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ANALYSIS-Search for yield has insurers running to alternatives

* Persistent low yields force search for alternatives

* Private pensions raise competition for bond supply

* Insurers turn to real estate, infrastructure projects

NEW YORK, June 2 (Reuters) - The rock-bottom yields on offer in the corporate bond market are putting pressure on investment returns for U.S. life insurers and driving them into riskier and less liquid investments such as private equity and infrastructure debt, insurers said.

Low rates have hurt insurer investment returns and the profitability of insurance products with guaranteed returns. Life insurers' portfolios, on average, lost 0.8 percent in 2013, according to SNL Financial.

Those weak returns, along with more competition from private pension funds for the supply of U.S. corporate bonds have prompted U.S. life insurers to consider riskier strategies to provide richer compensation.

"The key focus for us is the race for yield," said Todd Hedtke, vice president for investment management at Allianz Life Insurance of North America in Minneapolis, which has $80 billion in assets. Allianz, owned by Allianz Group in Germany, has been making investments in renewable energy projects, including more than $2 billion on wind plants in Germany and elsewhere.

U.S. life insurance companies, with investable assets of about $3.5 trillion at the end of 2013, are one of the largest sources of investment capital, representing 64 percent of the total U.S. insurance industry.

Over the last five years, David Lomas, head of the global financial institutions group at BlackRock in New York, said he has seen insurer assets in hedge funds, private equity and real estate rise by about 10 percent.

The foray into alternative investments shows how major investors are making changes to deal with low interest rates. Long-term assets such as real estate generally preserve value during uncertain economic periods, but carry risks due to their illiquidity.

"When you invest in equity-style assets such as equity real estate, they're very good matches for our long-term liabilities, which don't come due until 30, 40, or 50 years later," said Richard Leist, managing director at MetLife Inc's global portfolio management group in Morristown, New Jersey, which has assets of roughly $500 billion.

MetLife is one of the largest investors in the property market, with nearly $55 billion in real estate assets. Early this year, MetLife and Norges Bank Investment Management, Norway's sovereign wealth fund, jointly invested in office properties in Boston, Washington and San Francisco with an estimated value of $1.7 billion.

More than a third, or 35 percent, of chief investment officers of 233 global insurance companies intend to increase overall portfolio risk over the next 12 months, while only 8 percent said they will decrease risk, a recent Goldman Sachs Asset Management (GSAM) survey showed.

About 29 percent of chief investment officers told Goldman they will raise holdings of infrastructure debt, 28 percent will increase allocation to private equity, 26 percent to commercial mortgage loans, and 26 percent to real estate.

Allianz's Hedtke aims to shift 10 percent of his firm's assets into less traditional investments in the next three to five years.

"Long-dated, illiquid types of assets that also tend to be a little more complex tend to be where we focus," he said. "Private projects like infrastructure and renewable energy stuff are where you see new efforts and renewed focus among insurers."

In the case of infrastructure debt, default rates are low, while credit quality improves over time as the long-term project gets completed.

That said, illiquid investments have inherent risks. They do not trade often and therefore can't be sold quickly without a discount. For many life insurers now at their healthiest since the global financial crisis, the risks are worth taking.

"It's important to point out that generally speaking, illiquid investments tend to have to have much stronger covenants and contracts embedded for investors than most public investments," said MetLife's Leist.

DEARTH OF SUPPLY, LOWER RETURNS

Traditionally, life insurance companies are very large owners of corporate bonds - about 60 percent of their portfolios at the end of 2013, data from the National Association of Insurance Commissioners showed.

U.S. corporate bond issuance for 30-year maturities has been steady so far this year, but competition from other institutional investors such as corporate pension funds has increased for the same amount of supply, pushing down yields. The additional competition has forced spreads over U.S. Treasuries to tighten.

The extra yield buyers demand to hold corporate bonds instead of government debt has narrowed 0.36 percentage points since May 2013 when expectations rose about the Federal Reserve tapering its bond purchases. According to the Bank of America Merrill Lynch Master Index, the composite spread on high-grade bonds was at 1.11 percentage points or the tightest level since 2007. The tightening of spreads in junk rated bonds has been more dramatic. The composite spread on junk bonds was at 3.75 percentage points on May 30, or 0.75 percentage point tighter than the May 1, 2013, levels.

U.S. Treasury debt yields rose in 2013, compressing the unrealized gain that had been embedded in the portfolios of insurance companies, said BlackRock's Lomas.

Returns came to a loss of 0.8 percent on their portfolios last year, according to data from SNL Financial, a business intelligence data provider in Charlottesville, Virginia. In the three years ending 2013, the return was 4.67 percent.

The rise in long-dated yields has also curbed issuance of 30-year bonds - which life insurers like because they're used to match long-dated liabilities - at a time when the competition for new issuance has grown more fierce.

"Should rates rise, we would expect long corporate supply to diminish further as funding costs become less attractive to corporations," said John Melvin, global head of insurance fixed income at GSAM's insurance asset management group

It's no wonder insurers are looking for alternatives.

(Reporting by Richard Leong and Gertrude Chavez-Dreyfuss, Graphic by Stephen Culp. Editing by David Gaffen and John Pickering)