As markets remain close to record levels, pension investors have a hard choice in front of them: should they 1) hedge liabilities and lock in low returns, 2) aim for their return target and take their chances regarding the liabilities or 3) do a bit of both?
While they are increasingly expensive, markets are cooperating in one big way: the cost of insurance has collapsed in interest rates (and stayed low). By implementing a nonlinear hedge with interest rate options, investors can be hedged in scenarios where protection is vital and be less impacted by losses in scenarios where a hedge is a hindrance – always an attractive position, but all the more so at these low price levels.
Furthermore, at current spreads, investors should seriously consider diversifying away from credit risk in their portfolios. Right now a portfolio that is focused solely on the various flavors of the credit risk factor is receiving historically low levels of return. Credit has had a fair wind for several years now and there is little headroom remaining. Diversifying away from this makes sense.
Therefore, our recommendations include:
1. Using low levels of implied volatility to help the portfolio as a whole
The current level of implied volatility in long-dated swaptions, which has not been seen in over 10 years (and is 25% less expensive than at the start of 2017), makes these instruments a cost-effective choice to protect the portfolio.
2. Diversifying away from credit risk
Tight spreads and low yields for high grade credit continue to be a headwind for investors, forcing a dilemma of accepting poor returns in exchange for hedging liabilities. A singular focus on credit for Liability Driven Investing (LDI) implementation makes achieving return targets and overcoming index slippage a very tall order.
3. Moving from passive to active; macro to micro
Until recently, many investors have focused on making the right macro decisions and selecting passive strategies to implement their views. This is an approach that has certainly borne fruit in the recent one-way markets. The current historically high valuations of so many asset classes mean that making the right macro decision is increasingly difficult (as shorting in a pension fund can be challenging). Pension investors should resist the temptation to lash themselves to the mast of low yields and tight spreads. Rather, they should try to operate in a much more micro fashion and accentuate a more active role.
Macroeconomic trends are hard to call regardless of the amount of due diligence done. For microeconomic trades, however, the amount of due diligence meaningfully improves the odds of success. Rather than looking for asset class value, investors should re-focus on sub-asset class and individual trade value. In other words, invest actively rather than passively.
The start of the year saw some rediscovery of the truism that investing is hard and that markets go two ways. Whichever scenario we end up in, there is value in flexibility, opportunism and diversification. Being positioned for this sort of transition is never free but, remarkably, it is cheaper now than it has ever been.
Pension investors have a series of hard and possibly irreconcilable choices in front of them: should they hedge liabilities and lock in low returns or should they invest for high returns and not hedge liabilities, or should they do a bit of both?
Uncertainty remains high and investing in this environment may feel like being in an endless waiting room with no resolution. Looking at three potential future scenarios: normalization, a Japan-like scenario in the U.S., and the return of volatility (the bad sort), helps frame the issues. There are also non-symmetric choices for hedging rates such as using currently historically cheap swaptions that, when utilized, offer significant flexibility to investors in managing their overall portfolios. The other component worthy of consideration is that investors should pay heed to the tightness of credit spreads. Investors would be wise to remain engaged in credit risk replacement as a matter of urgency regardless of views on rates.
What are People Saying?
Recent talk (and actions) from the Fed and other central banks regarding an increase in inflation and rate rises has substantially influenced views among commentators and pundits. The strong global economy, and the slow withdrawal of monetary stimulus have bolstered hawkish rate views. Despite these factors, long bond rates still remain firmly within the range of the past five years.
Over the past few years, investors have seen almost every risk market move from significantly undervalued (2009) to priced for perfection (2017/2018). Today’s choice seems to be between a rock and a hard place: take your pick of one overpriced asset class over the other. This investment conundrum is further compounded by the requirement of pension investors to address their liability hedge ratio. What can be done? Well, there is one thing that continues to get cheaper even as everything else gets expensive: rate insurance. The cost of rate insurance has declined by nearly 30% over the past 12 months and — even after the shock to volatility at the start of February — remains at very low levels. This is demonstrated by the following chart which shows the relative change in implied volatility for VIX and for long-dated swaptions since the start of the year:
Swaption Implied Volatility (Level at 1/1/18 = 1)
As of May 31, 2018
What’s Been Going On?
We all know the headlines and the trends but stepping back and reconciling where we are today versus expectations of even a few years ago is quite enlightening. The past five years or so have caught the investing world in a one-way trip: according to pundits, long rates have been on the verge of “normalizing” for the entire period but have instead stayed within a range; meanwhile equities have been on a trip skyward (until the recent high in early 2018) and credit has steadily ground tighter. If, in 2012, you said that in 2018 the S&P 500 would have nearly doubled from 1400, unemployment would be at 4%, and the Fed would be shrinking its balance sheet with the end of Quantitative Easing (QE), but despite all of this, the 30-year rate would be close to 3%, there would have been some funny looks and probably laughter. Further, your counterpart, who was laughing at you, would have maintained their positions in preparation for a take-off in both rates and inflation (neither of which happened). Finally, if you told them that the cost of insuring against such a take-off of rates would be about 30% cheaper than it was then, they would have thought you were crazy. And yet here we are.
Cost of Swaption Insurance is the lowest since 2007
Source: JP Morgan Markets
As of May 31, 2018
Note: The 11-year date range was chosen in order to include the period leading to the 2008 financial crisis.
