companies are disposed to issue bonds in larger amounts, which trade more frequently with tighter spreads.

– Portfolios based on these factors will be meaningfully different from portfolios based on market value weightings. Portfolios favoring companies with high assets and high cash flow rather than high debt issuance should have lower average leverage and higher average cash flow coverage compared to a public benchmark. These tilts are embedded in the portfolio construction process and are a natural result of weighting companies by factors other than debt issuance.

– Companies with higher leverage and lower cash flow coverage are indeed riskier. Yet they do not provide a higher return as compensation for that risk. Taking on additional risk without higher return leads to a much lower Sharpe ratio, so allocating away from companies with high leverage, low cash flow coverage and toward companies with healthier debt levels is likely to improve the risk-return profile of a Buy and Maintain portfolio.

• Financial ratio screening

– When building a Buy and Maintain portfolio, financial ratio screening can help to identify companies at higher risk of downgrade. Deteriorating financial health is reflected in a company’s balance sheet and income statements, in adverse credit rating changes and by widening credit spreads that lead to negative bond returns. As described earlier in “Objectives of Buy and Maintain Portfolio Construction,” the academic finance literature has singled out certain financial ratios that are significant predictors of default risk. These include sales to assets, cash flow to assets, working capital to assets, and leverage.

– A falling sales-to-assets ratio can indicate deteriorating growth prospects due to weakening demand for a company’s products and services. Meanwhile, companies with a low, or declining ratio of cash flow to assets may be experiencing difficulty generating profits or may not have enough cash to meet debt payments. Similarly, companies with a low ratio of working capital to assets may have difficulty raising funding or meeting their short-term liabilities. Finally, leverage, as measured by total debt over total assets, can magnify or reduce each of the first three ratios, so companies with higher leverage tend to have smaller safety nets and less time to achieve a turnaround.

– Selecting securities based on how they score on a combination of these ratios can help Buy and Maintain managers avoid companies with a higher risk of suffering downgrades and a greater sensitivity to the credit cycle. This in turn should help to reduce drawdown risk without impairing expected return, while helping to reduce the need to trade securities.9

The impact of initial spread levels on performance

Buy and Maintain portfolio construction should also consider the radical changes taking place in fixed income dealing as well as the liquidity available in the investor’s own account. The level of spreads and interest rates when the portfolio is constructed should also be taken into account, as higher spreads improve a long-term investor’s chances of success.

The chance of success can be quantified, as demonstrated by the analysis in the J.P. Morgan Asset Management white paper “The Waiting Game: Credit and Long-Term Investment,”10 which concludes that the longer the time horizon, the greater the likelihood that investing in credit will pay off as opposed to government bonds. This is the case whether an investor’s base currency is the U.S. dollar, sterling or the euro. As shown in Exhibit 10 (next page), credit spreads peak at about the 20-year maturity mark, after which they decline because only the best credits can issue very long-term debt.

A robust credit assessment process during portfolio construction should minimize the need for portfolio rebalancing. While buying cheap cash flows is a central tenet of a successful Buy and Maintain approach, as mentioned previously frequent rebalancing has many drawbacks for insurance investors, namely higher trading and tax costs and potentially decreased book yields, among others.

Nevertheless, because they are long-term structural providers of liquidity to the market, Buy and Maintain fund managers should look to use their credit research skills to take advantage of the market’s volatility, looking to buy cheap cash flows whenever there is forced selling or outbreaks of market volatility.

9 The sections on financial ratio screening, and cash flow coverage and leverage, are based on analysis “Smart Beta Investing in Corporate Bonds: Conceptual and Empirical Grounds,” Research Affiliates (February 2014).

10 Paul Sweeting, “The Waiting Game: Credit and Long-Term Investment,” J.P. Morgan Asset Management (June 2014).


Hold a minimum of 200 issues to achieve robust portfolio diversification

At roughly $93 trillion, the global bond market is approximately twice the size of the global equity market. Nevertheless, there are some interesting observations from the global equity market that can help us to understand the subject of fixed income portfolio diversification and therefore ascertain how many issues would make a well-diversified Buy and Maintain portfolio.

Various studies have tried to determine the ideal number of holdings in an equity portfolio to achieve the full benefits of diversification. The much-quoted 1970 analysis by Lawrence Fisher and James H. Lorie, “Some Studies of Variability of Returns on Investments In Common Stocks” (published in the Journal of Business), found that a randomly created portfolio of 32 stocks could reduce the distribution of returns by 95%, compared with a portfolio of the entire New York Stock Exchange. As a result of this analysis, the commonly held belief is that you can achieve full diversification with a 30-stock portfolio.

