The recent issuance by the Italian government of a two-year bond yielding a negative interest rate is support for the idea that the concept of investing has been flipped on its head. Instead of taking a risk on the creditworthiness of a borrower and earning a positive expected return, investors are taking a risk on a borrower and, in many cases, earning a close to zero expected return,1 never mind what may happen if any inflation occurs. What does all this mean?
To fixed income investors obliged by the market to accept yields that are a fraction of return targets, such underperformance is pretty much the same as accepting a negative yield. In this context, the purchase of securities with negative expected returns (either on a standalone basis or relative to a return target) has ceased to be an actual investment. It now is really more of a product or a service providing certain characteristics rather than an investment intended to generate actual return. In other words, investors are purchasing a form of insurance but with all the credit risk previously associated with earning an investment return. Further, investors buy this product/service from entities that are not insurance companies and who may invest this money in ways that an insurance company would not or even could not. Investors, by accepting very low yields, are not being compensated for the risks that they are taking.
Substantial Demand for Fixed Income Investments
One of the putative causes of the 2008 crash was a worldwide desire for “safe” yield which led to the creation of an alphabet soup of instruments all designed to create investment grade risk out of underlying securities that were far from investment grade. This desire for “safe” yield has not gone away. A huge amount of global capital is chasing or being forced to chase long-duration investment grade fixed income.2 Overwhelming demand for fixed income assets, among other factors, has led to low and sometimes negative returns (in extreme cases).
The Practical Meaning of Very Low/Negative Yields
What does acceptance of guaranteed underperformance mean to an investor mandated to achieve a return benchmark? Buying insurance has a negative expected monetary value. No one expects to make money from buying car insurance; however, people judge the non-monetary value of the sense of safety that insurance brings to be worth the monetary cost. So what type of insurance are all these sophisticated investors buying? I would argue that there are two types:
1. Mitigation of risk of impairment of capital (Impairment insurance)3
2. Insurance against a decline in rates (Duration insurance)4
Bonds acting as duration insurance are actually a much worse deal than real insurance: not only is your premium at risk, but the entirety of the claim (your bond principal) is at the “insurance” company and subject to impairment.
The demand for investment grade credit exposure has created a scenario in which (currently) credible borrowers have changed hats and become unregulated insurance companies charging investors negative or near-negative yields for the privilege of “minding” their money and providing them with duration exposure. In addition, issuers are incentivized to issue more and more debt. Historically, sovereigns or companies with natural monopolies (e.g., railroads, for which there was very little technological innovation and no likely future disruption) were able to issue long duration debt. The Apple bond mentioned in footnote 1 is priced like it is a railroad, but can anyone argue that Apple faces little competition and a low possibility of disruption?
After all, things change. The 1994 Dow Jones 30 consisted of all investment grade companies, most of which were considered highly stable (by definition). In the intervening 21 years, six lost investment grade status and, of those six, three went bankrupt, including the previous technological darling Eastman Kodak. However, yields in 1994 for a long-duration investment grade portfolio were nearly 8%.5 They are around half that now5 meaning the return buffer for any downgrade or default is razor thin. This is the phenomenon of “returnless risk,” where investors are recast as consumers being sold insurance by unregulated insurers.
What to do? The first step is acknowledging the problem
What can investors do? The first step is to separate investing from insurance. An asset is no longer an “investment” if it was bought because of a characteristic other than return or if its return is lower than needed. Certain asset classes have crossed this line, moving away from being investments, and it is futile to wish for a positive expected return or outperformance of a return target from a fixed income instrument with a negative or very low yield. If the instruments must be held, what they are must be acknowledged and they should be managed accordingly. If there is a need for insurance, it is best not to manage it the same as an investment as insurance is the avoidance of risk; investment is the acceptance of risk. Managing both in the same way does not make sense.
It is important that the investment side focuses on investing with a positive expected value as well as a reasonable expectation that it can achieve whatever return target that has been set. Furthermore, investors should remember that something which may have qualified as an “investment” in the past may not be so any longer and may really only be in the portfolio as a source of protection. Investors need to budget for this cost accordingly with honesty in the expected return of the insurance part. In other words, they need to figure how much it will cost and come up with a strategy to pay for that cost or shortfall.
1 For example: 1. A 15 year Swiss Franc bond sold by Apple at the beginning of 2015: as of November 12, 2015, it yields 0.56%. 2. A two-year Euro-denominated Italian government bond came to market with a new issue yield of -0.023% on October 27, 2015. As of mid-November it was yielding 0.022%.
Source: Bloomberg, Financial Times
2 In the US, the top 100 corporate Defined Benefit (DB) plans alone represent $1.26 trillion; if just these engage in Liability Driven Investing (LDI) and attempt to match the duration of their liabilities (say between 10 and 20 years) they would need to purchase up to $2.5 trillion worth of long duration investment grade bonds. A good estimate of the available universe is the Barclays Long Gov/Credit Index which has a total market value of $2.6 trillion. This potential demand does not include smaller corporate and public plans who would also possibly have an LDI mandate (total US DB assets are $9.3 trillion). Nor does it include demand from all other possible purchasers of such bonds, never mind the effects of Quantitative Easing (QE).
3 Impairment insurance is the allocation to a well-diversified portfolio of investment grade credits—even if they are offering negative yields—to allow the investor both the capacity and the relative security desired.
4 Duration insurance is a service, not an investment. It hedges against the potential distorting effect duration exposure can have on the pricing of markets and the mispricing of risk in such markets.
5 Source: Barclays Live Long Gov/Credit Index, November 13, 2015
Ronan Cosgrave, CFA, CQF is a Managing Director and Portfolio Manager for Liability Driven Investing and Long Duration Solutions.
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