Recent Developments in the Puerto Rican Debt Crisis (05/17/2016)
On May 2, Puerto Rico failed to repay almost $400 million in bonds issued by the Government Development Bank (GDB), Puerto Rico’s main government bond issuer, intergovernmental bank, fiscal agent, and financial advisor. It was the largest missed principal payment so far by the island. The recent default is particularly significant because it means Puerto Rico is now heading towards defaulting on bonds deemed more secure. That is, in Jan. 2016, Puerto Rico defaulted on roughly $37 million in bonds issued under the Puerto Rico Infrastructure Financing Authority (about $36 million) and Puerto Rico Public Finance Corp. (about $1 million), which are considered lower priority bonds by the government as they are not backed by the Puerto Rican constitution. Puerto Rico’s economic crisis has intensified with this most recent missed bond payment because it has been enduring an ongoing economic crisis that seems to have reached a critical stage. Furthermore, if Puerto Rico defaults on its next payment, due July 1, it will have defaulted on approximately $800 million general obligation bonds, which were issued directly by the Puerto Rican government and are protected by the Puerto Rican Municipal Financing Act which states that holders of municipal general obligation bonds shall have the right to compel the municipality to exercise its power to levy taxes for the payment of the principal, interest and premiums of early redemption, if any, of said bonds. While the Puerto Rico debt crisis is not expected to impact the U.S. economy or its $3.7 trillion municipal bond market, a default of this magnitude could lead to years of court proceedings since Puerto Rico currently lacks the ability to file for bankruptcy. The U.S. Congress has been debating whether to grant Puerto Rico the ability to file for bankruptcy. Unless that happens, the only avenue investors will have to resolve their issues will be through the courts.
BACV of U.S. Insurer Exposure to Bonds Issued by Puerto Rico ($)
Par Value of U.S. Insurer Exposure to Bonds Issued by Puerto Rico ($)
As of year-end 2014, direct ownership of Puerto Rican bonds by U.S. insurers was $1.4 billion in book/adjusted carrying value (BACV). As of year-end 2015, it dropped to $1.16 billion, a decrease of 16.7%. Over the same period, the par value of these bonds increased, mostly due to purchases by bond guarantors. Purchases at deep discounts allow the bond guarantors to reduce their net exposure. In addition to the purchases in the last year at deep discounts, the aggregate BACV was also impacted by Other Than Temporary Impairments (OTTI) taken by insurers, reflecting low trading prices and expectations of defaults. From year-end 2014 to year-end 2015 the BACV of property/casualty (P/C) bonds decreased about 6.5% while the par value increased almost 25% (note that bond guarantors file as P/C companies). Recent prices for bonds not benefiting from a guarantee have ranged from $15 to $60, with most trading in the mid-$30s, depending on the specific issuer. U.S. insurance companies’ year-end 2015 exposure consisted primarily of Puerto Rico Sales Tax Financing Corporation (COFINA) bonds, or $788 million BACV representing 67.6% of total U.S. insurer Puerto Rico bond exposure. COFINA bonds are currently trading around $20 to $60. Regulators should consider where insurance companies are valuing bonds issued by Puerto Rico, especially those not insured by one of the bond guarantors.
Average Book Price of Aggregate Insurer Exposures
The Capital Markets Bureau will continue to monitor trends with Puerto Rico’s debt crisis as it evolves.
U.S. Insurance Industry’s YE 2015 Exposure to the Energy Sector: Warrants Continued Monitoring, But No Cause for Immediate Concern (04/26/2016)
At the close of markets on April 22, the price per barrel of West Texas Intermediate crude oil closed at $43.73. This represents a significant improvement from the environment for oil just two months ago, when the contract price traded in the area of $25/barrel, and almost dropped to $20/barrel. Nonetheless, concerns for the energy sector continue. Current prices are still substantially below where they were two years prior, and few market participants expect any substantial improvement in the near term. Bank exposures to weaker drilling companies have gained much attention. These concerns were emphasized in April when Peabody Energy, one of the nation’s largest coal producers, filed for Chapter 11 protection.Chart 1: Current Contract Price for West Texas Intermediate (6 months)
Reflecting the shifting fortunes of oil prices (as shown in Chart 1), stock prices for energy companies have been equally volatile, falling almost 37% from April 2015 to late January 2016. They have since recovered almost 30%. The U.S. insurance industry’s total common stock exposure to the energy sector was $18.3 billion as of year-end 2015, with the bulk ($15.5 billion) in P/C portfolios. The industry also had about $167.5 billion (81.3%) of aggregate bond exposure to the energy sector with life companies at year-end 2015, followed by $28.9 billion (14.0%) in bonds with P/C companies.
