By HENRY H. MCVEY Apr 25, 2018

Without question, the multi-year decline in interest rates since the Global Financial Crisis has had a profound effect on the insurance business. Importantly, it comes at a time when the investment part of the insurance business is now often taking on more responsibility for driving profitability than the traditional underwriting function. Given this backdrop, getting asset allocation right has never been more important, in our view. The good news is that many CIOs in the insurance industry understand that they are operating in what we are terming a New World Order for asset allocation, and as a result, they are increasingly implementing creative solutions to deal with the adverse impact on current income that global quantitative easing has created in recent years. These initiatives include using their capital more efficiently within each ratings bucket, or when appropriate, moving down the risk curve to pick up incremental return in what is often viewed as an out-of-favor asset class or too complex a structure to underwrite. Overall, given the industry’s strong capital position, its thoughtful allocation, and its commitment to managing both its assets and its liability profile in today’s low rate environment, we feel confident that the CIOs with whom we interacted while conducting our proprietary survey will help to smoothly navigate through the challenging investment environment that we are envisioning during the next few years. If we are right, then the opportunity to differentiate – and the upside for differentiation – could be extremely significant for those firms that properly balance the need for better returns, including more current income, in today’s low rate environment with the undeniable reality that valuations for many asset classes around the world now appear generally full in many instances.

When I made my way to New York City from Richmond, Virginia in the early 1990s, I cut my teeth in the equity research department at Morgan Stanley covering a broad array of financial services companies, including several in the insurance industry. For a history major from the University of Virginia with only a modest amount of accounting and finance under my belt at that point in my career, the financial statements of insurance companies were – without question – the most challenging part of that job. In fact, I still sometimes get an uncontrollable twitch when I see a Schedule D report!

Fast forward to today. I am again spending an increasing part of my time working with insurance CIOs as they try to deal with generating compelling returns amidst a massive secular decline in interest rates to levels that many would have thought impossible before the Global Financial Crisis. So, as I lightheartedly just reminded a KKR colleague who also worked with me at Morgan Stanley, one of my favorite movie lines spoken by Michael Corleone keeps coming to mind of late: “Just when I thought I was out, they pull me back in.”

All joking aside, my KKR colleagues and I have had the good fortune to spend time with a multitude of thoughtful and committed insurance industry executives in recent years who are trying to navigate a challenging investment climate where there are now almost nine trillion1 in negative yielding fixed income assets. As part of this process, the KKR Global Macro & Asset Allocation team, alongside our Insurance Asset Management team, recently conducted a proprietary survey to learn more about key investment trends, particularly as they relate to the intersection of insurance company asset allocation and the use of Alternative Investment products.

See below for full details, but our primary conclusions are as follows:

1. Both the absolute low level of interest rates and the extremely tight level of credit spreads have wreaked havoc on the insurance industry. All told, the overall portfolio yield on the nearly three trillion dollars of investable insurance assets that we surveyed, which represents an estimated 40% of the entire industry, declined by 30 basis points from 4.2% in 2014 to 3.9%, on average, in 20172. One can see the details in Exhibit 1. Importantly, our survey is not an outlier. In fact, the magnitude of this decline seen by our survey participants was in line with what we uncovered in the latest Annual Report on Insurance, which was released by the Federal Insurance Office of the U.S. Treasury. Consistent with this ongoing overhang from low yielding fixed income securities on the entire insurance industry, interest rate risk was cited as the number one concern by many of the CIOs we surveyed (Exhibit 21). Further details below.
2. To combat today’s challenging investment environment, insurance companies have begun to branch out into a variety of new products. All told, we estimate that Schedule BA assets, which the industry defines as other long-term invested assets that are not traditional bonds or common stocks now account for 14.5%3 of our survey respondents’ investment portfolios, a notable jump upward compared to 11.3% in 2014 for our survey participants and dramatically above the 5.0% allocation for the industry as a whole at the end of 2016 (latest data available)4. Importantly, this 14.5% total for our survey participants does not include Non-Investment Grade Debt, which would take the total to well over 20% for all these types of investments. All told, we estimate at least $200 billion of our survey respondents’ assets have already migrated towards these types of investments during just the last three years (Exhibit 16). To fund these increased allocations, insurance companies have meaningfully sold Equities and Investment Grade Debt in many instances.
3. There are a variety of factors beyond just lower interest rates that are driving the surge towards non-traditional investments. In particular, growth in excess capital across the insurance industry, more efficient structures (i.e., holding direct positions on balance sheets), increased third-party ratings usage across more products, low correlations amongst strategies in the Alternative Investment arena, better terms, and the backing of hard assets in certain investment vehicles, have all helped to fuel growth in non-traditional investments. Strong investment performance has also helped to reinforce this behavior pattern of late, even in the face of higher capital charges.
4. Within Structured Products, for example, we have seen greater demand by insurance companies for better capitalized and more transparent securitized investment vehicles, including CLOs, ABS, and CMBS, relative to the pre-Global Financial Crisis period.5 In addition, downside protected notes that also provide upside linkages to equity-like returns are growing in popularity among some of the more thoughtful insurance executives with whom we spoke. As one might expect, the advantage of getting a third-party rating, or some form of documentable collateral for these structures has become a major focus, as these types of validations often help to notably improve capital charges. All told, Structured Product market share increased to 5.9% in 2017 from 3.3% in 2014, which is the equivalent of around an $80 billion increase in the assets of our survey participants, we believe.
5. Within the Alternative Investment arena, Private Equity (PE) allocations have nearly doubled to 2.4% since 2014, though Private Credit remains the largest absolute Alternative allocation at 5.6% of total allocations versus a 4.7% allocation in 2014. Interestingly, PE allocations could actually have been much higher, but totals have been reduced by significant harvesting of existing positions in recent quarters, according to some survey respondents. Meanwhile, Private Credit has benefitted from both deeper penetration as well as broader participation by the industry, as many CIOs have employed more favorable structures to hold these assets. On the other hand, Hedge Fund allocations fell sharply to just 50 basis points, down meaningfully from 110 basis points in 2014. According to survey participants, this trend should continue as more CIOs rotate away from an asset class that they believe is challenged in today’s environment towards products that provide more current coupon and/or a greater overall total return.
6. Not surprisingly, given the significantly longer duration of their liabilities, life and annuity companies are much more aggressive allocators towards Private Credit and Private Real Estate. Specifically, the allocation to Private Credit within life insurance companies increased by 270 basis points, from 7.6% in 2014 to 10.3% in 2017. For Private Real Estate Equity, the allocation within life companies recently stood at 2.3%, up 130 basis points from 2014. Without question, our survey confirms that life insurance companies are aggressively looking to leverage the longevity of their capital to earn above average market rents in areas where banks have created a void after the Global Financial Crisis.
7. Meanwhile, within property and casualty companies (P&C), there has been a significant increase in Non-Investment Grade Debt, which recently reached 8.4% versus 2.8% in 2014. As we show below in Exhibits 6 and 7, high quality High Yield bonds have been competitive with stocks – and with less volatility and more current income. Given growing recognition of this reality, we were not surprised to see that both Domestic Equities and Investment Grade Debt have been sold aggressively to fund this new allocation towards Non-Investment Grade securities.
8. We believe Alternatives must continue to perform to gain further share. While excess capital in the industry, a conscious decision to diversify products, and more rated structures have all helped Alternative Investments to gain share, the capital charges associated with many of these products remain significant. As such, sustainable investment performance still matters, particularly for Alternative Investments that do not provide outsized current income. See below for specific assumptions in Exhibits 3 and 5, but our—admittedly—highly simplistic model suggests that products like PE need to earn returns of about eight percent, or roughly 500 basis points above the returns of Investment Grade Credit, in order to offset their balance sheet capital requirements. Current income certainly helps a lot in the Alternative arena, but there are also other considerations, including a firm’s immediate liquidity profile as well as the uniqueness of its long-term liabilities.
9. In terms of forward-looking guidance, we created a diffusion index to show intended asset allocation changes for 2018. This index suggests that on net fully 36.4% of our respondents plan to increase allocations to Real Estate Credit, followed by Private Credit (+29.5%), and Private Equity (+27.3%). On the other hand, the biggest shrinkage in net allocations was linked to expected reductions in Cash (-22.7%) and Domestic Equities (-20.5%). Given the breadth of desire for the aforementioned products, we believe that CIOs are increasingly of the view that a diversified set of Alternative Investments likely represents the best way to not only deliver strong results by harnessing the illiquidity premium to their advantage but also to minimize capital charges associated with these strategies.
10. Even though we believe long-term interest rates have bottomed, insurance CIOs do not see insurance asset allocation returning to prior allocations any time soon. Interest rates are now just too low in absolute terms to use a more traditional asset allocation playbook, according to our survey respondents. Moreover, as we detail below, we expect long-term interest rates to remain generally low in absolute terms during the next few years, driven by our view about the strong ongoing relationship between nominal GDP and nominal interest rates. We also believe that insurance companies have become increasingly sophisticated in their ability to create higher yielding structures that are more capital efficient than in the past. As such, we believe there is a strong likelihood that an increasing number of insurance companies outside our survey participants will actually begin to embrace some of the strategies identified within this report in the coming quarters.
11. In terms of macro risks to consider, both our survey respondents and the Global Macro & Asset Allocation team have several items of note to highlight. See below for details, but there is clearly some hand-wringing associated with the trade-off between higher returning yet more illiquid assets. Our proprietary work shows that the implied default rate for High Yield, which we view as a proxy for credit conditions, is suggesting that we are now back to optimistic levels not seen since just before the Global Financial Crisis. Given that we are now 106 months into a U.S. economic expansion, CIOs are generally concerned that the global capital markets are under-estimating the inevitable downgrade cycle that accompanies most recessions. Finally, we believe CIOs also have growing concerns about the Investment Grade market of late, including increased issuance as well as potential degradation in the quality of issuers.