However, as Jason Whitby pointed out in “The Illusion of Diversification,”11 the Fisher and Lorie study does not imply that a 30-stock portfolio is well diversified. Fisher and Lorie’s research was focused on measuring the reduction in a portfolio’s total volatility, which includes non-diversifiable market risk as well as diversifiable stock-specific (or idiosyncratic) risks. Whitby points to a study in 2000 by Ronald J. Surz and Mitchell

11 Jason Whitby, “The Illusion of Diversification: The Myth of the 30 Stock Portfolio,” Investor Solutions.

To capitalize on liquidity premiums and maximize yield per unit of credit risk, it’s important for Buy and Maintain managers to have a robust credit assessment process in place

EXHIBIT 10: CREDIT SPREAD AND DEFAULT PROBABILITY—FIXED RATE NON-CALL SENIOR BONDS

00 10 20 30

2

4

6%

Trade-Weighted Average Credit Spread (%)

Years to maturity

Fitted Credit Spread Kamakura Default Probability Fitted Default Probability

Source: J.P. Morgan, Kamakura Corporation, Market Access TRACE; data as of February 20, 2014.

Price (“The Truth About Diversification by the Numbers,” the Journal of Investing), which updated the Fisher and Lorie research using R-squared to measure portfolio diversification. In this study holding 30 stocks, or even 60 stocks, only achieves an R-squared of 0.86 (or 86% of the diversification of the market in question).

This research has important implications for Buy and Maintain fixed income investing. Although there are many more attributes to take into account when choosing fixed income securities (multiple issues per issuer based on tenor, subordination, etc.), each fixed income security has arguably less idiosyncratic factors driving its return than an equivalent equity security. When building a Buy and Maintain portfolio that is resilient to various economic environments and stages of the business cycle, one must therefore draw from the entire global fixed income market—and the global bond universe is huge.

But how many issuers are needed to achieve a well diversified Buy and Maintain portfolio? Given that there are over 200 industry sectors, then if the fund manager chooses five issuers per sector to feel confident of diversifying default risk, the portfolio would need to hold a minimum of 1,000 issuers in total! Depending on portfolio size, a reasonable objective might be to hold a minimum of 200 issuers to maximize yield and protect against both market risk (through smart sector and geographic construction) and idiosyncratic risk from any particular security (through smart issuer and issue selection).



Choose managers with the scale to buy new issues direct

Insurance companies have large enough portfolios to matter to the fund managers that regularly reap new issue discounts. Depending on conditions in any given trading session, acquiring a new corporate issue b, for example, from a fund manager with the scale to buy directly from a dealer can translate to a yield pickup of 25 to 30 bps, compared with acquiring the issue from one of the fund manager’s clients on the secondary market a few hours later.

For a Buy and Maintain investor, it is essential to have access to the new issue market, as this can significantly boost income over time. The Investment Insights paper “Making the Most of Interesting Times in the Bond Markets”12 provides further analysis of the new issue market, as well as a more detailed overview of the liquidity opportunities currently available to Buy and Maintain investors.

4. Ensure fundamental credit views drive sell decisionsSell discipline is an important determinant of investment outcomes

Buy and Maintain isn’t buy and hold. Securities can be sold (and bought) if there is a significant change in their credit outlook—notwithstanding important accounting considerations in certain markets. Therefore, it’s crucial that fund managers have a robust sell discipline, as this can be a major determinant of the shape and risk/return profiles of possible outcomes when looking at Buy and Maintain portfolios. Poor sell decisions often outweigh good buying ideas.

A recent study by Inalytics, a London-based investment research group, quoted in the Financial Times,13 looked at the impact on performance of all 45,000 trades made by a group of pension funds between December 2003 and September 2006. Whereas buying decisions, on average, improved returns compared with the relevant benchmark index by 0.47 percentage points before fees, selling decisions had a total negative impact of 0.94 percentage points.

The reason sell decisions are so difficult to make appears to be psychological. As the Financial Times article explains, investors can be slow to admit an error in their research if an investment falls in value (or begins to suffer credit downgrades). They do not want to crystallize a loss, although delaying a sale is likely to cause further pain.