The U.S. insurance industry’s exposure to the energy sector is not insignificant, but it does not warrant major concern at this time. The bulk of the industry’s energy bond exposure (90%) was investment grade, with another 8% in the double-B rating category. A total of $206 billion in energy sector bonds (year-end 2015) was modestly lower than the previously reported $226 billion at the end of 2013, as indicated in a Capital Markets Bureau Special Report published Feb. 27, 2015, titled, “The Current Oil Shock: Modest Impact on Insurance Industry Investment Portfolios.” Roughly 66% of the year-end 2015 exposure was in bonds with maturities of 10 years or less (see Table 1). Exposure to countries whose economies are impacted by volatility in oil prices (i.e., oil-producing countries) has also declined from $169 billion in 2013 to $167 billion in 2014 and $152.4 billion in 2015. In addition, excluding Canada (which had the largest exposure at $33 billion), the largest year-end 2015 investment in an oil-producing country was Mexico at $14.3 billion.
Table 1: NAIC Designations for Energy Sector Bonds by Maturity
NAIC Desig < 1 yr 1 - 5 yrs 6 - 10 yrs 11 - 20 yrs >20 yrs Total 1 4,326 22,092 18,985 9,692 12,787 67,883 2 9,165 31,282 32,918 14,063 29,923 117,351 3 945 6,552 5,132 1,801 1,677 16,107 4 77 1,983 1,503 53 37 3,653 5 125 460 392 - 47 1,024 6 2 49 7 - 5 63 Total 14,640 62,418 58,937 25,609 44,476 206,080 NAIC Desig < 1 yr 1 - 5 yrs 6 - 10 yrs 11 - 20 yrs >20 yrs Total 1 2.1% 10.7% 9.2% 4.7% 6.2% 32.9% 2 4.4% 15.2% 16.0% 6.8% 14.5% 56.9% 3 0.5% 3.2% 2.5% 0.9% 0.8% 7.8% 4 0.0% 1.0% 0.7% 0.0% 0.0% 1.8% 5 0.1% 0.2% 0.2% 0.0% 0.0% 0.5% 6 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total 7.1% 30.3% 28.6% 12.4% 21.6% 100.0%
As shown in Table 1, with almost 10% of the U.S. insurance industry’s bond exposure to the energy sector below investment grade, and more than 20% with maturities of more than 20 years, market values will potentially be volatile and warrant continued attention by state insurance regulators. Focusing specifically on below investment grade bonds, the total par value for the industry was $22.8 billion, with a book/ adjusted carrying value (BACV) of $20.8 billion and a reported fair value of $17.2 billion at year-end 2015.
The Capital Markets Bureau will continue to monitor market trends in the energy (and related) sector and report as deemed appropriate.
- Year-End 2015 U.S. Insurer Exposure to Private Equity Funds Decreases;
Hedge Funds Increases (04/04/2016)
On March 4, 2016, the NAIC Capital Markets Bureau published a special report on the U.S. insurance industry's exposure to private equity funds and hedge funds, which included data as of year-end 2014. The 2015 annual financial statements have now been submitted; while there are likely to be some continuing updates, significant changes are unlikely. This Hot Spot provides information on exposures for year-end 2015 and highlights changes since the prior year.
As of year-end 2015, the U.S. insurance industry held approximately $65.5 billion in private equity funds, a decrease of $4 billion since year-end 2014. Over the same period, hedge fund exposure increased to $17.7 billion from $16.8 billion. To gain further insight into these exposures, the Capital Markets Bureau sorted the private equity funds and hedge funds investments held in 2015 by company size (that is, assets under management, in seven groupings), as shown in Table 1 below.Table 1:
2015 Year-End Exposure Insurer Groups Based on Asset Size Private Equity Funds Hedge Funds < $250mm 177,479,907 194,360,215 Between $250mm and $500mm 360,807,226 422,921,764 Between $500mm and $1B 512,961,671 516,060,586 Between $1B and $2.5B 1,636,483,959 2,721,927,595 Between $2.5B and $5B 1,509,320,496 1,516,232,142 Between $5B and $10B 2,962,036,080 1,306,677,724 Greater than $10B 58,309,779,312 10,978,103,364 Grand Total 65,468,868,651 17,656,283,390 Change from 2014 (4,034,045,170) 865,133,360 -5.8% 5.2%
Notably, larger insurers (i.e., those with greater than $5 billion asset under management) generally reduced their exposure to both private equity funds and hedge funds during the year. (See Table 2.) Smaller and mid-tier insurer exposures to private equity funds stayed roughly the same. However, smaller and mid-tier insurers increased their exposures to hedge funds, more than offsetting the decrease within the larger insurers. Among the group of smaller insurers (i.e., less than $500 million assets under management), 31 of the 86 companies are new investors in hedge funds. Among the midtier group of insurers (i.e., between $500 million and $5 billion assets under management), 32 of 135 were insurance companies that reported exposure in 2015, but did not report exposure in 2014.Table 2:
Percent Change Private Equity Funds Hedge Funds Smaller Insurers -0.5% 9.7% Mid-Tier Insurers 0.0% 33.7% Larger Insurers -6.2% -3.1%
As shown in Table 3, in 2015, 89.1% of the industry's exposure to private equity funds was with the largest insurance companies—that is, those with $10 billion or more assets under management. Similarly, 62.2% of hedge fund exposure is also within the largest insurers category. There were a total of 343 U.S. insurance companies with at least some exposure to private equity funds, and 331 with some exposure to hedge funds.Table 3:
Percent of Total PE or Hedge Funds Private Equity Funds Hedge Funds < $250mm 0.3% 1.1% Between $250mm and $500mm 0.6% 2.4% Between $500mm and $1B 0.8% 2.9% Between $1B and $2.5B 2.5% 15.4% Between $2.5B and $5B 2.3% 8.6% Between $5B and $10B 4.5% 7.4% Greater than $10B 89.1% 62.2%
For both private equity and hedge funds, the exposure among U.S. insurers as a percent of total invested assets continues to be relatively modest and was 1.2% of total invested assets as of year-end 2015. Table 4 shows U.S. insurer exposure to private equity and hedge funds as a percentage of total invested assets in 2015.Table 4:
Percent of Invested Assets Private Equity Funds Hedge Funds < $250mm 0.1% 0.2% Between $250mm and $500mm 0.1% 0.1% Between $500mm and $1B 0.2% 0.2% Between $1B and $2.5B 1.4% 2.3% Between $2.5B and $5B 1.1% 1.1% Between $5B and $10B 0.9% 0.4% Greater than $10B 1.4% 0.3% Total 1.2% 0.3%
As noted in the March 2016 special report, performance (in terms of returns) for private equity funds and hedge funds have, in past years, proven to be less attractive relative to more traditional investments, and they remain relatively volatile. There are also concerns about transparency and liquidity. Additional review, especially for smaller and mid-tier insurers, focusing on exposure for individual companies as a percent of capital and surplus, is warranted.