While the aforementioned trends reflect aggregate industry behavior patterns, we do want to highlight that each insurance story we learned about is truly differentiated; said another way, there is no ‘correct’ insurance asset allocation that should be followed, in our view. To this point, for example, some insurance companies specifically manage their investment portfolios to generate the largest amount of current GAAP income, while others are solely focused on book value growth. Time horizons, liability streams, and risk tolerance all differ greatly by individual insurer.

We also want to emphasize that repositioning billions of dollars in insurance assets takes multiple quarters, not days or weeks. There are also many current regulatory and structuring changes to consider along the way these days, including recent tweaks to CLO risk retention rules, new tax considerations on municipal bonds, recent shrinkage in the deferred tax asset for U.S. companies, CMBS B-piece retention rules, and shifts in rating agency approaches to the packaging of Alternative Investments and Structured Products.

That said, as we discuss below in greater detail, the entire industry is moving faster than ever, and it has become increasingly sophisticated in terms of how it allocates its capital, given not only low rates and tight spreads but also the growing reality that the underwriting side of the business has been largely unable to deliver the economics that many insurance companies expected when their liability risks were originally priced in recent years. In particular, insurance companies have gotten much more thoughtful regarding capital relief, diversification, and J-curve reduction.

Looking at the big picture, the results of our proprietary insurance survey underscore two mega-trends that we see across most of the global asset allocation portfolios we review. First, while there are benefits to quantitative easing (QE), it does have the long-term effect of unduly punishing current savers by reducing interest rates to levels below where they otherwise would be. Besides earning less on their current investments, it also immediately increases the value of the liability stream for the insurance companies that serve as investment intermediaries for the millions of individual savers they represent.

Second, global QE perpetuates and in many instances accelerates the ongoing yearn for yield by investors. As a result, we believe that insurance companies must seek out new, often more efficient – and sometimes more complex – investment strategies to generate the cash required to meet both their existing and future obligations. As our survey responses underscore, Structured Credit, Non-Investment Grade Debt, and Alternative products can clearly help bridge the large gap that has accumulated since the onset of the Global Financial Crisis, but they can carry risks – including liquidity, credit, and operational – that too must be considered.

Importantly, as we peer around the corner today on what tomorrow’s macroeconomic environment may have in store, we do expect interest rates to increase from current levels. For starters, government authorities are clearly moving from monetary stimulus strategies to fiscal ones, many of which we believe will lead to bigger deficits – and ultimately higher interest rates. However, we do not expect a massive increase in global bond yields during the next three to five years, given worldwide demographics, excess savings, intensifying global competition, and increased pricing transparency.

Another consideration is the future return profile for many financial assets, which we think could disappoint relative to recent performance trends. Indeed, given the rich valuations that many asset classes now face after almost a decade of extraordinary monetary stimulus, forward-looking returns, including many of the asset classes in which insurance companies can invest, are likely to deliver significantly lower returns than in the past, in our view (Exhibit 2).

If we are right, this backdrop will likely mean that insurance company CIOs may continue to reallocate portions of their portfolios away from traditional products such as Investment Grade Debt towards ones that can provide either a larger current income (e.g., Structured Credit) and/or more robust total return (e.g., Private Equity). However, even with increasing use of more capital efficient structures in many non-traditional investment products, superior investment performance remains a prerequisite for success. In theory, as one CIO stated, “the insurance industry is perfect for holding illiquid assets, as long as one gets paid for that illiquidity and it remains well capitalized.” In our view, this statement elegantly underscores the need for higher returning products versus the risk to an insurer’s business model from either poor manager selection and/or mismanagement of liquidity.

Equally as important, we expect more volatile market conditions ahead, an environment which likely means that not only will CIOs have to pursue innovative strategies to generate their required returns but they will also have to learn to harness dislocation and uncertainty to their advantage. This environment will require a new mindset, but after spending meaningful amounts of time with the CIOs in our survey, we believe that this sub-segment of the market has already begun to embrace the ‘New World Order’ that we envision.

