Short positions on domestic insurance stocks continue to climb higher and it's likely this is through no fault of the companies themselves. The basic business of insurance has been made far more difficult in the low interest-rate environment and the problems extend well into the world of pension liabilities.
Insurance companies and pension funds have what is termed "long-dated liabilities." They receive payments in the short term, invest the proceeds and the growth of this investment pool allows for the eventual payment of life insurance policies and retirement pensions.
Insurance and pension fund assets are dominated by fixed income to limit portfolio risk. This was fine, thanks to the magic of compound interest, when bond yields were much higher – future liabilities were covered relatively easily. But now, with global interest rates plumbing historically low depths, even negative yields for over $6-trillion (U.S.) in sovereign bonds, the required returns are increasingly difficult to find.
As the accompanying chart highlights, the steepness of the bond-market yield curve – the 10-year bond yield minus the two-year bond yield – provides an effective indicator for the course of insurance stocks. (I'm using the U.S. bond market, the world's largest, as a proxy for global fixed income markets.)
There are a few reasons behind this. One, a steeper yield curve implies higher longer-term bond yields that help fund long-term financial commitments. Two, the yield curve also indicates the bond market's consensus view on future economic growth and inflation. The steeper the yield curve, the more economic growth is projected.
The accompanying chart shows the impact of bond yields on the stock price for Sun Life Financial (I'm not singling Sun Life out, the chart looks almost identical for competitor Manulife Financial). From 2011 to early 2014, Sun Life's stock price closely followed the steepness of the yield curve. This makes sense – the flattening yield curve between February, 2011, and July, 2012, occurred because the U.S. 10-year bond yield was cut in half to 1.6 per cent for the period. The stock-price weakness was the market's recognition that the insurer would have lower returns from their investment portfolio, and thus lower future profitability. The reverse, more positive case of a steepening yield curve and rising stock price, was visible from July, 2013, to December, 2014.
Sun Life's stock price began levitating above the yield curve steepness in May of 2014. Eventually, and I would suggest not coincidentally, investors began to pile on short positions in the stock. From July, 2015, the number of Sun Life shares sold short more than tripled to over 20 million. As a percentage of the total shares outstanding, this represented a rise from 1.1 per cent to 3.3 per cent.
To be clear, I'm not suggesting that the yield curve is the only factor involved with insurance stocks, nor that they are in any financial difficulty. There are numerous and complex methods by which interest rates can be hedged.
The point remains, however, that for insurers, pension funds and any financial entity that accept funds now with a guarantee to pay out in the future, an extended continuation of the low-interest-rate, flat-yield-curve environment will make life far more difficult than any period in recent memory.
Follow Scott Barlow on Twitter @SBarlow_ROB.