12 “Making the Most of Interesting Times in the Bond Markets,” J.P. Morgan Asset Management (March 2014).

13 John Authers, “Hard sell: why fund managers underperform,” Financial Times (May 21, 2014).

Fund managers should make informed sell decisions based on multiple factors

For Buy and Maintain fund managers, the aim should always be to try to hold securities to maturity, rather than trading the portfolio for short-term gains or to sell securities based on strict and inflexible guidelines as soon as they are downgraded. The insurance company’s stakeholders—its policyholders and shareholders—want to avoid transaction costs and accounting volatility.

However, simply holding a bond until maturity without making any allowances for ongoing risk controls or the threat of default may lead to higher losses. Therefore, the fund manager should be given the chance, when possible, to make informed and disciplined decisions to sell securities based on rigorous credit analysis.

An example of why a sell discipline based on rigorous credit research is important is provided by crossover credit securities. The opportunity in crossover credit exists at the point of separation between the credit ratings of high yield bonds and investment grade bonds. Credit spread differentials are widest in crossover credits, i.e, BBB spreads vs. BB spreads (Exhibit 11A and Exhibit 11B, next page).

The yield “pickup” in crossover credit may be disproportionately large relative to the incremental default risk incurred. The fund manager will therefore need to assess the trade off between the impact of any downgrade on the insurer’s capital requirements, vs. the cost of replacing the security in the portfolio if it is sold (in terms of trading costs, loss in yield etc.).

Credit analysis is key, but market and client factors also need to be taken into account

For the fund manager, the decision whether to sell a security will depend on the interaction among the portfolio manager, the credit research analyst and the trader. In a very long-duration portfolio, ongoing credit surveillance by experienced credit analysts is vital, as the longer a security is held the greater the chance of default.

Ideally, all securities covered by a credit analyst should be assigned a rating depending on their risk of default, on a scale from moderate to severe or even critical concern. Ratings can then be discussed in formal credit watch list meetings, with action points assigned to securities depending on whether they are held in strategic Buy and Maintain portfolios or higher turnover tactical portfolios.


However, the credit analyst will only give an opinion on the credit outlook for an issuer or security. It’s the portfolio manager who decides whether to sell, and if so, when to execute a sell order. The sell decision will be driven by many factors, not just the credit outlook. Even if a security suffers a deterioration in credit quality, the portfolio manager should weigh any urge to sell with the unique market considerations and constraints of the insurance client at the time. Ultimately, the only difference in view between the portfolio manager and credit analyst should be a question of timing on executing the order.

Discerning fund managers can take into account the wider spread differentials in crossover credits.

EXHIBIT 11A: INCREMENTAL YIELD VS. INCREMENTAL DEFAULT RISK

0.72%

2.10%

1.61%

0.17%

0.80%

2.31%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

A vs. Baa Baa vs. Ba Ba vs. B

Incremental portfoliogovernment OAS*

Incremental defaultprobability**

Earns largest incremental yield fordisproportionately small increase in default risk

Source: Bank of America Merrill Lynch, Moody’s annual corporate default study, 2013. *Based on global corporate and high yield indices averaged over 10 years to June 2014. **Annual issuer-weighted corporate default rate by letter rating, 1920-2013.

EXHIBIT 11B: HISTORICAL DEFAULT RATES

0.26%

1.37%

2.76%

4.24%

0.67%

3.70%

7.35%

10.70%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

1 Year 3 Years 5 Years 7 Years

Over time, downgrades and defaultscan increase, placing an emphasis on

portfolio construction and credit monitoring

Baa3Ba1

Source: Bank of America Merrill Lynch, Moody’s Annual Corporate Default Study 2013. *Based on Global Corporate and High Yield indices averaged over 10 years to June 2014. **Annual issuer-weighted corporate default rate by letter rating, 1920-2013.

A portfolio manager should not be forced to sell assets, either by a strict automatic sell discipline or simply based on relative value considerations, if the transactions lead to negative accounting or asset-liability implications, except in cases of hard regulatory constraints. As an example, in several local GAAP regimes, such as the U.S., as well as with IFRS, if a security that is classified as “held to maturity” (HTM) is sold, the rest of the portfolio immediately becomes tainted and is marked to market. As such, many insurance companies try to avoid the HTM classification and instead opt for securities classified as “available for sale” (AFS).14

Nevertheless, there will be times when the most prudent course of action is to sell a security. Sometimes a sale may even be mandated. For example, many insurance portfolios will target higher yielding A and BBB rated securities. If these securities are downgraded to below B-, some jurisdictions, such as Germany, will require a sale, while others, such as the U.S., will impose higher capital charges that become onerous depending on how far the security is downgraded. Once the decision is taken to sell, the portfolio manager will work with the trader to ensure the best price is obtained.

