Key features of a short-dated enhanced income strategy for insurers
- Targets a higher yield than comparable alternatives with relatively low risk and solvency capital requirement (SCR) contribution
- Aims for price stability, such as implementing a minimum A- portfolio rating and duration under 2 years
- T+1 liquidity
- Vanilla instruments only (derivatives for interest rate and foreign exchange hedges only)
- Very low modelled drawdowns and volatility
Investment environment
Both SOFR and SONIA benchmark interest rates have risen more than five percentage points since 2022. The return of yield to the market and the continued inversion of the yield curve have led insurers to focus on shorter tenor investments. As insurers prepare for potential future rate cuts and make sure they are working investments as hard as they can within risk and capital appetites, short-dated enhanced income (SDEI) strategies offer an option to improve the yield achieved on T+1 liquidity laddered assets.
Delivering an enhanced yield
As demonstrated in Figure 1 below, SDEI strategies have the potential to generate significant yield pick-ups (including when currency hedged) compared to money markets and other short-dated credit options – whilst keeping price stability and liquidity front of mind. We believe that SDEI strategies should not compromise on these principles, avoiding the chase for yield in higher-risk market segments.
Taking a global approach unlocks a broader opportunity to seek investment in higher quality credits that can deliver a yield enhancement whilst balancing liquidity and price stability.
Figure 1: SDEI (1) yield to worst vs alternatives
Source: abrdn and ICE BoAML Indices as at 31 May 2024. ( 1) A typical SDEI strategy is used a proxy to provide SDEI indicative yield to worst
Enhanced yield in action
One example comes from the real estate sector. In July 2023 we purchased the short-dated bonds (maturing in November 2025) of Cromwell Property, a European property company with a strong BBB rating.
Due to sector headwinds at the time, we were able to access a yield to maturity of 9.2%, comparing favourably to 4.8% for a generic BBB 1-3 year Euro corporate bond. By nearly one year later (31 May 2024) the bonds had delivered a total return of 12.3% (Euro hedged).
This is around 8.7% percentage points higher than the 1-3 year global corporates index, which delivered 3.6% (Euro hedged) in the same period. Furthermore, Cromwell’s credit profile remains stable, and with 18 months to maturity remains attractive compared to alternatives.
We expect the average yield enhancement over money markets to be +1.75% a year.
Bond yield curves are currently inverted, with cash yields anchored to central bank rates. However, SDEI strategies can still target 0.5% to 1% a year (depending on shareclass currency) above money markets. In the long run, we expect the average yield enhancement over money markets to be +1.75% a year.
Price stability
The investment guidelines of an SDEI strategy are essential. They should set the foundation for delivering liquidity and price stability, balanced with the flexibility to deliver an enhanced yield. We think the below factors are some of the most important to deliver this outcome:
- Portfolio duration of two years or less, generating pull-to-par effects and reducing volatility
- Core opportunity set formed of single A- rated credit or better, which supports a minimum average A portfolio credit rating
- High yield allocations constrained, with quality remaining a focus:
- Maximum of 20% of overall portfolio
- Core opportunity set BB rated
- Maximum of 5% allocation to single B rated names
- No CCC rated names allowed
To assess how SDEI strategies’ net asset value (NAV) risk might materialise in practice, we have constructed an index representing an average asset allocation and risk profile based on the guidelines discussed in this paper.
We have compared this to global corporate indices (1–5 year and all maturity indices) and to a global government bond index. The results are shown in Figure 2.
Key takeaways from this analysis:
- SDEI strategies have the potential to offer an enhanced risk-adjusted outcome with a considerable reduction in volatility
- 2008 was the largest drawdown (3.8%) but much better versus alternative credit indices
- 2022 (one of worst periods on record for fixed income) saw 3.5% drawdown – a strong outcome vs alternative credit and government bond indices.
In practice, an active manager would aim to enhance the return and further reduce drawdowns. An example SDEI strategy has a yield of c.6% a year compared with the proxy index of 5.3% (USD).
Figure 2: Proxy index – maximising an SDEI* strategy yields vs. volatility & drawdown (as at 31 May 2024)
Performance and volatility
| Proxy Index | 1-5 year global corps | Global corps | Global govt. | |
| Yield (%) | 5.3 (SDEI* c.6%) |
4.9 | 5.1 | 3.6 |
| Duration (years) | 1.3 | 2.7 | 6.0 | 7.2 |
| Total return | 3.0% | 3.3% | 3.9% | 2.8% |
| Volatility | 1.6% | 2.6% | 5.3% | 3.7% |
| (Total Return / Volatility) | 1.8 | 1.3 | 0.8 | 0.8 |
Drawdown analysis
| Max drawdown | -3.8% | -8.4% | -18.0% | -14.6% |
| 2022 (Russia/Ukraine) | -3.5% | -8.4% | -18.0% | -14.4% |
| 2020 (Covid 19) | -2.5% | -3.8% | -6.9% | -1.0% |
| 2015 (energy sellof) | -0.2% | -0.7% | -3.1% | -3.3% |
| 2013 (Euro sov crisis) | -0.3% | -1.2% | -3.9% | -2.7% |
| 2008 (financial crisis) | -3.8% | -5.4% | -10.8% | -2.3% |
*Example SDEI strategy. Performance USD hedged, gross of fees. Proxy index blend: 55%
ICE BofA 1-3 Year Global Corporate Index, 10% ICE BofA US Treasury Bill Index, 10% ICE
BofA 1-3 Year BB-B US Cash Pay High Yield Constrained Index, 20% ICE BofA 0-1 Year US Corporate Index, 5% abrdn US money markets fund.
Source: abrdn, 31 May 2024.
Liquidity
T+1 liquidity can be targeted by SDEI strategies when guidelines are carefully considered. The SDEI strategy discussed in this paper maintains 10% in treasury bills, which supports maintaining a minimum of 15% of assets inside a 1-year maturity (current allocation over 35%).
This also serves to further drive the price stability objective of these strategies. Achieving T+1 liquidity is an improved outcome versus traditional short-dated credit funds, which are typically T+3 liquidity.
Solvency II capital treatment
SDEI strategies can offer an attractive investment for insurers in terms of Solvency II capital efficiency.
On a standalone basis (i.e., ignoring all other assets and liabilities), the abrdn strategy’s standard formula SCR at 29/09/2023 was 9% of the investment value, significantly lower than the 12% or 20% from abrdn’s short-dated and all-maturity corporate bond funds.
The increase in capital requirements from investing in SDEI would be materially lower than 9%
Notably, the increase in capital requirements from investing in SDEI would be materially lower than 9%, since this figure takes no credit for diversification with (i) other investments and (ii) non-investment risks. Furthermore, cash/money market investments attract a non-zero capital charge. Therefore, an insurer moving out of cash would expect to see their capital requirement increase by an amount much lower than 9% of the amount invested.
Summary
At first glance, SDEI strategies might look similar to other short-dated options. However, through careful portfolio construction, a truly global approach and an understanding of insurance asset management, SDEI strategies can blend the benefits of money markets and credit to provide an attractive option for insurance companies.
Companies are selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance. Past performance is not a guide to future results.