Keeping an eye on things
The chart above shows estimated losses on the recent credit spread movements on the corporate bond exposure of a firm like Just Group. First of all, let me state I have nothing against Just, which I am using as an example. My target, as always, is the regulatory system that approved the capital position of such a firm in the first place.
As we commented here, increase in spreads could indicate decrease in ratings down the line. The chart indicates that the BBB spread has jumped up following the market collapse this month. Insurers hold significant amounts of this ratings class – see e.g. the Just Group financial report out today, p.17, so they are at some risk of their holdings being downgraded to junk status.
InsuranceERM comments today “Widening credit spreads and bond downgrades will weaken insurers’ capital, particularly for life insurers with guaranteed products or large portfolios of annuities. Bond downgrades will either force insurers to hold more capital, or sell the assets.” Correct, and as we noted in our earlier post, the assets sold will have to be replaced by better-rated assets, generating an instant and irrecoverable loss.
Zerohedge discusses the problem here, noting that $3 trillion in bonds are on the cusp of downgrade, that the bulk of BBB rated issuance was used to fund the trillions in buybacks that levitated the stock market over the past few years, and stating (without any sense of alarmism, meh) that
as of this moment, over $140 billion of debt issued by independent oil and gas producers, oilfield services providers and integrated energy companies has triple-B credit ratings from Moody’s or S&P and is now at risk of falling to junk status.
But as they also note, rating agencies have in the past been “painfully behind the curve and slow to adjust to changing fundamentals” so it will take some time for all this to work out.
Fortunately life insurers have plenty of time.
The screen was not a pretty sight this morning.
There was an interesting article last week in the Actuarial Post about the impact of the crisis on life insurers. Unfortunately they got the main point wrong, arguing that the asset side would be hit by “declines in bond yields”.
See table below, sourced from Financial Times market data. The FTSE is down 11% since the start of the current market crisis (around the middle of February 2020), but it looks as though insurers have been disproportionately affected.
Kevin writes here
It also gets interesting if the firms use different valuation approaches from each other. In that case it would be theoretically possible for both parties to post a profit on the transaction or for both parties to post a loss on it.
He is referring to the approaches used to value the embedded put option in the ERM, and the actual put option used to hedge the ERM.
There is a troubling reminder here of what happened to AIG Financial Products in the run-up to the last financial crisis.
Earlier this week, Golden Retriever (who is a bit of a dog) asks
Would also be great to get any thoughts you have on why Network Rail bonds yield more [20bp] than gilts even though they are guaranteed by the UK government
This is an objection to my earlier observation that illiquid spreads amount to a matter of basis points. Continue reading “From the postbag – Network Rail bonds”
A busy day at the Post Office. K9.dogs is still intrigued by our earlier suggestion that the illiquidity premium is only c.5bps. Could we have a blog on that? Indeed, but that will have to wait until next week. Illiquidity premia require patience (unless you are an insurance company).
Max LikeyHood (sic) at maximumlikeyhood@gmail.com asks if we can make our implementation of the Bank’s structural model available. Yes, in the interests of transparency, public disclosure etc, here it is. The usual disclaimers apply – at your own risk, no representation is made etc. There is an additional bonus in that we have included the Basel IRB model at the bottom. Any questions, please ask in the usual way.
And keep up with the weird email addresses!
K9 asks whether I believe some or all of the following.
1) the Merton model is inappropriate here;
2) that the BoE has parameterised the Merton model incorrectly; or
3) that this “residual” bit of the spread is accounted for something other than credit and liquidity.
All three as it happens.
The Retriever has found another juicy bone. He (or she?) writes in raising a number of points about credit spreads, questioning my suggestion (following John Vickers’ assertion) that credit spreads rose in 2018 ‘Largely, if not wholly, because corporate credit risk has gone up’.
Retriever raises a number of interesting points. For the moment (and in a subsequent post) I will focus on the challenge presented to our case by the Bank of England’s structural credit model. As Retriever points out, Chart E of this 2016 inflation report (page 13 of the PDF, and copied above) suggests that the Bank of England thinks that the illiquidity premium is something like 50% of the corporate bond spread.
Presumably you must think that either 1) the Merton model is inappropriate here; 2) that the BoE has parameterised the Merton model incorrectly; or 3) that this “residual” bit of the spread is accounted for something other than credit and liquidity.