Asset Management Portfolio Diversification

BACKGROUND

Here is an article highlighting the need for life insurers to “broaden their horizons” due to low-yield returns in existing investment strategies.

It recommended non-traditional investments and different assets to consider alternatives in infrastructure, real estate-backed loans, asset-backed securities and unsecured assets such as high yield bonds.

This post will outline the few risk and opportunities of the non-traditional assets identified.

Link to article as follow:-

http://www.theactuary.com/news/2015/01/life-insurers-told-non-traditional-assets-critical-to-maintaining-profitability/



INFRASTRUCTURE INVESTMENT

1. Infra Opportunities
The assets themselves tend to be single purpose in nature, such as a gas pipeline, tollroad or hospital. The private investors' participation in the asset is often for a finite period. The initial development involves high upfront capital costs with payback occurring over the assets generally lengthy life. An example would be constructing a highway for the government with a pre-determined toll rate and period of time which is then handed back to the government upon expiry.

From observation, infrastructure assets have the tendency to become monopolistic in nature which becomes attractive to investors but not in favor of the users.

Infrastructure assets require a high startup costs with low returns for example the cost of building a highway versus the toll fees collected from 1 user. A monopolistic infrastructure enables the investors to reap attractive returns with a large startup costs.

2. Infra Risks

The inherent risks in the assets are risks from the design, construction, operations, maintenance of the infrastructure asset and is associate with the maturity of the assets. As an asset matures, its risk profiles decreases while valuation increases.

Risks such market risk, economic risk, and political & political risks are associated with the asset class/portfolio.

Interest rates risks have the largest impact on Infrastructure asset with prevailing interest rates affecting discount rates applied to the valuation of infrastructure investments, and the debt portion of the investment structure.

The impact of interest rates will soften over a medium to long term period as revenues generated from the assets start to grow. Increased Revenue estimations are derived from an increase in CPI (in high growth environments) and increase in volume in growing economies.   

ASSET-BASED SECURITIES

ABS can be categorized into two types of receivables mainly consumer loans and receivables such as home-equity loans, vehicle loans, credit card debts and student loans. The other type of receivables is business receivables such as trade receivables and equipment leases.

Not to be confused with mortage-backed securities (MBS) which consists of securities created from pooling of only mortgages and sold  to investors. Most ABS are secured with collaterals or credit enhancements policies embedded.

1. ABS Opportunities

Asset-backed securities rely on either a fixed interest rate or floating rate (floaters) and depends on the purchase price of ABS and the term length.

Portfolios such as credit card loans which utilize the floating rates follow a specified index providing an equilibrium between income and payment by the issuer.

2. ABS Risks
Because the cash flow of the underlying assets is uncertain, Credit ratings of ABS are derived from the ABS structure and sold assuming an average maturity rather than giving a guaranteed maturity date.Therefore the yields of asset-backed securities are generally higher than corporate bonds of comparable maturity and credit rating.. Maturity of ABS is only estimated using projections and prepayment models. ABS have a high market risk in the secondary market (trading of ABS) due to credit spreads between ABS and other fixed income securities as well as the quantity of new ABS bring issued in the market. There are also sector risks for every different ABS issued caused by triggers and rippling effects in the industries. (For example the subprime default rate’s effect on MBS and ABS from home equity loans). 

ABS key risks are interest rate risks and early amortization events. ABS based on amortizing loans such as home loans has a higher interest rate risks and prepayment risks then revolving accounts such as credit cards.

A prepayment risk is a result of borrowers paying off the loan earlier with money borrowed at existing lower interest rates or when the borrower decides to sell of the assets.Therefore a decrease in interest rate might trigger a reinvestment risk causing a decrease in prices of ABS in the secondary market due to a higher probability of the amortizing loans paid off early.

Lastly, early amortization events are based on triggers and require an investment-grade rating from credit rating agencies. Triggers could be due to insufficient payment by the borrowers, rise in default rates above the permitted level and bankruptcy of servicers.

Once triggered, all money received from the assets are used to return the principal to the ABS investors regardless of expected maturity date and the amortization or accumulation period ends.


HIGH YIELD BONDS

High yield bonds are obligations that were below investment grade - otherwise known as "junk bonds" and has a bond rating of Ba or lower according to Moody's, or BB or lower on the Standard & Poor's scale. 1. High Yield bonds Opportunities

Because their yields are higher than investment-grade bonds, they're less vulnerable to interest rate shifts, especially at lower levels of credit quality, and are similar to stocks in relying on economic strength.

2. High Yield bonds Risks

There is risks of bonds evergreening with companies dumping bonds before they actually default and get downgraded and to replace them with new bonds.If the fund's turnover is extremely high (over 200%), this may be an indication that near-default bonds are being replaced frequently.

Credit risk is the risk of a company failing to make timely interest or principal payments and default on its bond. Defaults also can occur if the company fails to meet certain terms of its debt agreement.

When the price of a bond moves in the opposite direction than market interest rates there is interest rate risks. Bonds with longer maturities generally present greater interest rate risk than bonds of similar credit quality that have shorter maturities. Investors are likely to try to sell their bonds and replace their riskier high-yield bonds with safer ones if economy declines. Therefore when supply exceeds demand,  prices of the bonds will fall causing an economy risks. Liquidity risk is the risk that investors seeking to sell their bonds may not receive a price that reflects the true value of the bonds (based on the bond’s interest rate and creditworthiness of the company) due to its low trade volume & frequency. High-yield bonds may be subject to more liquidity risk than, for example, investment-grade bonds.