Issues & Answers: Investing in Alternatives

Reed Nuttall
Principal and Chief Investment Officer
AAM

 

“Both history and our models suggest that diversification and being disciplined about adding risks lead to higher returns and more stability. That’s our strategy.”

We focus solely on the insurance industry. As such, we have an eye toward maximizing income for any given level of risk. We’re trying to maximize income whether the 10-year Treasury is at 6% or whether it’s at 1%. However, what we’re seeing down here at 1% is that risk assets tend to be mispriced, as everyone crowds into the same risk in search of yield. We have a disciplined approach to evaluate each client’s risk profile and suggest asset classes that improve income within each client’s specific profile. We found private placements, commercial mortgage loans, convertible bonds, bank loans, and high yield, all stand out as opportunities in this environment if managed with a focus on risk mitigation.

A portfolio consisting of both common stock and convertible bonds provides a great mix of market upside with some downside protection. A convertible bond has two components, a bond and an option on the stock price. What you’re doing is buying exposure to the underlying stock price movement. It comes with a floor on the downside, and that floor is established by the price of the underlying bond. It’s this bond component that gives convertibles favorable capital treatment in insurance company portfolios. A properly managed convertible portfolio can provide both the upside of the stock market and the stability of bonds in a capital-efficient way.

How do private placements and mortgage loans contribute to client portfolios?

We’ve been investing in investment-grade private placements for decades. We found that they offer superior yield and more credit stability than public securities, and they fit well for both P&C and Life portfolios. In March of last year corporate bond spreads significantly widened versus Treasuries and then retraced pretty quickly in the second quarter. Private placements, because of their nature, tend to be less liquid and less volatile than public bonds, yet offer higher yields for similar risks.

What can companies do to limit the negative effect of rising interest rates on their portfolios?

If you have callable bonds in your portfolio, when rates rise, those call options may not get exercised. This causes durations to extend in portfolios with excess call risk. At AAM, we’re very disciplined about duration management. What we saw in the first quarter of 2021 is that the duration of mortgage backed securities (MBS) moved from 2.3 to 4.1, so a lot of extension. We stayed away from the MBS sector last year, and it’s even less attractive this year. We do find that higher quality bank loans, collateralized loan obligations or CLOs, provide both additional yield and price stability because their coupons reset as interest rates go up and the prices stay around par. Also, some of the strategies that we talked about—being disciplined about your approach to duration, adding yield where you can in a high-quality fashion—have really helped us enhance the income to our clients’ portfolios. There’s no such thing as a free lunch.