Captive Insurance Industry Looks at What Is Next for Bond Yields, Inflation

Silhouette of businessman standing against cloudy sunset

November 23, 2016 |

Silhouette of businessman standing against cloudy sunset

One of this editor's favorite songs is Elton John's "Where to Now St. Peter?" from the 1970 album Tumbleweed Connection. It seems extremely apropos to the bond market after the recent election results. Bond investors have seen the yield on 10-year Treasuries climb from 1.79 percent on November 4 to 2.32 percent as trading opened the morning this article was being written. For many captives that may be heavily invested in US Treasuries and agencies, this has come as a rude shock resulting in erosion of unrealized gains and potentially leading to unrealized losses in their investment portfolios.

First, it illustrates the notion that all good things must come to an end, including the long-term secular decline in bond yields. However, it also provides a lesson in how the panic of the herd works. In watching the financial press over the last week, the majority of the articles focused on the sell-off in bonds driven by the recent increase in inflation.  A casual reader or maybe even a captive board member might be excused for thinking that inflation is really starting to pick up and the Federal Reserve System may already be behind the curve. This is certainly evident in the mass liquidation from bond funds over the prior week. The herd is moving away from bonds.

However, investors might want to question this prevailing wisdom. There are a number of factors that suggest the fear of a rapid rise in inflation with the new administration may be overblown. Chief among these is the fact that the size of the US debt load will limit the impact of any stimulus spending during the next 4 years. The larger something is, the more input you need to make a significant change, which means that as the US public debt as a share of gross domestic product has risen, it will take more stimulus spending to drive inflation higher.

While this is true within the United States, the trend against much higher inflation is even stronger abroad. The debt loads of the southern tier of Europe and for many emerging market economies are even higher and will provide a constraint on high how yields are likely to rise. The fact of the matter is that many of these countries cannot support drastically high yields on their debt without the fear of default. (Parenthetically, the United States may well be in the same boat; we just choose to believe we are somehow immune.) Observers of the bond markets will note there have been numerous premature inflation calls over the past decade. While it is probably true that inflation and therefore bond yields are headed higher, from this editor's perspective we are not going to retrace the inflation route of the late '70s and early '80s, but that has not stopped a large percentage of the investing public from dumping bonds.

For captives, deal with the short-term pain in your portfolios. Be contemplative in how you approach any asset allocation shifts in your portfolio, and remember we all wanted to see bond yields move back toward normal to help produce some additional interest income we all can use.

As always, your comments are welcome; contact us.

November 23, 2016