Many fixed income portfolios were adjusted in anticipation of this year’s announcement of interest rate increases, which have yet to materialize. More risk is on the horizon now that low rates are already pushing some investment managers to take on more risk. The longer the term of a fixed income portfolio — especially for government securities — the more sensitive it becomes to interest rate increases. While the recovery in rates continues to elude managers, some prefer to stick with the status quo and remain exposed to volatility risk. Others, believing rate hikes are just around the corner, are seeking to protect themselves.
“Cutting terms makes us less sensitive to interest rates,” explains Christian Robert, director of investment solutions with Addenda Capital. However, there are limits. “Reduced sensitivity shouldn’t be achieved at any price and in a way that further undermines performance.” Managers can also use derivatives to reduce the terms through overlays, but again, there are costs involved.
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“It all boils down to managing short-term interest rate risk,” says Mathieu Provost, a senior consultant with Mercer. “Tactically speaking, managers tend to reduce the terms to position themselves for an interest rate increase. They trade their sensitivity to a rate hike for more exposure to risk.”
The world of risk
Persistently low interest rates are already driving managers to move into riskier fixed income securities to optimize yields. Managers are snubbing federal government bonds and looking more toward provincial and corporate bonds — even commercial mortgages, private debt or alternatives — which offer the prospect of absolute returns with no target time frame.
To this list, Provost adds solutions or products carrying risk that is less tangible and understood. “Managers will strive to improve or beat the benchmark index to eke out additional yields by relying on credit strategies, real assets or emerging markets. Or make trade-offs with riskier, less-liquid securities, or by adding an exchange rate variable — not to mention the sometimes higher management fees.”
For Provost, low interest rates are prompting managers to seek out opportunities without overexposing themselves to an equity market he believes is already expensive, and without increasing their exposure to a bond market that has become very expensive. In terms of liabilities, there are a growing number of transfers through annuity purchases, with the insurer taking on the volatility risk.
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Most managers say there will be fewer index-based actions for fixed income portfolios and more active management with a broadening of the investment universe. The average interest rate measured in Canada’s benchmark bond index is comparable to management fees. In other words, the prospects for making money are slim. Many will resort to leveraging based on liability-driven investment strategies, given the portfolio’s notorious sensitivity to interest rates.
For an increase of a few basis points, it will take two to three times as much time to recover the loss if the increase is applied to a 2% rate of return rather than a 5% to 7% rate. Benoit Durocher, executive vice-president and chief economic strategist with Addenda Capital, goes even further. For a rate of return of 2.2% over a seven-year period, an increase of about 30 basis points would be needed to wipe out the current yields. He captures the reality fixed income securities managers must deal with on a daily basis: a 30-year term winds up with a rate of return of less than 2% at maturity. “It’s hard to make peace with the idea of freezing your capital for 30 years at a rate that provides zero wealth after inflation,” Durocher adds.
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The same issue affects 10-year maturities, which offer a real rate of zero, while negative rates prevail for shorter terms — which is equivalent to paying insurance premiums. “The cushion the coupon rate might provide is very weak,” adds Robert.
Volatility can certainly generate sporadic returns that can rise from one year to the next. Then again, “all you are doing is borrowing against future returns. Models show that annual performance converges to the yield to maturity over the long term,” says Durocher. Even if managers rely on the yield curve, there is little, if any, manoeuvrability in the 10- to 30-year range, or anywhere for less than five years. “The wiggle room between five- and 10-year maturities is very slim,” he adds.
Jean-Pierre Aubry, an economist and associate fellow at the Center for Interuniversity Research and Analysis of Organizations, also stresses this convergence toward the yield to maturity, adding “a drop in interest rates also means that nominal rates are declining. If we turn to alternative solutions, we risk paying more than the actual value, which reduces potential yields by the same amount. There’s no way around it.” The tension between assets and liabilities is heightened as a result.
Recovery rate
And yet, wouldn’t a rate recovery be welcome? Generally speaking, low rates undervalue the need for asset/liability matching and reduce anticipated income, which raises two bigger questions. What is the source of the inflows—are they quality-based and predictable? And at what rate should they be discounted? These questions, in fact, argue in favour of a gradual rate increase. In the end, the nature of the liability will determine the rest. Provost says when faced with a matching problem, using fixed income to manage liabilities is generally recommended, while the quest for higher yields is entrusted to the portfolio’s growth portion. He emphasized that, on a solvency basis, DB pension plans would welcome an increase in interest rates.
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Claude Lamoureux, former president of the Ontario Teachers’ Pension Plan and an active retiree today, agrees. “If interest rates rise and the matching is perfect, the liability’s value should fall to the same extent as bonds. But since liabilities generally have a longer term, their value should decline deeper than bond values.
“Maintaining a matched position is how you reduce investment risk,” Lamoureux adds. For plans that are not 100% funded, or for which matching is not a concern, “the main risk lies with demographics, not investment,” due to the aging population.
There is broad consensus among pension plan managers and insurance companies: a rate increase is desirable, even if it triggers a short-term shock. The hope is for a fairly smooth transition, spread over a period of time, rather than a sharp, sudden shock. It’s also desirable to avoid a situation where short-term rates start to outshine the previous long-term rates, says one expert, wishing to remain anonymous. Discipline will be key for managers.
Interest rates: ambiguity still reigns
“It is distressing to see that the real economy can’t manage to generate real returns,” says Aubry. He attributes this strange dynamic to an economy still feeling the effects of central banks’ quantitative easing. “There is an excess of liquidities right now”— a surplus that’s expected to persist.
Over the longer term, however, the Bank of Canada’s expectations of a so-called neutral interest rate that is lower in the future continues to prevail. “The aging of the population or slow population growth is synonymous with sluggish growth, which is consistent with lower rates,” says Aubry. Durocher adds: “These trends are tough to ignore. The potential for longer-term economic growth has changed, and in the immediate term, central banks are keeping rates down in this period of monetary repression.”
Gerard Bérubé is a financial journalist at Montreal-based newspaper Le Devoir.
This article was translated from the original version published in Avantages.
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