Section I: Details of the 2018 KKR Insurance Survey

In the following section we detail various aspects of our survey, including who we surveyed, notable changes in asset allocation from 2014 to 2017, where survey respondents are most likely to invest on a go-forward basis, and finally, market risks.

Who We Surveyed

In completing our survey, we received information from approximately 50 large, well-capitalized insurance companies that are either existing clients of KKR or prospects of the firm. As we show below in Exhibits 10 and 11, the average insurance company we surveyed has $60.4 billion in investable assets, compared to around $1.2 billion for the industry average. In terms of specific industry verticals, 44% of the respondents were property and casualty companies (with average assets of $19.3 billion), while around 38% were life and annuity companies (with average assets of $123.2 billion). The remaining category, which we termed ‘other’ (it includes multi-line, health and reinsurers), represented 19% of the total (with average assets of $30.9 billion). Collectively, our survey participants oversee nearly three trillion dollars in investable assets, which we believe represents nearly 40% of the total U.S. insurance industry investable assets.6

Greater than 90% of the companies surveyed are domiciled in the United States. However, many of these firms not only conduct business abroad but also manage European and Asian investments as part of their local international offerings. Given these global footprints, currency hedging was identified as an important part of their overall investment risk management processes.

On the asset side of the equation, we found that on average, each company held about 61% of its assets in Investment Grade Debt. One can see this in Exhibit 13. Looking at the details, however, we noticed that both P&C companies and ‘other’ insurance companies had around 67% of their assets in Investment Grade, compared to just under 49% for life companies. The other big deltas in terms of asset allocation centered on Structured Credit, Private Credit, and Real Estate Credit, three areas where life companies have been much more aggressive in terms of leaning in. Collectively, these three asset classes account for over 30% of total investable assets within the life insurance companies we surveyed, compared to 5.1% for P&C companies. On the other hand, P&C companies have more noteworthy exposure to Domestic Equities and Non-Investment Grade Liquid Credit, which one can see in Exhibit 13.

What drives this difference in asset allocation? While each business is a different entity, the overall key influence is a company’s liability profile, we believe. Indeed, as we show in Exhibit 14, 70% of the liabilities for P&C companies are four years or less; by comparison, life companies have more than 81% of liabilities with a duration of seven years or more.

Given the variety of assets to which insurance companies allocate, many of the firms with which we interacted outsource management of a meaningful portion of their holdings of non-traditional assets. As we show in Exhibit 15, lack of in-house expertise was cited as a primary factor. This approach was particularly true amongst the P&C companies, which generally had smaller investment portfolios relative to the life companies we surveyed.

In terms of potential bias, we do want to highlight that our survey participants represent somewhat of a unique sub-segment of the insurance market as it relates to their heightened usage of more complex investment strategies relative to a larger industry peer group. Indeed, according to the National Association of Insurance Commissioners (NAIC), Schedule BA Assets, which the industry defines as other long-term invested assets that are not traditional bonds or common stock (see Exhibit 17 and Exhibit 43 in the Appendix for full details), accounted for about five percent of U.S. companies’ allocation to Alternative assets at year-end 2016 (latest available). This industry total compares to 14.5% for our survey respondents. Moreover, in terms of pure use of Alternative Investments, which we define as Private Equity, Hedge Funds, Commodities/Energy, Private Credit, and Infrastructure, the industry’s average investable assets of roughly five percent, compare to 9.3% percent for companies in our survey7.

We link the appetite for more complex products to two characteristics inherent in our survey participants. One is that the survey reflects CIOs who either do business with KKR or have an interest in our products. So, without question, there is a bias towards Alternatives, we believe. Second, many of our respondents are large, often publicly traded companies or mutual companies with broad books of business that likely have more flexibility in their asset allocation mandates than some of their smaller, more focused peers. Life and annuity companies, in particular, are focused on using Alternative Investments to meet their annuity hurdles, our survey suggests.

In terms of what keeps folks up at night, duration/interest rate risk and credit risk were cited as the two most influential areas of concern. One can see this in Exhibit 21. Within life insurance companies, however, duration risk was clearly the most influential consideration. Given that real rates in most of the major economies in which these companies invest are still negative (Exhibit 22), we did not find this result totally surprising. By comparison, credit risk ranked first with property & casualty investors, which – given their more than 17% allocation to Non-Investment Grade Debt and Domestic Equities as well as a sizeable 67% to Investment Grade Debt – makes sense to us too.