- Negative Interest Rates and Market Implications (02/16/2016)
Recent weeks have seen considerable discussion about negative yields and negative interest rates, not the least of which were comments made by Federal Reserve Chair Janet Yellen. Negative interest rates—or in effect, paying a financial institution to store cash—seems counterintuitive. But, major central banks are using this unconventional tool in their efforts to stimulate economic growth. The expectation is that they will encourage banks to increase lending activity, resulting in more consumer and business spending. In addition, negative interest rates could lead to the devaluation of a country’s currency, making exports more competitive.
In June 2014, the European Central Bank (ECB) cut the deposit rate, or the rate banks receive for funds deposited at the central bank, to negative and lowered it further twice since then. The central banks of other countries—including Japan (most recently in January 2016), Sweden and Switzerland—have also adopted a negative interest rate strategy. On Feb. 10, 2016, in a testimony before the Committee on Financial Services, Yellen was questioned on the possibility of negative interest rates in the U.S., and she commented that the concept is not “off the table” but that further analysis is required to determine its feasibility—legally and structurally. Nevertheless, she said there are no expectations “that the FOMC (Federal Open Market Committee) is going to be soon in the situation where it is necessary to cut rates” given the strengthening labor market and continued moderate expansion in economic activity. However, the market appears to disagree—with the 10-year Treasury yield down 52 basis points (bps) since the beginning of the year to 1.75% as of Feb. 12, 2016—so it will be interesting to see if weakness in either, or both, of these indicators changes Yellen’s view.
Chart 1: Central Bank Policy Interest Rates
As central bank rates serve as a benchmark for borrowing costs, some sovereign bond yields have turned negative—particularly at the shorter end of the yield curve, and in some cases, as far out as six years and even beyond (e.g., Germany, Japan, the Netherlands and Switzerland). Negative yields on market instruments are different from negative rates at central banks. As interest rates have fallen near zero, prices of bonds have traded above par, resulting in their yields becoming negative. In addition, as central banks continue asset purchase programs to stimulate the economy, the additional demand has resulted in even higher bond prices and greater negative yields.
Chart 2: Government Bond Yield Curves
The impact of negative interest rates on the capital markets is akin to an extreme case of low interest rates. Negative yields on government securities lead to even lower yields on investments, putting further pressure on net interest margins and profitability of banks. They could pass through the added costs to their customers, but it would be at the risk of customers withdrawing deposits or losing customers altogether. Since U.S. insurance companies, for the most part, invest in assets that are priced to earn an expected return above a benchmark government rate, a negative yield on the relevant U.S. Treasury rate would result in a lower expected return unless the market-based premium expanded to offset that negative impact. In addition, insurance companies would likely find it challenging to meet long-term liabilities in a negative yield environment—particularly life insurance companies that offer products with fixed rates. Although there has been limited evidence of insurance companies reaching for yield in the past several years, a sustained period of negative yields (after what has already been a lengthy period of low interest rates) could create significant challenges that might encourage them to take on added, and potentially excessive, risks and invest in higher yielding assets at an increasing rate. Negative yields would also significantly affect the money market funds space—a $3.1 trillion market as of Dec. 31, 2015, according to U.S. Securities and Exchange Commission (SEC) data. Money market funds typically invest in highly-rated short-term corporate or government debt for a small return. If these returns turn negative, the business model of money market funds would no longer make sense, and the liquidity and capital preservation they provide would no longer be available to investors.
Although negative yields in the U.S. seems unlikely, the Capital Markets Bureau will continue to monitor developments and trends in the U.S. and global economies and report as deemed appropriate.