5. Measure performance based on initial portfolio economics and credit migrationInsurance companies hold economic capital proportionate to the difference between the market value of their investment portfolio relative to liabilities and a “worst case” value given some severe market shock (Exhibit 12, next page). The goal is to earn a return on that capital that is appropriate to the expectations of the insurance company’s stakeholders.

A fund manager’s success in managing a Buy and Maintain portfolio should therefore not be measured by whether or not they are outperforming a public benchmark or smart beta index. Instead, Buy and Maintain investors should be focused on measuring multiple factors, including the portfolio’s economics and credit deterioration over time.

14 Bonds classified as HTM are not marked to market. AFS bonds are marked to market with the unrealized gains and losses usually flowing through “other comprehensive income” and not included in the income statement, but recorded as a separate line item on the balance sheet until realized. Bonds classified as “trading” will reflect all valuation changes directly in the income statement. Insurers seek to minimize this classification, as it can introduce market volatility into their reported income statements and thus the company’s valuation.



Measuring portfolio economics

It is essential that the fund manager gets the “economics” of the portfolio construction right. This means that the fund manager has to ensure that bonds can be purchased and the portfolio constructed to achieve a risk/return profile that is comparable to, or better than, the custom asset benchmark. Investors should focus particularly on how well cash flows are being matched to minimize reinvestment and liquidity risk.

Because the custom asset benchmark cash flows are based on the investor’s own liability cash flows and capital position, investors can measure ongoing performance relative to the benchmark. On this basis, the fund manager will generate value depending on how well the credit and duration bets perform relative to the asset benchmark within agreed risk parameters. Investors should measure average credit quality requirements, as well as spread targets to exceed for each maturity bucket in the portfolio. These targets will be set based on the insurer’s capital position, acknowledging that the manager should not sell existing securities but can only deploy new money or money from maturing bonds.

As illustrated in the second element of this framework regarding benchmark construction, it’s crucial for investors to build custom asset benchmarks that take the Buy and Maintain objectives of their portfolios into account. Only then can the performance and skill of their fund managers be measured effectively.

Once this approach is integrated into performance measurement, insurers can seek fund manager compensation linked to how effective portfolio construction has been and to what extent

the fund manager is helping to meet its asset-liability objectives. The fund manager should not be compensated based on outperformance of a public benchmark, but rather held to a custom benchmark that takes into account credit migration for the non-discretionary portfolio. As Exhibit 13 (next page) demonstrates, the true performance for a fund manager will be the spread less realized losses and the cost of capital set aside to compensate for credit migration, among other items.

Measuring credit migration

Given the importance of Buy and Maintain portfolios for regulatory capital and accounting purposes, measuring credit migration is critical. Downgrades (and upgrades) should be measured, as they will effect the insurer’s capital position, while defaults must also be tracked, as they will crystallize losses on the balance sheet. Any outperformance in terms of the credit quality of the portfolio will generally be positive for an insurance company’s reserves and capital, while any underperformance will be negative.

Buy and Maintain investors should therefore incorporate some expected downgrade and default risk into their return forecasts. This could involve composing the reference portfolio from a market measure of downgrades and defaults (such as Moody’s or Fitch data on corporate bond downgrades and defaults), which would then allow the Buy and Maintain portfolio’s ratings migration to be compared with a benchmark over time (Exhibit 14, next page). Using a market measure of downgrades and defaults makes sense when gauge credit migration, as changes in public ratings will drive capital consumption through regulation.

Insurers need to hold sufficient capital to absorb a worst-case shock to their net asset-liability position from market risk factors.

EXHIBIT 12: ZURICH EXAMPLE BALANCE SHEET EXPOSURE TO RISK FACTORS

Equity risk

Interest rate risk

Term structure risk

Credit (spread) risk

Liquidity risk

Risk factors

Equity risk

Assets Liabilities Zurich Insurance Group net exposure

Liquidity risk

Interest rate risk

Term structure risk

Commodity risk

Credit (spread) risk

Typical insurance balance sheet exposures

21%

9%

14%

48%

8%

Darker shades indicate higher exposures

Source: companies’ website, financial reports.