Changes in Allocation Between 2014 and 2017: Big Shifts Have Been Under Way

In 2007 before the Global Financial Crisis, the balance sheets of global central banks, the G4 in particular, were relatively modest. As one can see, they were hovering around four trillion dollars before they were forced to respond to what we believe was the greatest financial services de-leveraging since the Crash of 1929. By the end of 2017, however, assets on central bank balances sheets had more than quadrupled to nearly $15.6 trillion. As a result, today $26.4 trillion or 64% of the BofAML universe yields less than three percent. In 2007, by comparison, the percentage was just $3.6 trillion, or 19%. One can see the magnitude of this shift in Exhibit 24.

Given this backdrop, we believe yields on all investment portfolios have declined meaningfully. Insurance companies have not been immune, with overall yields declining to 3.9% in 2016 from 4.2% in 2014. In particular, property and casualty companies have been the hardest hit, as we showed earlier in Exhibit 1. To compensate for changes, insurance companies have been notable net sellers of Domestic Equities to fund increased exposure in higher yielding areas such Structured Credit, Non-Investment Grade Debt, and a broad array of Alternatives (except for Hedge Funds). One can see this in Exhibit 26.

In terms of notable changes in asset allocation preferences between 2014 and 2017, we would highlight the following specific modifications in recent years as the most noteworthy:

• P&C companies have boosted their allocation to Non-Investment Grade Debt to 8.4% from 2.8% in 2014. Without question, this increase represents one of the most dramatic shifts in our overall survey allocations, we believe driven largely by CIOs’ yearn for yield in today’s low interest rate environment. They also believe that Non-Investment Grade Debt, BB securities in particular, have proved to be strong performers with solid income and lower volatility than many other liquid risk assets (e.g., Public Equities).
• While life companies have not been as aggressive with their Non-Investment Grade Debt allocations, they have chosen to materially increase their allocations to both Private Credit and Private Real Estate. All told, total allocations in the life universe to Private Credit ended 2017 at 10.3%, compared to 7.6% in 2014, while Private Real Estate Equity increased from 1.0% in 2014 to 2.3% in 2017. As we mentioned earlier, we link the notable uptick to not only more favorable structures but also increasing in-house expertise in these specific areas of investing (particularly with respect to Real Estate) within the life insurance companies we surveyed.
• Structured Credit enjoyed strong growth in recent years, a trend we expect to continue. We link this growth to insurance companies’ willingness to thoughtfully explore new products such as downside protected notes and other forms of capital efficient structures, including certain separately managed accounts that help to boost overall returns in today’s low rate environment. Rated asset-backed securities too have grown in popularity.
• Overall allocations to Private Equity have nearly doubled to 2.4%, compared to 1.3% in 2014. To date, as one might expect in strong markets, Private Equity has been an important tool for boosting returns. Not surprisingly, strategies that help mitigate the J-Curve, including buying PE secondary ‘blocks’ and/or robust co-investment programs (alongside significant fund commitments) are gaining in popularity. However, similar to a complaint we heard about Real Estate Equity, there is some consternation that real income is not booked until capital is actually returned (though mark-to-market does help along the way).
• The ‘other’ category has reduced Investment Grade Debt and Private Credit from quite high levels to fund increases in both Private Equity (4.8% versus 1.0%) and Real Estate Credit (4.3% versus 3.0%). While the Investment Grade Debt reduction dovetails with the general trends reflected in the survey, we believe the rotation from Private Credit to Real Estate Credit likely reflects personal preferences within the Private Markets versus a more structural change in sentiment towards Private Credit. However, the significant and broad-based jump in Private Equity does reflect CIOs’ interest in boosting overall returns, given the ongoing degradation in total return from existing portfolios, we believe.

To be sure, an increased allocation toward higher risk investments does not come without a cost. For the highly regulated insurance industry, illiquidity concerns and capital requirements ranked one and two, respectively, in obstacles faced in investing in private markets. One can see this in Exhibit 27. If there is good news, the industry today seems fairly well capitalized. In the property and casualty sector, for example, some estimates suggest that this market could be overcapitalized by 25%.

So Where Are We Headed?

