fixed income in a sub-zero yield · pdf filefixed income in a sub-zero yield environment...

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


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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


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


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)

p.5

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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

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.


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% ?


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


Will vary due to plan specific details.

Tactical Range


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


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


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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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


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



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


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


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


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


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


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

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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...


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%

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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%

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3%

4%

5%

6%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

UK Govt 2Y UK Govt 10Y


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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About GARP | The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated to preparing professionals and organizations to makebetter informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies,academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM®) and the Energy Risk Professional (ERP®)exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of risk management via comprehensive professional education and training forprofessionals of all levels. www.garp.org.

© 2012 Global Association of Risk Professionals. All rights reserved.

fixed income in a sub-zero yield · pdf filefixed income in a sub-zero yield environment...

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