Yield-starved European insurers look past risks to mull emerging bonds

* Insurers’ emerging debt holdings remain relatively tiny

* But half of EMEA insurers plan increase in 2016 - survey

* Yields negative on 3 trillion euros of European debt

* Insurers can earn average 6.5 pct on emerging dollar bonds

* Emerging debtholders risk ratings downgrades, defaults

* Yield hunger especially acute among life insurers

By Carolyn Cohn and Sujata Rao

LONDON, March 15 (Reuters) - Starved of yield in Western bond markets and at risk of defaulting on future payments to policyholders, Europe’s 10-trillion euro insurance industry is turning to emerging debt for the higher returns it desperately needs.

While emerging debt has mostly lost investors money in recent years and brings its own risks in the form of higher default rates, a survey by the world’s biggest asset manager BlackRock found that half the insurers in Europe, Middle East and Africa planned to increase allocations to emerging debt in 2016.

The firm has “quite a number” of requests for proposals from insurers to invest in emerging debt, said Patrick Liedtke, head of BlackRock’s EMEA financial institutions group.

Emerging debt holdings of insurance companies remain comparatively miniscule, unsurprisingly for a traditionally conservative sector, but they are likely to grow.

Insurers are among the businesses that stand to lose most from the current near-zero or negative interest rates on much Western government debt, because they need steady income to pay out on policies and typically obtain this from high-grade government bonds.

Almost a quarter of insurers could fail to meet obligations in the coming years if interest rates remain low for a prolonged period, Europe’s insurance and pensions regulator warned in 2014.

Since then, 10-year yields on German government bonds have fallen to zero and the amount of European debt trading with negative yields has swollen to around 3 trillion euros ($3.33 trillion).

(For comparison of German 10-year government bond yields and Polish equivalent, click on:


The industry is also increasingly constrained from buying stocks. Pension funds, the other investor category reliant on higher yields, can boost equity investment but the European Union’s new Solvency II capital adequacy rules make it costlier for insurers to do so.

Insurers therefore have also fanned out into risky property bets such as car parks, or homes in provincial Britain.

“If you are aiming to meet your policy guarantee ... then the core fixed income markets don’t get you all the way there,” said Gareth Haslip, who runs the insurance solutions analytics and advisory team at JPMorgan Asset Management.

Yield hunger is especially acute among life insurers, which offer long-term policies such as pensions, often with income guarantees of as much as 3.5 percent a year, Haslip said.

“We have seen a lot of activity from insurers moving into non-core fixed income like emerging markets, high-yield debt, private credit or loans,” he added.

Based on existing investments, European insurers can expect annual returns of 2.4 percent, below the 2.7 percent minimum they need, according to a 2015 survey by Standard Life Investments of insurers managing 2.4 trillion euros.

On emerging dollar bonds they can earn average 6.5 percent yields, while bonds in currencies such as the Turkish lira yield even more, albeit with greater volatility.

“Insurers want to see how much yield they get relative to the capital they tie up, and EM jumps out,” said Yacov Arnopolin, portfolio manager at Goldman Sachs Asset Management.

On that basis, yields on investment-grade emerging company bonds are the most interesting fixed income investment for insurers, Arnopolin said.

The market also compares favourably with Western corporate debt, said Paul Traynor, international head of insurance at BNY Mellon. “If you have two issues in the same currency in different countries - the telecoms company in Brazil rated single-A will pay more than a single-A telecoms company in the United States,” he said.

European insurers’ moves are being replicated in Japan, where institutions have long been driven overseas by near-zero yields. A recent move to negative interest rates means yet more investment must shift to foreign bonds, the head of Japan’s life insurance industry body warned recently.

GRAPHIC - Europe’s largest insurers:

GRAPHIC - Emerging market debt issuance:


Data on insurers’ emerging debt holdings is elusive, but it is fair to say they are tiny - around 3-5 percent of European listed insurers’ investments, estimates Mathilde Sauve, insurance solutions strategist at Axa Investment Managers.

Given the sector’s risks, that may not be a bad thing.

Insurers tend to avoid bonds denominated in emerging currencies in favour of safer dollar bonds issued by investment-grade rated countries and companies, but there are dangers here too.

For one, countries and companies face risks from $1.6 trillion in debt repayments due in the next five years, a schedule that could cause a rise in default rates.

Second, many vaunted developing economies including Brazil and Russia have had credit ratings slashed to junk and more, such as South Africa and Turkey, may follow. The average credit rating of emerging government bonds tracked by the EMBIG index risks sliding back to junk, six years after it became investment grade, JPMorgan warns.

That may leave funds clustered around the hard currency bonds from investment-grade Asia and central Europe.

But despite recent volatility, insurers have proved tenacious. Data from the eVestment consultancy shows they were still putting money into emerging debt in the first half of 2015, unlike pension or sovereign funds.

That trend reversed in the second half but withdrawals happened at a slower rate than for other investor categories, the data shows. That is because insurers’ assets, unlike those of pension funds, are not generally “marked to market”, meaning funds’ value is not computed daily and communicated to investors, said Sauve.

So in a volatile environment, “insurers can live with it - they are less likely to sell”, she added.

David Lai, investment director with the fixed income team at Eastspring, UK insurer Prudential’s Asian asset management arm, said Asian debt appeared most attractive for now.

“People are a bit cautious on emerging markets but if the interest rate divergence continues ... structurally the allocation to emerging markets will go up,” Lai said. ($1 = 0.9000 euros)