Behind the Scenes

For many investors, fixed-rate annuities are like blind trusts.

Investors enjoy tax and insurance benefits and can see the final output or result--usually in the form of a guaranteed payment that they receive--but they typically don’t have any idea what investments are producing the income.

Fixed annuities typically pay investors a return based on interest rates and the time period payments are made, which could be over just a few years or a lifetime. There are many kinds, but in general they transfer investment risk to the insurer. A classic “life annuity” pays a regular income as long as the client lives, with the insurer taking on the risk that they will live a long time.

Fixed annuities are direct obligations of insurance companies and don’t provide the same disclosures of other managed portfolios such as mutual funds or even variable-rate annuities. (Variable annuities invest in portfolios like mutual funds but typically guarantee a minimum value or return.)

Peter McMillan helps choose the investments used to back fixed annuities, and is responsible for managing more than $20 billion. He’s the 40-year-old chief investment officer and executive vice president for SunAmerica Investments, a unit of Century City-based SunAmerica Inc.

McMillan specializes in “junk,” or high-yield, bonds, which, together with an assortment of other fixed-income investments and a smattering of stocks, form the backbone of SunAmerica’s annuity portfolio.

Although the company doesn’t release total-return figures for its general account, McMillan says the firm generally earns 2.9 to 3 percentage points a year more on its portfolio than it pays out to annuity holders. With some of the company’s most popular products now yielding about 5%, that implies overall returns in the neighborhood of 8%.

The high-yield component that McMillan directly oversees has beaten industry averages since he joined the company. SunAmerica’s high-yield portfolio generated a 16.75% annual return from January 1990 through May 1998, compared with 13% for the high-yield market overall.

McMillan has been with SunAmerica since 1989. He spoke recently to Russ Wiles, a financial writer in Phoenix.

Times: Can you invest in anything you want?

McMillan: We have leeway to look at a variety of assets and securities. But while we invest in some common and preferred stocks, our focus is on fixed-income investments. Because we’re guaranteeing to pay a fixed rate of interest to our customers, we think the most appropriate way to deliver that is with fixed-income investments.

Times: In terms of the major asset categories--stocks, bonds, cash and real estate--how are you currently positioned?

McMillan: We have 34% of the portfolio in high-grade corporate bonds, 26% in mortgage-backed securities, 12% in commercial mortgages, 8% in high-yield bonds, along with roughly 6% in stocks and 5% in asset-backed securities like receivables on credit cards and auto loans. The rest is split among cash, Treasuries and direct real estate investments.

Times: Are you required by state insurance commissioners to invest so conservatively?

McMillan: It’s not a requirement.

Times: I assume you’re able to earn more on your investment portfolios than you pay out on the annuity contracts?

McMillan: Yes. The spread between our assets and liabilities is in the range of 290 to 300 basis points (2.9 to 3 percentage points) a year. We’ve been able to earn that fairly consistently over the past several years, and we believe we can maintain that going forward.

Times: Are most bond maturities you buy in the intermediate term, since your obligations are in that range?

McMillan: Yes. The term of our liabilities is fairly short, so the term of our assets also is fairly short. We focus on securities maturing in three to seven years.

Times: What’s your approach to buying bonds?

McMillan: We don’t bet on interest rates, and we don’t just chase after the [highest-yielding] assets. Our job is to add value through security selection. One asset category that we invest in more heavily than most other insurance companies is high-yield bonds.

That said, I should mention that our level of nonperforming assets is quite low. Even though we have a higher allocation to high-yield bonds than our competitors, our defaults on bonds and individual commercial loans are well below industry averages. [Annual] defaulted assets account for only about 0.2% of our portfolio.

Times: Why do you like high-yield bonds?

McMillan: It’s one of the less-efficient asset classes that we follow. You can find good values if you take a long-term approach. Going forward, we still see value, although we are a little concerned with what’s happening in Asia. There could be a short-term impact that causes high-yield bonds to underperform.

Times: Investors nervous about the potential of the Asian crisis spreading or deepening are buying more secure bonds, such as Treasuries. Has this affected you?

McMillan: We, too, have been increasing our allocation to Treasuries somewhat.

Times: What are some favorite bonds?