For example, take a new annuity that is priced according to a reference portfolio and custom benchmark. If the custom benchmark is constructed based on Fitch averages for historical downgrades and defaults, and if the Buy and Maintain manager’s own superior credit analysis allows the portfolio to outperform these averages in terms of migration and default, shareholders and customers benefit. Importantly, through time, with positive experience, underwriters can gain the confidence to offer more competitive crediting rates.

This is why it’s crucial that investors employ fund managers with proven credit research resources, so that their Buy and Maintain portfolios have the potential to experience lower migration and defaults than the market.

Using a performance scorecard

Buy and Maintain portfolios are designed to reflect funding profiles (both liabilities and capital) and the objectives of all of an insurer’s stakeholders—both policyholders and shareholders. Shareholders are naturally more interested in the short-term level and volatility of accounting earnings (as they impact analyst valuations), while policyholders are naturally more interested in longer-term solvency (to pay out their policies).

Credit spreads typically consist of many components, so assessing each one accurately is the key to unlocking fixed income alpha

EXHIBIT 13: DECOMPOSITION OF CORPORATE YIELDS

Spreads

Composition of yield

Market yield

Liquidity

Credit

Rates

Composition of spread What is at risk to insurer?

No risk if funded by illiquid and matched liabilitiesLiquidity premium

Cost of capital

Expected losses

Inflation

Term premium

Real rates

Lower risk to insurer

Default volatility*: fully at risk

Expected losses: fully at risk Higher risk to insurer

Downgrade risk: if downgrade causes credit limit breach and forces sales

Spread volatility: only at risk if unmatched sold prematurely

Source: J.P. Morgan, Oliver Wyman; for illustrative purposes only. *Capital set aside to cover deviation of actual losses from expected losses.

A market measure of credit downgrades can help investors assess the credit migration performance of their Buy and Maintain portfolios over time.

EXHIBIT 14: FITCH GLOBAL CORPORATE FINANCE AVERAGE ANNUAL TRANSITION RATE PERCENTAGES. 1990-2013

AAA AA A BBB BB B CCC to C D Total

AAA 93.62 6.12 0.26 0.00 0.00 0.00 0.00 0.00 100.00

AA 0.13 90.00 9.43 0.38 0.02 0.02 0.00 0.04 100.00

A 0.01 2.03 91.85 5.46 0.46 0.07 0.04 0.08 100.00

BBB 0.00 0.17 3.37 91.88 3.63 0.54 0.20 0.20 100.00

BB 0.02 0.04 0.10 8.47 81.99 6.78 1.40 1.20 100.00

B 0.00 0.00 0.22 0.39 8.81 84.36 4.07 2.15 100.00

CCC to C 0.00 0.00 0.00 0.35 2.08 19.55 51.38 26.64 100.00

Source: J.P. Morgan Fitch.



To keep track of whether their Buy and Maintain portfolios are achieving these objectives, investors can build a performance scorecard that measures performance relative to their own individual investment and risk objectives, such as the example in Exhibit 15.

The performance of the portfolio is measured by comparing it with the insurer’s customized reference portfolio (or asset benchmark), using traditional attribution factors such as key rate duration and curve positioning, currency exposure, credit spread exposure, cross-market exposure, inter-market exposure, curve roll and accretion exposure, and residual exposure.

Client-specific factors should reflect the preferences of all stakeholders, including policyholders, creditors and shareholders, if any. These factors might include analysis of accounting measures (Generally Accepted Accounting Principles and Statutory Accounting), portfolio risk vs. the reference index (effective convexity, spread duration, weighted average life, option adjusted spread and Sharpe ratio), the rate of return vs. the reference index (including performance of credit positions vs. duration positions), and the portfolio’s credit migration over time.

Weighting each of these measures in the objective function of the group should then reflect the relative importance of the preferences of each of the stakeholders and their representatives, the regulators and the board of directors.

Performance should be measured relative to individual investment and risk objectives.

