fixed income in a sub-zero yield · pdf filefixed income in a sub-zero yield environment...
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Fixed Income in a Sub-ZeroYield Environment
Farid Kabbaj
Director, Investment Strategy & Solutions
Russell Investments
April 2015
2
The views expressed in the following material are the
author’s and do not necessarily represent the views of
the Global Association of Risk Professionals (GARP),
its Membership or its Management.
2 | © 2012 Global Association of Risk Professionals. All rights reserved.
Introduction
Global interest rates have fallen to historical lows
On the back of low growth/inflation expectations & QE (US, EU, JP, etc)
Often negative yielding: return free risk
From a business perspective, this is extremely challenging:
The combination of low solvency & tight regulation steer Institutional Investors into
holding an asset that could be in bubble territory
In most cases, pension funds and insurance companies need a higher rate of return
but have a limited risk budget
3 | © 2012 Global Association of Risk Professionals. All rights reserved.
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EUR 10Y Par Swap Rate
Interest rate development in the Eurozone
Source: Citi, 01-01-1999 to 21-04-2015
The average 10 years swap yield was 3.8% (since inception 01 Jan 1999)
› Very low market expectations regarding future growth combined with LTRO & QE
Average = 3.8%
20 April 2015 = 0.4%
ECB LTRO
2011 & 2012
Credit Crisis
2008
ECB QE
2015
4 | © 2012 Global Association of Risk Professionals. All rights reserved.
Are we experiencing a black swan?
10-years Euro Swap Yield3.75%
Probability
20 April 2015: 0.45% 1σ
68%
2.43% 5.07%1.11% 6.39%
96%
1σ2σ 2σ
Source: Citi, 01-01-1999 to 21-04-2015
5 | © 2012 Global Association of Risk Professionals. All rights reserved.
Yields in historical context (1815 to 1995)
During the period 1815 -1995 the average long term yield on Dutch government bonds
was 4.5% (based on a perpetual issued by the Dutch government in 1815)
The lowest rate was 2,7% (1895 & 1896)
Close to the UFR of 4.2% (2.2% real yield & 2.0% ECB inflation target)
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Yield on Dutch Government Bonds
Source: CBS “rendement 2.5% Grootboeklening”, JPMorgan
Average = 4.5%
20 April 2015
10 yrs swap
6 | © 2012 Global Association of Risk Professionals. All rights reserved.
6
Liability Driven Investment – the theory
Liability‘Least Risk`
Portfolio
ExpectedReturn &
RiskTolerance
Bonds (gvt)
Derivaties
Markt exposure βManager skill α
MatchingPortfolio
ReturnPortfolio
As a starting point, the liabilities are represented by the least risk portfolio
Calculated as a full cash-flow matching portfolio (nominal, real or a combination)
This theoretical portfolio becomes the liability benchmark (LDI approach)
The risk free return on the least risk portfolio will normally not be enough to fulfil theambitions of the fund so a risk budget is used to generate additional return
Leads to a risk free Matching Portfolio and a risky Return Portfolio
All risks within the portfolio are based on conscious decision making (´in control´)
Every risk is evaluated on a separate basis (reporting on effectiveness)
For illustrative purposes only.
7 | © 2012 Global Association of Risk Professionals. All rights reserved.
Issue # 1: Where will rates go?
Both rising and falling rates could be risky:
› For example, if the Euro rates drop to Swiss levels, a pension fund with a 50% hedge ratio would
see another 4%-5% drop in coverage ratio
› An increase of 2% would be beneficial for the coverage ratio but would see a collateral call of
around 14% for the industry (€168 billion)*
* Assumptions: coverage ratio = 100%, duration extension (overlay) = 7, pension assets = €1,200
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EUR 10Y Par Swap Rate
Source: Citi, 01-01-1999 to 21-04-2015
Swiss scenario?
20 April 2015 = -0.1%
Reversal to long term
average 3%-4% ?
8 | © 2012 Global Association of Risk Professionals. All rights reserved.
5%
6%
7%
8%
9%
10%
11%
12%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Hedge Ratio
Vo
lati
lity
of
On
eY
ear
Rela
tiv
eR
etu
rns
Issue # 1: Optimal hedge ratio - ALM perspective
From an ALM perspective, the optimal hedge ratio is around the 65% - 80% range
Diversification effect – not much reduction in Funding Level Volatility beyond 55% hedge ratio
For most pension funds, there is an opportunity to tactically move within this range
without breaching the “no additional risk” requirement (for pension funds in recovery)
8
For illustrative purposes only.