As part of our exercise, we also spent time with our survey participants trying to figure out ‘where the puck’ may be headed in terms of asset allocation trends. The key message, we believe, is that CIOs are still looking for new ways to offset the decline in the yield on their investment portfolios in recent years. Consistent with this view, we note that, while Private Real Estate Credit is not currently the largest allocation, our diffusion index suggests that it is most likely to receive increases in allocations in the coming months. Already, though, from our perch at KKR, we have seen an increase in demand by insurers for higher yielding forms of RE Credit that extend well beyond the traditional low leverage, fixed rate, stabilized insurance loans that one typically associates with this business. The most notable forms have come through two forms of transitional lending:

• Direct – insurance originations for ‘light’ transitional (floating rate) lending
• Indirect – through financing transitional lenders (i.e., financing a REIT) or investing in CRE, CLOs, private lending funds, and risk retention funds

We have also already seen an increase in demand from insurers for higher yielding structured investing. In particular, there has been an uptick in insurance companies accessing the lower portions of the CMBS capital structures (i.e., BBB/BB versus AAA/AA/A historically). In addition (and consistent with the survey results), we are now seeing insurance companies participating more in CMBS B-pieces through a variety of innovative structures. Other hard assets including rail cars were mentioned as part of this growing wave of securitization holdings by insurers. Not surprisingly, because there are hard assets pledged against these investments, we believe that it has helped to broaden both adoption and penetration per insurer in these newer areas of the market.

Meanwhile, Private Credit, which has already gained popularity in recent years, should continue to enjoy further market share gains, according to our survey. Without question, the message we heard during our follow-up survey work is that many CIOs, life and annuity ones in particular, want to use their long-dated capital to earn above average economic rents in areas that have been abandoned by the banking sector in recent years. CIOs also prefer the sizeable current income that Private Credit provides as well as the product’s more limited duration relative to Investment Grade Debt in many instances.

Interestingly, Private Equity, which generally provides little to no current income, ranked third on our diffusion index. Our conversations with CIOs who took the survey suggest that the strong absolute returns of Private Equity in recent years have been more than enough to offset increased capital charges associated with these positions. We also think that there has been a notable migration by insurance CIOs towards customized PE programs that can help minimize the J-curve effect as well as a concentration in larger and less cyclical companies, including core portfolios. Many also noted the wide dispersion of performance between top quartile and bottom quartile managers within the PE space (Exhibit 28).

To pay for these increased allocations, our CIOs are most likely to reduce exposure to Cash and Domestic Equities. As Exhibit 29 shows, it appears that CIOs have largely sold their Investment Grade Debt allocations. This insight does not come as a huge surprise, given allocations to this asset class have already dropped to 60.7% from 68.2% in 2014 amidst shrinking yields and extended durations.

Where Are We Headed From Here in Terms of Long-Term Interest Rates?

Without question, many of the survey respondents with whom we spoke told us to tell them where interest rates were headed and then they would tell us exactly where their forward-looking allocations might go. So, we thought it might make sense to lay out in some detail how the Global Macro & Asset Allocation team at KKR thinks about the future for interest rates. We think that there are several points to consider. First, as we mentioned earlier, we do believe that rates have bottomed. This statement is not to be taken lightly, as the bull market in bonds dates back to the early 1980s. As we show in Exhibit 30, our current forecast is for 10-year Treasury yields to reach 3.25% in 2018 and ultimately peak at 3.50% in 2019.

However, we are also cognizant that the current economic cycle is relatively long in the tooth, which restrains our outlook for GDP and interest rates over the longer term. Indeed, as part of our base forecast (Exhibit 30), we do assume a recession at some point in coming years (e.g., we assume zero U.S. real GDP growth in 2020), which is sufficient to restrain our outlook for average nominal growth over the next five years to around 3.5%. In our bull case, we have nominal rates moving to 4.5% under the scenario that President Trump energizes the U.S. economy, and as a result, there is no recession on the horizon. Conversely, in our bear case, the effects of the current fiscal stimulus are underwhelming, leading to quite modest growth until the onset of a recession in early 2020.

Key takeaways for each scenario follows:

• Our base case (50% weight) assumes U.S. GDP reaccelerates in 2018 before slowing late in 2019. The slowdown is the result of a mild U.S. recession sparked by Fed tightening and a credit cycle. We assume full-year U.S. GDP growth around zero in 2020, similar to levels seen in the recession of 2001.
• Our high case (25% weight) assumes that there is no recession in the next five years. Our bull case is in line with to slightly above the IMF global baseline forecast for most countries.
• Our low case (25% weight) assumes that the effect of U.S. fiscal stimulus is underwhelming, trade tensions escalate, and that U.S. growth remains stuck in the low two percent range until falling into a moderately deep recession in 2020.

Importantly, given our strong belief that nominal GDP and nominal interest rates are closely linked, we actually forecast that 10-year yields run in a range of two to three percent over the later years of our forecast in 2020 to 2022. One can see the tightness of the relationship in both Exhibits 31 and 32.

