IT´S NOT THE LEVERAGE, IT´S THE ILLIQUIDITY THAT WILL HURT / THE WALL STREET JOURNAL

It’s Not the Leverage, It’s the Illiquidity That Will Hurt

How insurers and pensions could give investors a fright in the next market downturn

By Paul J. Davies


GOING PRIVATE
European insurers are putting more of their equity holdings into private companies

Too much short-term debt backing long-term assets fueled the last credit bubble a decade ago.

This time round, investors are hunting for yield in hard-to-trade, often private assets. As a Goldman Sachs economist put it recently: “illiquidity is the new leverage.”

The natural buyers of illiquid assets are in many ways insurers and pension funds. With rates low, they have moved further into assets with a limited market, which includes private bonds or loans, private equity, large real-estate assets, or even lightly-traded, very long term government debt.

Such assets aren’t necessarily worse quality than liquid debt or equity, but they can be very volatile. And in times of strain, their values highly uncertain. For shareholders in insurers or in companies responsible for large pension funds, that can be a major worry.

This uncertainty is why such assets typically pay a higher return, or a so-called illiquidity premium, which is what many insurers are chasing.

Insurers’ investment portfolios are very large, so their positions change slowly. But the share of European insurers’ equity holdings that are unlisted, for instance, has grown to 34% at the end of 2016 from 28% in 2011, according to European insurance and pensions regulator, EIOPA.

Investing in loans, rather than more-liquid bonds, has also become more popular.

In the U.S., Moody’s Investors Service has found similar trends. U.S. insurers’ holdings of private bonds grew to 22.5% at the end of 2016 from less than 21% of all assets in 2013. Commercial mortgage holdings also rose to 11.9% from 10.8% of assets in the same period.

Individual insurers echo the trend. MetLife has 15% of its fixed-income portfolio in private bonds, while private equity accounts for 35% of its equity holdings. German giant Allianz, has €101 billion, or 14%, of its assets in alternative investments and wants to increase that by €40 billion in coming years. U.K. annuity companies are furthest down this path with a quarter of all assets already in illiquid investments, according to the International Monetary Fund, with plans to lift that to 40% by 2020.

Anecdotal evidence suggests pension funds are making similar moves. And investment banks are exploiting the trend, by creating and selling long-term illiquid products.

Insurers and pension funds need long-term assets. The better they match the maturity profile of their assets and their long-term liabilities, the more stable their capital needs will be. Also, because they can’t typically suffer a run on funding as banks do during crises, they should be able to ride out market ups and downs.

However, insurers especially still have to keep asset values current, or mark them to market.

With really illiquid assets, there is no market and so they must mark them to modeled valuations — or educated guesses.

That’s when shareholders can get worried about an insurer’s or pension fund’s true value and head for the exit, hitting share prices. For insurers, that can cause real havoc.

The more that everyone pursues the same strategy, the more dangerous it will become.