Will vary due to plan specific details.
Tactical Range
9 | © 2012 Global Association of Risk Professionals. All rights reserved.
Issue # 1: How to play the hedge ratio?
Stick to a fixed hedge ratio
This approach is simple and over time works well
In times of rising rates, it has no flexibility
Use a flight path based on the coverage ratio or absolute rate levels
Rate trigger: risk of lowering the hedge ratio to fast
Coverage ratio trigger: risk of lock-in
Specialist manager
QE and other severe market distortions taken into account in positioning
Often active management is seen as adding another risk. In the current environment, it is also a
risk mitigating measure
Can be implemented using the overlay and/or in the physical portfolio
10 | © 2012 Global Association of Risk Professionals. All rights reserved.
Issue # 2: UFR is now a non-hedgeable benchmark
A key assumption of the matching portfolio is that the liabilities can be hedged using
the risk free rate
• Due to the introduction of the UFR, a pure matching portfolio is loss giving
Also, since the Euro crisis, it is debatable if government bonds are really risk free or
should be considered as just another credit
• Are all members states risk free or is it just Germany?
Source: DNB, Citi
31 March 2015
Maturity UFR Curve Swap Curve Spread
1 0,08 0,01 0,07
5 0,24 0,25 -0,01
10 0,56 0,56 0,00
15 0,71 0,72 -0,01
20 0,79 0,78 0,01
25 0,98 0,80 0,18
30 1,28 0,80 0,47
11 | © 2012 Global Association of Risk Professionals. All rights reserved.11
High GradeGvt Bonds
Hed
gin
go
verla
yfo
rD
Bin
vesto
rs
Global IGCredit
Return Seekingfixed income
strategies
35%
For illustrative purposes only
5%
20%
Matching Portfolio
Also used as collateral for swap overlay
The Netherlands, Germany and Finland?
Also move to Matching Portfolio?
Credit component utilises risk budget but adds
diversification
Currency hedged
Return Portfolio
Assets such as HYD, EMD, Securitised and
leveraged loans
Diversifying effect
Issue # 2: A more pragmatic approach to the matching portfolio
From a risk perspective, it makes no difference if credit is placed in the matching or
return portfolio
In practice, it provides more scope for tactical positioning
12 | © 2012 Global Association of Risk Professionals. All rights reserved.
Issue # 3: The physical fixed income portfolio
Pre-2008, a FI portfolio was for most managers a 1-way bet on credit
We still believe that bonds with credit risk will generate higher returns than those of
comparable high-quality government securities over a market cycle
But, we are cognizant of the potential risks involved
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730
Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14
Op
tio
nA
dju
ste
dS
pre
ad
(bp
s)
Global Agg Industrials OAS Global Agg Finacials OAS Global Agg Utilities OAS
Global Agg Industrials OAS Average Global Agg Finacials OAS Average Global Agg Utilities OAS Average
Fed cuts rates to0-0.25%
Policy Action
Lehmanfiles for
Chapter 11bankrupt
protection
Green Shoots
Improving Fundamentals
European Sovereign
ECB LTRO...
Source: Bloomberg
13 | © 2012 Global Association of Risk Professionals. All rights reserved.
Issue # 3: Our conception of styles in fixed income
The array of active strategies has evolved considerably
Managing risk by diversification over regions, alpha sources & investment styles
For illustrative purposes only.
14 | © 2012 Global Association of Risk Professionals. All rights reserved.
Issue 3: Diversifying fixed income alpha sources
• Actively rotates between alpha drivers
• Often biased to spread sectors
• Depending on the managers some may have a morepronounced expertise in certain spread sectors vs.others.
Sector Rotator
• Usually high conviction with large currency andinterest rates bets
• Depending on style some managers are better atcountry RV, curve or directional duration
• Most successful ones are quite value anchored
Global Government
• Derivatives based investment proposition aiming inoverlaying benchmark replication with alpha sleeves
• Sleeves mostly focus on macro strategy eitherfundamental and or quantitative
• Usually shorter term in nature and focused on riskmanagement
Portable alpha
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Example fixed income strategyFor the active part of the FI strategy
CONSTRUCT
Low Contribution to expected excess return High
Return Drivers
SpecialistGvt BondManager
30%
SpecialistMortgageManager
10%
SpecialistCredit
Manager30%
CoreRotationalManager
25%
SpecialistAbsoluteReturn FI
5%
Total
Governments
IG Credit
Securitized
HY
EMD
FX
16 | © 2012 Global Association of Risk Professionals. All rights reserved.