One final point to highlight is that, while interest rates and GDP are highly correlated, the relationship is not static over time. Exhibit 32 illustrates the different regimes of yields relative to nominal GDP that have existed since the 1950s. While regimes have varied, what we think stands out is that interest rates have tended to run moderately below the level of nominal GDP growth as long as the Fed was not actively trying to suppress run-away inflation. It was only during the Volcker Fed era of the 1980s that rates ran notably above nominal GDP for a sustained period. Importantly, our belief is that – on a go-forward basis – inflation will not run away to the upside, as it will be restrained by challenging demographics and pockets of global excess capacity. As such, our base case is that rates can run in a range of approximately zero to 1.5% below the rate of nominal GDP growth.

To summarize, our base case is that interest rates should head higher over the next few years, but not in the uncontrolled fashion that some investors now think. Key to our thinking is that inflation does not materially surprise to the upside, and as such, the long-standing relationship between nominal GDP and nominal interest rates holds. Under this scenario insurance companies may experience some relief in their investment portfolios. However, it might not be enough to offset the current shortcomings in their portfolios, and as a result, they could have to continue to extend their asset allocation considerations to include more innovative strategies that allow them to better achieve the investment returns they need to satisfy their constituents.

Section II: Risks to Consider

So, as we talked to CIOs about what keeps them up at night, there was plenty of discussion. Reinvestment risk in today’s low rate environment is certainly topical to many, but from a macro and asset allocation perspective, we would note the following:

Point #1: Some Worrying Signs in the Investment Grade Debt Market Reflect a General Conservatism Surrounding the Quality of Capital Markets Issuance of Late

Without question, many CIOs feel that there has been a notable decline in the quality of the Investment Grade Debt market. This viewpoint is significant as this is the single largest asset within investment portfolios. In particular, as we show below in Exhibit 35, the BBB segment of the market has grown ten times to $2.9 trillion since 1998, and it now represents almost half of the entire Investment Grade market versus a more modest 30% in 1998. In our view, this dramatic increase in size of the total market is notable both in absolute terms but also relative to history (when BBBs were a much smaller part of a much smaller overall market).

Meanwhile, as we show in Exhibit 36 above, BBB spreads relative to Treasuries are just 145 basis points, which is extraordinarily tight relative to history. Potentially more concerning is that, with spreads this tight, duration has actually been extended to 7.3 years, compared to around 5.8 years in 2009, according to my colleague Kris Novell in our Liquid Credit team. Importantly, this duration extension comes at a time when the interest, or coupon on BBB securities, has essentially been cut in half during the same period.

So, our bottom line with the BBB market is that we agree with our CIOs: Things are not necessarily as they seem. In particular, there is a growing risk that the traditional IG market, the BBB segment in particular, proves to be a weak link during the next market downturn. If we are right, then the current size and breadth of this market could serve as a major headwind to most investors, insurance companies in particular, if they do not remain extremely vigilant around credit quality in this now sizeable part of the credit markets. Already, we note that of the 11% of the total Investment Grade market on negative watch from Moody’s, 72% were given negative watch in 2017 and into 2018.

Point #2: A Very Optimistic Implied Default Rate Across Much of Credit

From almost any vantage point, the global risk free rate is unusually low relative to both history as well as current global growth trends. This backdrop was not the case in prior years, and as such, it could create price risk across most bond portfolios, according to the CIOs with whom we interacted. Moreover, many noted that spreads across Credit appear tight amidst a time of booming consumer and investor confidence.

To help quantify the optimism in the global capital markets that CIOs are picking up on, we updated our favorite measure for quantifying potential over-optimism in the credit markets: our implied default rate monitor for High Yield. See Exhibit 37 for details, but our model is currently suggesting an implied default rate of 0.4%, well below the historical average of 4.4% and a far cry from levels seen as recently as the first quarter of 2016 (i.e., around eight percent). Importantly, we do not think this optimistic implied default rate is isolated to the High Yield market. In fact, our colleagues in Credit are actually more concerned about the BBB market than the ‘traditional’ high yield market (as measured by the BB market, which is the highest quality segment of the High Yield market). Indeed, as we show in Exhibit 38, the BB segment of the High Yield is now 47.3% (i.e., the highest rated bonds now represent the largest portion of the index); by comparison, as we showed earlier in Exhibit 35, the most speculative part of the Investment Grade market is now the largest at just under 50% of what is a much larger market in absolute dollars ($6.4 trillion in size for Investment Grade Debt versus $1.3 trillion in size for High Yield8).

Maybe more importantly, though, is that we think that this optimism towards the credit cycle has extended into the Private Credit markets as well. In fact, similar to several CIOs with whom we spoke, we have more consternation about the underwriting standards that we see in the small segment of the Private Lending market than we currently see in the High Yield market.

