Benchmark government bond yields in the major advanced economies have been falling for many years. The fall accelerated after the 2008 financial crisis, with yields in the US, the UK and Germany hitting lows below 2% in the summer of 2012. The yield on the US 10-year Treasury dropped to as low as 1.4% and German yields even got close to the 1% mark.
Slow growth, modest inflation and very expansionary monetary policies arguably contributed to the decline. The major central banks across the globe have not only been keeping policy interest rates close to zero, they have also resorted to unconventional monetary policy instruments. These include purchases of government bonds and mortgage backed securities (MBSs) to lower long-term yields, incentives for banks to lend to the economy via ‘funding for lending’ schemes, and pledges to keep interest rates low for a pre-defined period or until certain conditions are met.
It seems the days of these extraordinary measures are slowly coming to an end, with a gradual exit from this extraordinary monetary expansion. In May 2013, the then-chairman of the Federal Reserve Board (Fed), Ben Bernanke, hinted that the Fed would consider tapering the amount of assets it was purchasing on a monthly basis. The markets responded immediately, with bond yields surging so much so that the Fed had to backtrack on its tapering plans. However, the Fed has now begun to reduce its monthly asset purchases, starting with a US$10bn cut back this month from US$85bn to US$75bn. Our expectation is that Fed will halt the monthly purchases entirely before the year is out.
Will Rising Yields Choke Economic Recovery?
There are worries that the end of very loose monetary policy will choke economic recovery. However, despite tapering, the Fed has made it clear that tapering is not tantamount to raising interest rates. Indeed, the general expectation is that the Fed will keep policy rates at their current level close to zero throughout 2014. In addition, long-term government bond yields remain at very low levels, despite the sharp increase in 10-year Treasury yields of more than one percentage point in 2013. We expect yields to rise only gradually to 3.5% by the end of 2014 – a level no higher than in early 2011. Finally, rising interest rates reflect an improving economy that should be increasingly resilient to a moderate interest rates increase.
The risks from the Fed’s return to more normal monetary policy are a little higher outside the US. Remember that when the Fed started talking about tapering for the first time last May, the reaction was most severe in emerging markets. The Indian rupee (INR) and the Brazilian real (BRL) dropped by around 20% and the South African rand (ZAR) by more than 10% between late March and August. As investors withdrew from emerging markets, spreads on emerging market bonds increased. While US stock markets barely blinked, the MSCI emerging markets index lost around 10%. This market reaction reflected fears that investors will withdraw their money from higher-yielding investments as returns become more attractive again in the US and other advanced markets.
European stock markets also suffered in response to the Fed’s tinkering with the idea of tapering. The European economies are more vulnerable to rising interest rates than the US due to highly leveraged corporate balance sheets in the peripheral economies and the uncertainty around the health of the banking system. Fortunately, the increase in European yields has been more muted up to now. In fact, peripheral yields even declined in 2013. Still, a spike in bond yields could pose a risk to the fragile upswing in Europe.
Insurers will Eventually Benefit from Rising Yields
Savers will benefit from rising interest rates and ‘savers’ includes insurers. The global insurance industry is estimated in 2012 to have managed and invested around US$26,800bn in funds, or about 12% of global financial assets. The bulk of these investments is managed by life insurers. So, an increase of one percentage point investment returns will result in additional investment income of about US$268bn per year, or about 6% of global premium income. For this reason, the expected increase in interest rates should be a blessing for insurers, and life insurers in particular. According to Market Consistent Embedded Value/European Embedded Value (MCEV/EEV) reports, the economic worth of insurance companies rises with increases in interest rates.
However, it would be a fallacy to believe that interest rate increases will benefit insurers immediately. First of all, companies roll over only a small fraction of their investment portfolios every year and as such, rising interest rates have both a marginal and lagged impact on the investment portfolio. For example, in Germany – a market where life insurers have been particularly hurt by the low level of interest rates – insurers’ fixed income portfolio yield would continue to decline from 3.2% in 2012 to 2.7% in 2017 under the assumption of a gradual increase in interest rates from 1.8% to 4.2% over the same timeframe. This is because the maturing bonds dropping out of the portfolio will still have a higher coupon than newly-bought bonds, lowering the overall portfolio yield. Life insurers’ struggle to serve their long-term guarantees written when interest rates were higher is thus unlikely to come to an end soon.
Secondly, the immediate impact on accounting balance sheets may even be negative. This is because the market value of bonds declines as interest rates increase. This decline on the asset side is not always matched by a corresponding decline in liabilities since under many accounting regimes liabilities are not marked-to-market. The resulting loss in equity will be a reversal of the artificial equity gains seen over the last few years as interest rates dropped.
Insurers should therefore not get carried away by the apparent trend reversal in interest rates. Instead, life insurers should continue to focus on ways to make their products, which often contain long-term interest rate guarantees, more resilient under any interest rate scenario.
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