Example fixed income strategyTracking Error: Ex Ante Active Risk Decomposition
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Dec-14
Co
ntr
ibu
tio
nto
Trac
kin
gE
rro
r(%
)Specific
Other Spread
Sector
Quality
Currency
Yield Curve
Duration
Source: Wilshire as of 30-Dec-14
17 | © 2012 Global Association of Risk Professionals. All rights reserved.
More complex structures require sophisticated risk management and daily
monitoring
• All based on full look through and a ‘clean’ data wharehouse
Risk Infrastructure
RiskMetrics
Multi-Manager
Equity
Multi-Manager
Fixed
Direct Inv.Cash Fixed
Income
AlternativeMulti Asset Overlay
ServicesForeign
ExchangeTransition
MgmtPortfolioSolutions
Investment Division
Market DataIndex Data
Axioma WilshireBloomberg,Barclays Pt
MeasureRisk Alt Soft CustomBarclays
PointCustomCustom
Holdings Data
18 | © 2012 Global Association of Risk Professionals. All rights reserved.
Conclusion
Interest rates have been at record lows, providing a big challenge for institutionalinvestors.
Part of the drop can be explained by low growth expectation (within the models) butthis is amplified by central bank policy (not in the models)
• Great uncertainty going forward - regime change can be a speedy affair (Grexit?)
• Not captured in the standard template
We believe diversification and flexibility are key in this environment and institutionalinvestors should be prepared:
• Ensure a proper risk framework is in place, including clear bandwidths
• Be pragmatic – the market doesn’t care about theory
• Especially in times of crisis, positioning should be managed on a frequent basis(daily)
• Derivatives might be a key source of liquidity in illiquid times
Active management can provide diversification and the agility to deal with uncertaintimes
19 | © 2012 Global Association of Risk Professionals. All rights reserved.
HY & EMD Spreads
Notes: BarCap US Corp High Yield OAS (average since Feb-94), BarCap Global Emerging Markets OAS (average since Aug-01).
Source: Bloomberg as of 31-Dec-2014
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mrt-08 sep-08 mrt-09 sep-09 mrt-10 sep-10 mrt-11 sep-11 mrt-12 sep-12 mrt-13 sep-13 mrt-14 sep-14 mrt-15
Op
tio
nA
dju
sted
Spre
ad(b
ps)
US Corporate HY OAS JPMorgan EMBI Global Spread
US Corporate HY OAS Average JPMorgan EMBI Global Spread Average
Fed cuts ratesto 0-0.25% Policy Action
Lehmanfiles for
Chapter 11bankruptctprotection
BearStearnsrescue
Green Shoots
Improving Fundamentals
EuropeanSovereign Crisis...
ECB LTRO...
20 | © 2012 Global Association of Risk Professionals. All rights reserved.
2yr and 10yr Developed Market Government Bond YieldsUS & Europe decline in Q314
Notes: 2 year and 10 year Government bond yields, weekly. Source: Bloomberg as of 31-Dec-14
0%
1%
2%
3%
4%
5%
6%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
US Govt 2Y US Govt 10Y
-1%
0%
1%
1%
2%
2%
3%
3%
2006 2007 2008 2009 2010 2011 2012 2013 2014
JP Govt 2Y JP Govt 10Y
-1%
0%
1%
2%
3%
4%
5%
6%
2006 2007 2008 2009 2010 2011 2012 2013 2014
DE Govt 2Y DE Govt 10Y
0%
1%
2%
3%
4%
5%
6%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
UK Govt 2Y UK Govt 10Y
21 | © 2012 Global Association of Risk Professionals. All rights reserved.
Italy and Spain government bond yields
Notes: 10 year Government bond yields, weekly. Source: Bloomberg as of 31-Dec-2014
1%
2%
3%
4%
5%
6%
7%
8%
IT Govt 10Y SP Govt 10Y
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© 2012 Global Association of Risk Professionals. All rights reserved.