In sum, while none of us are forecasting major credit deterioration in the next 12 months, the risk to insurance companies’ portfolios is now as high as it has been since the 2006 to 2007 period, we believe.

Point #3: QE Unwind Amidst Rising Deficits Is Concerning to Many Investors

The passage of the budget agreement on top of the recent tax cuts means that the U.S. budget deficit is projected to surge to $1.1 trillion by 2019, the largest since 2009 to 2011 when the country was still recovering from the Global Financial Crisis (Exhibit 40). This higher deficit will necessitate greater Treasury supply and as such, we expect U.S. Treasury net issuance to reach $1,051 billion in 2018 and $1,150 billion in 2019, more than double the amount issued in 2017 ($488 billion). We expect the distribution of 2018 gross issuance to skew towards shorter-dated issues, with approximately 50% comprising bills and notes with maturities of three years or less. Another 30% of issuance will likely have maturities between five and seven years, with the remaining 20% made up of 10- to 30-year bonds.

From our vantage point, we think that adding fiscal stimulus to an economy that is already operating at full employment is highly unusual. Budget deficits over the next 18 months – 4.1% of GDP in 2018 and 5.0% of GDP in 2019 - are set to be historically large compared to late points in previous expansions (Exhibit 40). While we expect this to boost nominal GDP growth to a 13-year high of 5.2% in 2018e, we caution that the surge in net issuance used to finance higher deficit spending will coincide with Fed and European Central Bank QE turning from a tailwind to a modest headwind beginning in October 2018.

Moreover, all this supply is happening at a time when the global central bank policy is changing. Indeed, as we show in Exhibit 39, the combination of less QE, coupled with the additional issuance we highlighted above, suggests that 2018 could be the first year of net issuance (i.e., net issuance less central bank purchases) since 2014.

In our view, the changing technical picture could be noteworthy, particularly if trade tensions lead China to dump some of its massive holdings of U.S. Treasuries. This view is not our base case, but similar to our CIOs, we do recognize that the environment likely is turning more volatile than it has been during the past few years.

Section III: Conclusion

From almost any vantage point, the recent decline in interest rates and credit spreads is having an unprecedented effect on the profitability and sustainability of the entire insurance business. Importantly, it comes at a time when the investment part of the business is taking on more responsibility for shareholder returns than the underwriting in many instances. One can see this in Exhibit 41. Given this backdrop, getting asset allocation right has never been more important, in our view.

The good news is that CIOs in the insurance complex are not sitting idly by and hoping that the underwriting results and/or the investment environment miraculously improve(s) overnight. Rather, many are implementing creative solutions to deal with the adverse impact on current income that global quantitative easing has created in recent years. These initiatives include using their capital more efficiently within a ratings bucket, or when appropriate, moving down the risk curve to pick up incremental return in what is often viewed as an out-of-favor asset class or too complex a structure to underwrite. They are also working harder to understand their liabilities, so that they can better adjust allocations within the asset side of their business model.

Interestingly, while we feel better about the asset allocation game plan after completing this survey and working with CIOs to better understand its results, we do have some concerns. A lot of money has moved into the Alternative, Non-Investment Grade Debt, and Structured Product areas in recent quarters, and as such, measured deployment pacing from this point forward with the right managers in the right areas of opportunity has become of paramount importance. As one CIO said to us, “It is all about the ‘underwrite’ and the ‘pacing’ at this point in the cycle.” We also think that investors should be kicking the tires on current ratings to make sure that they can withstand both good and bad markets, particularly in newly minted securitized and private markets.

That said, our survey results definitely underscore that our CIOs are cognizant of the risk in today’s environment. The cost of capital is rising, as both rates and credit spreads have both likely troughed. As we described above, our base case now includes some form of a recession in 2020. Further supporting this fundamental view is our proprietary KKR Quantitative Recession Model (Exhibit 42), which shows a heightened sense of economic slowdown risk (as measured by the red color code) in 24 months. Some with whom we spoke, however, thought it could be earlier.

Overall, though, given the industry’s strong capital position, its thoughtful allocation, and its commitment to managing both its assets and its liability profile in today’s low rate environment, we feel confident that the CIOs with whom we interacted will help to navigate smoothly through the challenging investment environment that we are envisioning during the next few years. If we are right, then the opportunity to differentiate – and the upside for differentiation – could be extremely important for those firms that properly balance the need for better returns, including more current income, in today’s low rate environment with the undeniable reality that valuations for asset classes around the world are now generally full. Without question, we have entered a New World Order in the insurance industry.

APPENDIX

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