For those in the Boston metro area who just experienced several consecutive major snowstorms of 2024, the day after could be a day with a magnificent view only seen in the movies, or an agonizing wait for the power company to arrive to fix the downed power lines blocking the driveway. Perspective matters.
In asset management, perspective matters as well. Asset backed securities (ABS) and other securities securitized by assets in other collateral accounts (commonly referred to as securitized credits) are often viewed as securities with attractive characteristics. For example, when compared with short duration corporate bonds, ABSs
- Are often more liquid.
- Offer higher yields.
- Have had lower historical defaults.
As such, ABSs (and shorter duration securitized credits) tend to be favored by most short duration asset managers and are a good fit for shorter duration liabilities such as cash balance pension benefits.
However, when viewed through the lens of ALM for long duration liabilities, such as whole life, LTC and traditional corporate DB plans, the shortcomings of ABS as an asset class become obvious. Here are a few:
- Short duration. The duration of a typical ABS portfolio less than 5 years. When ABS is incorporated in the fixed income asset mix, one would most likely need to increase the weight of long duration assets, such as long duration Treasury bonds, strips, or interest rate derivatives when permissible. These long duration instruments tend to offer lower yield than other long duration credits such as corporate bonds.
- Low spread exposure. When compared with the liability, ABS has a much lower spread duration (and DTS, or duration times spread, a better measure of spread risk exposure than spread duration) than what is imbedded in the discount rates, which tends to be the rates of long duration high quality corporate bonds. This would lead to higher surplus volatility, and result in big swings of surplus when market level of spread changes. From horizon analysis perspective, shorter spread duration would lead to reinvestment risk in terms of spread. Please note that spread risk is much harder to hedge than interest rate risk.
- Investing in ABS could also lead to additional reporting requirements for life and LTC insurers, such as AG53.
One could selectively invest in long-duration ABS securities. However, long-duration ABSs are often collateralized by different underlying assets than shorter duration ABSs, and hence have different liquidity and risk profiles.
#ABS, #AG53
