Falling gov bond yields make ILS an even more valuable diversifier: Schroders

The value of insurance-linked securities (ILS) as a diversification play within asset portfolios is now even higher, as falling government bond yields have made other diversifiers less attractive at a time when ILS is only increasing its value proposition to investors.

This is according to Stephan Ruoff, Head of specialist insurance-linked securities (ILS) and reinsurance investing firm Schroder Secquaero and Brad Angle, Alternatives Director at global asset manager Schroders, in a recent paper.

The response of Central Banks to the COVID-19 pandemic has driven a divergence in the fortunes of some alternative asset classes known typically as offering portfolio diversification.

The result of the stimulus has been to drive down government bond yields, while putting upward pressure on valuations of risk assets, which the pair believe has created issues for some conventional diversification strategies.

But not for insurance-linked securities (ILS), such as catastrophe bonds and other reinsurance linked assets.

ILS, thanks to its relative lack of correlation with broader financial markets, can serve an important diversification role in normal times.

But right now, as ILS has been unaffected by the pandemic related government stimulus, the diversification it offers as a portfolio component can be even more valuable for investors.

At the same time, dynamics across the global insurance and reinsurance market are driving ILS yields higher.

With the highest yields seen in a decade currently available in ILS, the pair explained in a recent paper that diversification within ILS is also important to consider.

Building diversified portfolios across ILS assets, even including life ILS, can generate better results for investors, Ruoff and Angle believe.

Asking investors to consider diversification “through a new lens” Ruoff and Angle explain that ILS can be a less volatile proposition if diversification goes further than just perils and geographies.

“The best outcome is seen when diversifying exposures, such as Life ILS, are included; investors in diversified strategies could see performance 20% better than simple Cat Bond strategies,” the pair said.

Providing a bullish outlook on the investment opportunity at this time, Ruoff and Angle also explain that market dynamics are likely to mean the higher yield opportunity in ILS persists for a time.

“The volatility in the assets and liabilities of insurance company balance sheets has resulted in a diminished capacity to absorb risk. As a result, we believe insurance companies are likely to seek additional reinsurance capacity over the coming months,” the pair continued.

Adding that, “Yields on Cat Bonds, a proxy for the broader ILS market, have increased 400 bps since 2017. We strongly believe that the increased supply of ILS is likely – at least temporarily – to outstrip investor demand and result in continued increases in yields available for ILS investors.”