Investments Benefitting from Higher Interest Rates

[maplevalue]

With the Fed about to begin a hiking cycle, I would be curious to hear the community's thoughts on investments that will do well in a higher rate environment. Specifically ideas that would do well if the Fed had to hike significantly faster than what is priced in. Right now Eurodollar futures have the Fed hiking to ~2% by 2024, so I am thinking of what would do well in a scenario where the Fed has to hike to 5% in a similar timeframe (for context the Fed was at 5.25% before the 2008 financial crisis). Rates at 5% could mean GDP growth is good, or GDP growth is bad, so feel free to share ideas for either case.

 

Some 'textbook' ideas include insurers, banks, and commodity producers. Although with many of these breaking out to new highs it would be interesting to hear some more niche names/sectors that could stand to benefit and are less in favour than the aforementioned sectors.

 

For example, a more niche idea is rate reset preferred shares trading at a discount (since they trade at a discount as rates go up their coupon increases more than the rate increase).

[Gamecock-YT]

Distressed Debt companies, too bad Oaktree sold out

[fareastwarriors]

Might be late to the party already but SCHW.

Highly interest rate sensitive and well run business. 

 

[Spekulatius]

Life insurers have about the most leverage to rising interest rates that I have seen.

[gfp]

If only we could find an insurance company with tons of long duration float but almost zero - say less than 2% of assets - existing bond holdings.  A company like that would surely be more valuable if rates rise.

[BroKon]

But wouldn't the earnings multiple of that particular insurance company have to re-rerate lower @gfp? Just even on the basis of some of its equity holdings.

 

A better pond to fish in might be insurance companies with super conservative investment guidelines, especially those that haven't been reaching for yield by extending the duration of their portfolios the last few years (RE for example extended their portfolio to 3.6 years, so will miss out on some of gains).

 

 

[Cigarbutt]

^i think gfp's comment was tongue-in-cheek and referred to BRK (longer-term bonds to assets = 1.97% as of Q3 2021) with the rest of float coverage in cash and very-close-to-cash Treasury Bills. 

One could reasonably criticize the aversion to reach for yield in the fixed income space (most insurers have been slowly drifting this way to various degrees with slowly and gradually higher exposure to lower graded bonds, CLOs etc (including RE last time i looked)) but Mr. Buffett had made this inflation "fear" very clear in his communications to owners since the 1980s.

Example from 1987:

"Both the timing and the sweep of those consequences {inflation and even possibly runaway inflation} are unpredictable. But our inability to quantify or time the risk does not mean we should ignore it. While recognizing the possibility that we may be wrong and that present interest rates may adequately compensate for the inflationary risk, we retain a general fear of long-term bonds. (my bold)

"A company like that would surely be more valuable if rates rise."

Mr. Buffett however has also said not to expect cash at BRK to rise to 150B (149.2 at end of Q3) so who knows about sweep and, especially, timing?

[scorpioncapital]

what is considered too long duration for an insurance company's bonds? I am not entirely sure something like 4-5 years is so long but neither is it 0-2 years. presumably they will miss some delta between <= 5 years higher bond yields but on the other hand they are owning these bonds on a leveraged basis. So the loss, short of unexpected massive rate rises that are not expected, the loss should not be so huge.

[Cigarbutt]

4 hours ago, scorpioncapital said:

what is considered too long duration for an insurance company's bonds? I am not entirely sure something like 4-5 years is so long but neither is it 0-2 years. presumably they will miss some delta between <= 5 years higher bond yields but on the other hand they are owning these bonds on a leveraged basis. So the loss, short of unexpected massive rate rises that are not expected, the loss should not be so huge.

i clearly don't have an answer to your question but insurers have a fair amount of flexibility in dealing with interest rate risk exposure (it's mostly more qualitative than quantitative so..). There is a tension between the companies (outside of the institutional imperative) who aim for higher ROEs as a trade-off to higher solvency risk and regulators aim for the opposite so..

