Although immunisation and asset matching strategies are essential for captive insurance portfolios so as to minimise business risk, central bankers have forced bond yields to such artificially and historically low levels that returns on fixed income portfolios have been disappointingly low.
Further as interest rates persist at these low levels and coupon payments remain at low levels, insurance company portfolio duration automatically extends to the extent that actuarial projections previously calculated no longer apply.
While fixed income coupon payments are at historically low levels, dividend paying stocks have moved into what we consider “the sweet spot” of investing. Whereas in previous decades fixed income securities were purchased for income, coupon payments are so low that blue chip companies like Royal Dutch Shell and AT&T are paying far more on dividend payments than they do on their medium term debt issuance (see Figure 1) even after taking account of tax withheld at source.
Figure 1: Equities for yield
Source: Bloomberg 9/06/2012 * 5 year Bond Yield
So while low interest rates are problematic for captive portfolios, dividend paying stocks which have a history of maintaining and increasing income distributions to its shareholders should be considered, particularly for more mature captives.
Whereas bonds have previously been used for income, matching income receipts against claims payouts, they must now be viewed as capital preservation vehicles and applied to captive portfolios as would a zero coupon bond – ie maturity of bond against expected payout of claim. Fixed income securities should still be used by captives for capital preservation purposes, but dividend paying stocks, controlled for consistency of payment, do provide an opportunity for recovering income flow into the portfolio whilst giving potential for capital appreciation.
Moreover, a captive portfolio entirely invested in fixed income securities presents some risk to the captive when one considers that in a rising rate environment, bond prices will fall.
The Fed Model compares S&P 500 earnings yield against the US Treasury Ten-Year bond yield. When Ten-Year Treasury yields are well in excess of earnings yields on the S&P 500 Blue Chip stocks, as in the years 1983 to 1994, we say that stocks are overpriced relative to US Treasures.
Alternatively during the years from 1980 to 1982 as well as since 2011, stocks were under-priced on a yield basis relative to the Ten-Year Treasury. Although these anomalies can persist for some time, history has shown that they provide rich opportunities when yield disparities are at their extremes. (See Figure 2)
Figure 2: The Fed Model: 10-Year Treasury minus S&P 500 Earnings Yield
Market risk is a fundamental reason for excluding stocks from a captive portfolio. After all captives are set up to insure risk and any market risk must be “controlled” so as to not distract the captive from its core enterprise objectives.
In 1998 Credit Suisse First Boston (CSFB) initiated a study to measure extremes of investor sentiment. Of interest to BIAS is how the extremes of investor sentiment signal turning points of stock market performance as indicated by the S&P 500. (See Figure 3)
Figure 3: CSFB’s Global Risk Appetite and the S&P 500 Index
Previous Extreme Lows in Global Risk Appetite Have Been Associated with a Major Turning Point for Equities
Source: Credit Suisse First Boston
Specifically, extremely negative sentiment, as shown by a global risk appetite (GRA) score in excess of negative 3, was followed by strong rallies in the stock market. We see this in 2002, 2008/9 and more recently in 2011.
At present GRA hovers slightly above the panic stage which tells us that stocks are reasonably valued (because sentiment remains somewhat negative) and that any deterioration in sentiment near term could result in a strong upward movement in the broad stock indices thereafter. Many stocks in the S&P 500 do not pay dividends and those that do tend to fare better in good and bad times. All of this leads us at BIAS to believe that the place to be during times of negative GRA is in stocks that have a discipline of regularly returning capital to investors in the form of dividends.
This is proven by a review of the performance of our Dividend Income Strategy for various time periods up to 31 August, 2012. The outperformance relative to the S&P Global 1200 has been outstanding.
Mature captives are generally willing to invest approximately 20 per cent of their assets in equities; however, to date this exposure has been focused on total return with little concern for income. Although the total return objective should not be ignored over the longer term, captives would do well to focus on income generation during quarterly performance reviews. Indeed in assessing BIAS’ own dividend income strategy, performance well exceeded that of the broad stock indices as indicated in Figure 4.
Figure 4: BIAS Global Dividend Income Strategy vs. S&P Global 1200
* All performance shown is current Dividend Income Strategy back-valued five years, rebalanced annually.
Past performance is no guarantee of future results.
In addition to the greater return benefits, dividend income strategies have provided a lower level of risk than the broad stock indices as shown in Figure 5.
Figure 5: Risk return comparisons of stock indices. Last 10 Years June 2002 – June 2012
All this argues for a higher allocation to equities in captive portfolios subject to capital constraints and subject to equities exposure being focused on stocks that have consistently maintained or increased dividends over an extended period of time.
Captive sponsors should be aware that in the event of an economic recovery, bond yields will be released from their current artificially low levels resulting in falling bond values.
In order to make up for low levels of income produced by fixed income portfolios in the current low interest rate environment as well as the risk of higher interest rates and falling bond prices in the future, captive insurance portfolios should increase their allocation to equities wherever possible focusing on dividend payers which have consistently increased dividend payments over an extended period of time.