EXHIBIT 15: MEASURING ATTRIBUTION AND PERFORMANCE VIA A SCORECARD APPROACH

Accounting Measures

Market Value ($MM)

Book Value ($MM)

Un- realized

Gain/Loss ($MM)

Book Yield (%)

Impair- ments

Net Investment Income ($MM)

1M QTD YTD

Portfolio Characteristics

Rating % Coupon % OAD % WAL %

Credit Migration

Rating Impact YTD Downgrade No Change Upgrade Total

Portfolio Risk vs Benchmark

Delta

Val

ue

1bp

Opt

ion

Adju

sted

Du

ratio

n (O

AD)

Effe

ctiv

e Co

nvex

ity

Spre

ad

Dura

tion

Wei

ghte

d Av

erag

e Li

fe

(WAL

)

Opt

ion

Adju

sted

Sp

read

Valu

e at

Ris

k

Shar

pe

Ratio

ROR (%)

MV + A ($MM) YTW YTM 1M QTD 3M YTD 1Yr 3Yr

Simple Attribution Model (Portfolio vs. Benchmark)

Credit Sector

3 months YTD

Return

Market Value plus

Accrued Interest (%)

Over/Under (%) Return

Market Value plus

Accrued Interest (%)

Over/Under (%)

Port

folio

Benc

h

Port

folio

Benc

h

Sect

or

Secu

rity

Tota

l

Port

folio

Benc

h

Port

folio

Benc

h

Sect

or

Secu

rity

Tota

l

Source: J.P. Morgan, for illustrative purposes only.


ConclusionBuy and Maintain portfolios provide an effective way for insurance companies and other liability-driven investors to match investment income from a portfolio of investment grade bonds to their balance sheet liabilities while preserving that income over time and avoiding the need to realize losses—or gains—that could give rise to accounting volatility.

Because insurers seek to maintain their holdings for the long term, Buy and Maintain investing requires a different way of thinking. As we saw during the credit crisis, using the wrong principles to manage Buy and maintain investments can lead to income impairment and, ultimately, capital losses. Our comprehensive investment framework describes how investors can build more resilient Buy and Maintain portfolios that can be measured effectively over the lives of their investments.

First, investors should avoid public benchmarks when instructing fund managers to construct portfolios or measuring performance measurement. This is crucial, mainly because market indices will have sector and issuer weightings that Buy and Maintain portfolios are not forced to replicate. Therefore, any comparison with a benchmark is likely to be irrelevant at best, or at worst lead to fatal errors in portfolio construction that can seriously harm future performance.

Instead, the portfolio construction process should begin with an analysis of the liabilities of the company and its specific investment objectives and risk constraints. The portfolio can then be constructed to meet those liabilities without any reference to a benchmark allocation. In order to confidently pick securities that can be held to maturity, Buy and Maintain fund managers require an investment process that is focused on fundamental credit research, so that the key drivers of the credit profile of a company can be fully understood. The investment team also needs to have long-term visibility on the sectors that issuing companies operate in, so that it can pick securities that are resilient across the business cycle.

Although the objective of Buy and Maintain is to keep holdings to maturity, there may be times when securities need to be sold or replaced. This sell discipline needs to be flexible and driven by the fund manager’s fundamental opinion on the credit quality of the issuer. The aim should always be to try to hold securities to maturity, rather than to trade the portfolio for short-term gains. Regular rebalancing and portfolio trading are the enemies of the Buy and Maintain investor.

Finally, performance measurement should reflect the investor’s individual risk profile and the objectives of all stakeholders, as opposed to a simple focus on book yield maximization or relative to a public benchmark. We suggest a comprehensive performance scorecard approach to help investors evaluate the success of their investments—including, most crucially, the credit migration of their portfolio over time, as any outperformance in terms of the credit quality of the portfolios would generally be positive for an insurance company’s capital position, while any underperformance would be negative.

The author would like to thank Patrick Justen and Richard Hall for their contributions to this report.


NOT FOR RETAIL DISTRIBUTION: THIS COMMUNICATION HAS BEEN PREPARED EXCLUSIVELY FOR INSTITUTIONAL/WHOLESALE INVESTORS AS WELL AS PROFESSIONAL CLIENTS AS DEFINED BY LOCAL LAWS AND REGULATION.

The opinions, estimates, forecasts, and statements of financial markets expressed are those held by J.P. Morgan Asset Management at the time of going to print and are subject to change. Reliance upon information in this material is at the sole discretion of the recipient. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as advice or a recommendation relating to the buying or selling of investments. Furthermore, this material does not contain sufficient information to support an investment decision and the recipient should ensure that all relevant information is obtained before making any investment. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data.

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