For a real-life example of potential outlier characteristic, here's a piece of FFH's annual report in 1999 when they were still fascinated by the Japanese 'experience':

Left unsaid was the associated difficulty in dealing with negative cashflows at insurance subsidiaries operating in a declining premium level environment but it goes to show that interest rate risk is a two-edged convex knife.

FFH though has changed in more ways than one and now (AR 2020): "At the end of 2020, our fixed income portfolio, which effectively comprised 73% of our investment portfolio, had a very short duration of approximately 1.8 years and on average is rated AA. As we said last year, we do not expect rising rates to materially impact our fixed income portfolio."

Opinion: this appears to be a most difficult period for the fixed income management of float portfolios and the odds of recognizing a loss for buy and hold strategy related to safe long term bonds have never appeared so much "guaranteed" but sometimes it get darkest before the dawn.  

In the land of the apparently ever rising sun, they are still expecting rates to rise and don't even hold the title of hegemonic reserve currency. 

 

[BroKon]

Depends on the type of Insurance company, but for a P&C insurer 4-5 years would be considered long, where as obviously for a life insurer that would be short.

 

You can view the duration as a proxy for the amount of time it will take the insurer to start benefitting from the new rate environment (which was the initial question) Not a great proxy admittedly as it also depends on the initial steepness of the yield curve etc, but its clear that in a rate rising environment you prefer shorter duration books. 

[Spekulatius]

1 hour ago, BroKon said:

Depends on the type of Insurance company, but for a P&C insurer 4-5 years would be considered long, where as obviously for a life insurer that would be short.

 

You can view the duration as a proxy for the amount of time it will take the insurer to start benefitting from the new rate environment (which was the initial question) Not a great proxy admittedly as it also depends on the initial steepness of the yield curve etc, but its clear that in a rate rising environment you prefer shorter duration books. 

I think it is the opposite, you want to own long tail insurance with higher rates. While it is true that they will take a hit to book value, their income will rise as fixed income assets roll over. ,if insurance liabilities are long term and we’re sold assuming a certain interest rate  or discount rate. They take a hit if they can’t get the returns from their fixed income investments over the time of the contract (which span decades) and get a windfall if their returns exceed the presumed returns at origination. This all assumes higher interest rates for a long time, not just a quick spike that quickly reverses.

Edited January 18, 2022 by Spekulatius

[BroKon]

5 minutes ago, Spekulatius said:

I think it is the opposite, you want to own long tail insurance with higher rates. While it is true that they will take a hit to book value, their income will rise as fixed income assets roll over. ,if insurance liabilities are long term and we’re sold assuming a certain interest rate  or discount rate. They take a hit if they can’t get the returns from their fixed income investments over the time of the contract (which span decades) and get a windfall if their returns exceed the presumed returns at origination. This all assumes higher interest rates for a long time, not just a quick spike that quickly reverses.

When I said shorter duration book I was talking about investment book, not the type of insurance they write. I don't have a view on whether life insurance vs P&C insurance is better. I take your point on why long tail might be better but as you imply it depends on the rate cycle, and whether the yield curve inverts etc. I could also make a case that for P&C as the market hardens, any pickup in their investment return will juice the ROE. 

[Cigarbutt]

10 hours ago, BroKon said:

I could also make a case that for P&C as the market hardens, any pickup in their investment return will juice the ROE. 

Interesting.

In the Inflation Swindles the Investor, Mr. Buffett had offered the assumption that the corporate 'coupon' was sticky with ROE (OK volatile from year to year) pretty much stuck at 12%. It turned out this did not apply to P&C insurers after:

ROE over time:

ROE recent:

With rates going down, nominal investment returns have tended to go down and combined ratios have also tended to go down. If one expects inflation/interest rates to go up, over time, there would likely be at least some inflation protection (through higher nominal investment returns). This is interesting now because there has been hardening in rates and likely some built-in underwriting profitability for a while. It looks like FFH is expecting this outcome. BRK would also benefit but more in the sense that it could benefit from more than one (almost any) scenario.