Meanwhile, the term premium in the rate curve has gone away: the difference between the 2 year and the 30-year yield is less than 1% as the short end has crept higher. This is despite the Fed’s signaling to the market both a continuing increase in the short-term rate level as well as the slow shrinking of current holdings of other duration bonds. There is a continuous bid for the long end of the curve, as suggested by the 2.41 bid to cover ratio of the recent 30-year auction in April. This was in line with January’s ratio of 2.74 which was the highest such ratio since 2014.¹ Fixed income investors are in an endless waiting room, stuck there for an indefinite period for judgement and eventual consignment to an appropriate fate. While there, they are caught between requirements to be long duration and unsustainable return targets.
Collapse in Term Premium
Source: JPMorgan Markets
As of May 31, 2018
Note: The 11-year date range was chosen in order to include the period leading to the 2008 financial crisis.
So Where Do We Go From Here?
Taking an agnostic view of the motivations behind a flat yield curve, what does it tell us about the future? First off, the markets are saying that there is more capital than opportunity. In the long term the markets think that the appropriate risk-free rate of return for investing for 30 years is somewhere around 3%. Second, there is a lot of talk of the future and how this situation in rates may or may not change. Assuming we don’t revert to the waiting room of the past few years of low volatility markets, let’s look at three possible scenarios that could play out in the short-medium term that merit consideration by investors.
Scenario 1: Normalization – at last!
• Economic growth is strong
• The bond market sells off, driven by central bank removing QE
• Everything is stable and steady
In this scenario, the term premium should increase, partially driven by the central banks of the world unwinding their QE balance sheets. Investors sell out of bonds and reinvest in better opportunities. This reduces the demand for long-duration bonds, raises yields and funds productivity-enhancing investments, increasing the “pie” for all.
But might this actually happen? This could be a sort of hell for the holders of long-duration assets as a new rate regime consistent with what was previously considered normal reasserts itself. However, given that there is a large set of pension investors following a glide path that requires them to sell their risk assets and buy the required long-duration bonds, a rising equity market has the side impact of also providing a steady bid for duration. This occurs despite rising yields at the short end. In other words, pension investors are forced to buy into a bond market depressing yields below where they would otherwise be, maintaining the current flat yield curve.
In this scenario, the economy lives up to the hype implied by equities. Normally we would expect that the curve should start to steepen as bond investors are attracted to other asset classes, but LDI glide paths don’t account for this. They will either cause yields to stay stubbornly static or force investors into a losing trade. This would replicate the situation in the UK gilt market, where a limited issuance of long-dated gilts has been eagerly snapped up by a set of constrained investors.
Scenario 2: Japan-like Scenario in the U.S.
• Stagnant Growth
• All investments perform poorly
In this scenario, the economy does not grow and inflation is not the problem — deflation is. Yields keep going down and the curve is basically flat, meaning no term premium at all. Holding long duration assets produces capital gains but the yield is derisory. Equities perform poorly over the long term as growth is in line with what has been predicted by the low and flat yield curve. This will hurt investors who choose to remain unhedged to rates as well as those who focus on a passive approach to risk assets.
Scenario 3: Something Happens – Volatility!
• Exogenous shock
• Positive or negative development draws capital from bonds
• Yields increase
In this scenario, an exogenous shock forces markets to adapt to a new economic equilibrium causing real change to the long-term calculus embedded in current markets. Such a change can be positive or negative. A positive change brings a set of transformative technologies and investments that pull capital from safe assets to reinvest in productivity-enhancing assets. Such a shortage of capital for bonds will drive yields up. The withdrawal of QE is also meant to have a similar effect.
On the negative side, an event that causes a large destruction of economic capital, such as a natural or manmade disaster, attracts large amounts of financial capital away from other uses in order to rebuild and regenerate. In other words, volatility! We had a little bit of a taste of what volatility is at the start of February; market participants that had grown complacent riding market trends suddenly experienced real uncertainty and actual losses. In the event of real uncertainty around future prospects, bond investors will get hit by both rising rates and widening spreads.
Pension Investors’ Dilemma
The weight of glide paths on the long-duration bond market is critical; pension plans betting that rising long rates will bail them out of poor funded-status by keeping the hedge ratio low may be very disappointed. Similarly, fully hedged plans hoping that a rise in risky assets will bail them out of the gap between current yields and the expected return on assets may also be disappointed. There is no simple solution to this other than the hard work of investing beneath the macro level and staying open to opportunities, diversifying away from tight credit spreads and finding cheapness where possible, both for hedging and for return-seeking parts of the portfolio.
1 Source Department of Treasury, Bureau of the Fiscal Service 30 Year Auctions of Jan 11, 2018 and April 12, 2018.
Ronan Cosgrave, CFA, CQF is a Managing Director and is Portfolio Manager for PAAMCO’s LDI and Long Duration solutions. He serves also as the main point of contact for certain institutional investor relationships. Prior to joining PAAMCO, Ronan worked as a Process Engineer at IBM’s Storage Technology Division sites in Silicon Valley, Germany and Ireland. He also did chemical engineering design and commissioning for ProsCon, an Irish engineering and process control consultancy. Ronan received his MBA from Columbia Business School, and B. Eng. in Chemical and Process Engineering (Honors) from Cork Institute of Technology. </span>
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