McMillan: We’ve invested in a number of CLECs, or competitive local exchange carriers.

One of our larger holdings is in Intermedia Communications. CLECs are telephone companies that still are in the early stages of building out their networks, with Intermedia a little further along in the process than most. These companies are facing negative cash flows, although they’re expected to go cash-flow positive this year. They’ve been adding lines and bringing on customers at a fairly rapid pace.

Times: What’s driving this business?

McMillan: These companies are competing with incumbent telephone companies in various markets, essentially going after the business of large companies while ignoring the residential market and even small firms. Basically, they’ve come in with the idea that they can provide better-quality lines, better service, better rates or some combination of the three.

Times: What’s an example of a high-grade corporate bond that you like?

McMillan: One is Mirage Resorts, the gaming company. The company’s yield spread relative to yields on Treasuries has widened to levels where Mirage bonds are very attractive--they pay about 140 basis points (1.4 percentage points) more than 10-year Treasuries. The spread has widened because of concerns about hotel and gaming overcapacity developing in Las Vegas in the next six to 12 months or so. Those concerns are valid, but we think the securities are attractive.

Times: How about mortgage-backed securities?

McMillan: One very important theme is that we always try to minimize prepayment risk [the danger that too many mortgages will be refinanced at lower rates].

One way we do this is by purchasing lower-coupon securities, which are backed by mortgages with lower interest rates. On these loans, there’s less of an incentive for homeowners to refinance, even if rates keep dropping.

. . . Most of what we purchase are private securities backed by jumbo home loans. They’re packaged and sold by Countrywide Credit and other mortgage bankers.

Times: You are assuming that homeowners in general will refinance more?

McMillan: Yes. We think interest rates could continue to move lower. What’s driving our forecast is the Asian crisis and how that might impact the U.S. economy. I don’t think the Federal Reserve will tighten at all. I think the Fed’s next move could be a lowering of interest rates over the next six to 12 months.

Times: If a recession did materialize, I assume that would cause some havoc with some of your high-yield holdings?

McMillan: We expect the default rate will rise somewhat even without a recession because the overall credit quality of high-yield securities being issued today is lower than it was just 12 to 24 months ago. This is why you need to be more selective in the high-yield market now.

Times: You hold some stocks in the portfolio, albeit a small proportion. Any particular themes or companies that you like there?

McMillan: We’re not trying to run a broadly diversified equity portfolio. Most of the stocks we own are shares that we picked up as a result of investing in the same firm’s high-yield bonds. We’re paid an interest rate on the bonds, usually a fairly high one, and receive an equity kicker for providing the money. In some deals, we receive from 10% to 20% of the company’s stock at no cost.

One company I like is Steinway Musical Instruments, in which we are the largest shareholder. The company manufactures pianos along with band and orchestra instruments. Band and orchestra instruments are a very stable business that has shown fairly good growth. Pianos aren’t as stable but also have shown good growth. . . . We own about 18% of the company, and I’m a director. . . .

Times: How does SunAmerica minimize the risk of defaults?

McMillan: We do an extensive amount of research on each company, and it doesn’t end after we make an investment . . . For example, if we invest in a consumer-products company, we’ll call its seven or eight largest customers and try to get in touch with a buyer at each of those firms.

Typically, four or five won’t talk, but usually two or three are willing to discuss the company, whether it’s gaining additional shelf space, how its products are selling and more. You need to do this on an ongoing basis because the fortunes of companies can change dramatically very quickly. It’s important to look at the firm’s financial statements, talk to management and talk to some analysts. But that’s only a good start.

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PROFILE

Name: Peter McMillan, chief investment officer and executive vice-president for SunAmerica Investments, specializing in high-yield investments used to back fixed-rate annuities.

SunAmerica Inc. at a Glance

Business: Financial services firm specializing in retirement products and services.

Headquarters: Century City

Products: Fixed and variable annuities, guaranteed investment contracts, mutual funds, trust services, investment counseling, corporate and mortgage lending.

Assets under management: $55 billion

Annuity sales: $2.8 billion a year.

Best selling fixed-annuities: Sterling Select annuities, currently yielding 4.85% (three-year term) and 5.10% (five-year)

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Source: Times research