It's interesting to note that with the 10-yr going down, insurers have been relatively slow (as a group) to strive for more underwriting profitability (insurers at large have been lamenting about this for a while but it's been partly due to the fact that it's easier to signal virtue than..). This aspect and settling for slightly lower ROEs explain the divergence.

The wildcard is that nobody seems to be truly able to explain the long secular downtrend in interest rates and we are entering a phase when tightening is announced as real rates are at a record negative level.

[BroKon]

@Cigarbutt, part of the reason why with 10yr going down insurers couldn't achieve better underwriting profitability was surely all the new capital coming in chasing yield because the 10y was going down. So is it possible if the 10y reverses the vicious circle turns into a virtuous circle? It would probably need a 10y at 4% for this to really take effect so maybe unlikely.

 

BRK's non-insurance aspect is too big these days to treat is as an insurer, and while I haven't looked at FFH for a while (last time I looked they were flattering their CoR by taking out their workout book), maybe I should again given how popular it is on this site. The London insurers look like a better bet to play this theme.

[Cigarbutt]

On 1/18/2022 at 8:21 PM, BroKon said:

@Cigarbutt, part of the reason why with 10yr going down insurers couldn't achieve better underwriting profitability was surely all the new capital coming in chasing yield because the 10y was going down. So is it possible if the 10y reverses the vicious circle turns into a virtuous circle? It would probably need a 10y at 4% for this to really take effect so maybe unlikely.

BRK's non-insurance aspect is too big these days to treat is as an insurer, and while I haven't looked at FFH for a while (last time I looked they were flattering their CoR by taking out their workout book), maybe I should again given how popular it is on this site. The London insurers look like a better bet to play this theme.

Yes, in the last 20 years or so at least and apart from very muted episodes, we have lived in a world awash with excess and abundant capital. This has driven yields (forward) down across the board and this has been visible, for example, in the related alternative capital arena tied to reinsurance: insurance-linked securities. Shown below is the spread trend for catastrophe bonds:

Higher spreads of earlier years were tied to learning how to price the products using a wider than usual spread and the returns were quite strong. Returns have come down and have pretty much paralleled junk bonds' returns since after the GFC years. Spreads have come down as a result of very abundant capital looking for yield and only moved up some with the very catastrophe-prone 2017-8 years. But abundant capital has come back with a vengeance. Interestingly, going forward and despite low spreads now and very easy money (still), the asset class is likely to outperform most other asset classes including high yield bonds which have credit spread risk (junk bonds have been trading at negative real yields and very thin spreads lately..).

Hoping for a virtuous cycle again, somehow. Good luck with those "London" insurers.

-----

Fairfax deserves another look. Running off legacy lines is pretty much history of the past and they have, consistently and for a while, reported positive reserves development in all material operating subsidiaries. The underwriting component for ROE looks good especially if they don't become hurt on the asset side (if ever capacity really becomes an issue again). If you think inflation is on the way and don't mind their relatively high equity exposure (with a 'value' skew), their fixed income portfolio is potentially positioned to take advantage of opportunities.

[CafeB]

EQRR - Equities for Rising Rates ETF

 

www.proshares.com/our-etfs/strategic/eqrr/

 

--"targets sectors that have had the highest correlations to 10-Year U.S. Treasury yields"

 

--sector weightings: Financials ~30% / Energy ~25% / Materials ~20% / Industrials ~15% / Telecom ~10%

 

 

[maplevalue]

Thank you for all of the terrific suggestions. It has given me a lot to think about.

 

One that hasn't been mentioned that has piqued my interest is BDCs. They all differ, but they tend to provide floating rate financing to mid-market companies. So as rates go up your income is protected. Here is an article which talks about them https://www.kiplinger.com/investing/stocks/dividend-stocks/602058/need-yield-try-these-5-best-bdcs-for-2021. I need to do more work since many of them are externally managed (general negative), and of the internally managed ones many trade at rather high P/B ratios (MAIN trades ~1.85 PB).