Why and how to deal with negative rates?

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 Jérôme Teiletche, Unigestion’s head of Cross Asset Solutions, assesses the impact of current negative bond yields on investors, suggesting tactical or more structural solutions for global asset allocation.

For each investor, the appropriate solutions will be greatly impacted by their return targets as well as their risk budgets. This is whether economically determined or imposed by a regulatory framework. And, it will probably require dynamic adjustments over time.

Historically, negative interest rates occurred at specific times and have been very rare until now. Most of these periods were characterised by the fear or uncertainty felt by investors who fled to safer assets.

We currently find ourselves in a situation where Japan, Denmark, Sweden, Switzerland and several Eurozone countries have bonds with negative yields. Overall, as of mid-February 2015 the current volume of bonds with negative yields represent roughly 25% of the BofA ML Euro Government index.

The current situation can be linked to the exceptional demand from central banks that added to the structural demand for fixed income caused by financial sector regulation (i.e. Basel III and Solvency II); this is despite investment from corporates and households remaining weak.

Why do investors continue to invest in negative yielding assets?

As recent auctions from different countries have shown, negatively yielding bonds have encountered significant demand from investors. Beyond investors allocating passively to bond benchmarks, a less constrained investor may find rational reasons to purchase negative-yield bonds.

Firstly, we need to distinguish between the nominal and real rate of return. For investors located in countries affected by a high risk of deflation, negative yields are attractive as long as they are higher than inflation. In simple terms, a return of -1% is not necessarily unattractive if inflation is at -2% because the real rate of return is positive.

In addition, the Japanese experience shows that even with low yields, government bonds can be the best asset in a deflationary economy (Figure 1).

A closely related argument is based on the carry earned. Central banks use negative deposit rates as a tool to encourage risk taking and credit creation (Eurozone, Japan and Sweden) or to depreciate their currency (Denmark and Switzerland).

Using this framework, the interest rate curve remains steep and investors will prefer long-term bonds rather than lower yielding shorter term positions. In short, the yield curve has shifted into negative territory, but the mechanism of carry investing remains the same.

How negative can rates become?

If central banks were to drive yields on bank deposits too deep into the negative then bank runs could occur. Indeed, people would choose to hold cash instead of accepting negative yielding deposits. A bank run is the worst case scenario for a central banker. It is a constraint on the central bank to set negative interest rates. Some years ago, Fischer Black argued that nominal short rates can never be negative because “people would rather keep currency in their mattresses than hold instruments bearing negative interest rates”.

In practice, the floor for negative rates could be the estimated cost of storing cash. The negative lower bound for interest rates is probably lower than the -75bps currently prevailing in Switzerland, based on the cost of storing gold or the fees applied on payment transactions. Based on this reasoning, yields as low as -2% or -3% are possible – at least temporarily.

What are the consequences?

While the situation is pretty new, we can identify several consequences of negative yields for asset allocation.

Firstly, investors are encouraged to take more risk and switch to spread products such as corporate bonds or peripheral countries in the Eurozone (Figure 3, overleaf). This search for yield has been taking place since the summer of 2011 and we expect it to prevail in the short term. This is especially true for regions that will be affected more than temporarily by negative yields (Eurozone, Sweden, Japan and Switzerland).

Secondly, investors have expanded their geographical allocation by moving from low to higher yielding countries without necessarily downgrading their sovereign risk.

The US Treasury market has benefited the most from this trend. This has given way to a new conundrum as yields have remained very low in the US despite the Federal Reserve’s QE exit and its declared willingness to increase rates following the significant recovery in the US economy.

Beyond these short-term effects, negative rates will in our view have a long-lasting impact. For investors, the forward looking risk-return profile has significantly deteriorated. Simple measures for long-term expected real returns on their portfolios – based on yields on assets and inflation expectations – have substantially declined, mainly due to the fixed income part.

Risks have increased as well. While bond volatility remains near historical lows, the forward looking risk of fixed income has in our view increased significantly.

Due to the decline in yields, the duration in portfolios has increased and, as yields approach a floor, the prospective distribution of bond returns is becoming more and more negatively skewed. This risk is totally ignored by risk measures such as volatility.

This increase in risks could be even more pronounced for investors who have decided to pursue the search-for-yield race, as they have added substantially higher credit and liquidity risk on top of duration risk.

The liability side is more complex to evaluate. It depends on the regulatory and accounting setup of each investor. For investors who have to re-evaluate their liabilities in relation to the level of yields – either sovereign or corporate – their future situation has deteriorated, although their surplus has probably increased in recent years. It depends mostly on the future inflation path. If a deflationary scenario takes place for many years, the sole long-standing solution might be to reduce the nominal value of pensions (in case of an absence in nominal rigidities).

The consequences on the liability side are more complex to evaluate. They depend greatly on the regulatory and accounting framework of the investor. For investors who have to value their liabilities with current yields – either sovereign or corporate – the current situation has deteriorated significantly. The final outcome depends mostly on the future level of inflation. If a deflationary scenario endures for many years, the sole long-standing solution might be to reduce the nominal value of pensions. Even in the contrary scenario where inflation increases subsequently – as is probably the desired outcome of central bank policies – the real pension income might be lower compared to current levels.

What are the solutions?

We do not believe that the solution is necessarily to avoid bond investing in total. In some geographical areas such as the Eurozone, the situation is fundamentally related to deflationary forces which could support bonds as a source of return, albeit in a limited fashion. Furthermore, the bond market is affected by other technical factors. For instance, net issuance will be limited in developed sovereign bond markets in the coming months, but demand may stay structurally strong as central banks are implementing QE and some institutional investors are being forced to reduce their equity allocation due to regulations like Basel III or Solvency II.

Nevertheless, bond investors need to tactically adapt to the new environment. Firstly, they need to be more discriminant and restrict themselves to countries where the ratio of real carry-to-risk remains attractive. In particular, we advise to apply risk-based solutions in fixed income that do not restrict the definition of risk to just volatility. At the moment, this means avoiding JGBs and favouring countries such as New Zealand and Ireland. US T-Notes and UK Gilts are offering attractive carry in relative terms, but the market may be underestimating the risk of rate hikes in these countries. Therefore, investors who are sensitive to changes in nominal valuations need to ensure an appropriate entry level.

As mentioned before, a solution followed by several investors has been to chase yield without discrimination – in particular by lowering the constraint on ratings.  We don’t think this is an appropriate solution for all investors as we are concerned by the deterioration in liquidity in many fixed income categories. In this regard, our current preference is for European high grade corporate bonds, non-core Eurozone sovereigns (excluding Greece) and selected emerging countries such as Mexico and even Brazil.

As we expect the situation of low (and even negative) bond yields to prevail for some time, and given that the risk to bonds is significantly higher, investors probably also need to address the problem more strategically – notably by broadening their scope beyond traditional fixed income.

There are two reasons why investors hold governments bonds in a diversified portfolio: i) as a source of income ii) to protect their portfolios against shocks that impact other asset classes during adverse periods – most notably growth assets such as equities during a recession. Unfortunately, we do not believe that any other asset can play both these roles on a standalone basis. As an example, being long equity volatility is very good protection for most shocks. However, it has a substantially negative yield and, therefore, cannot constitute a buy-and-hold solution. Rather, we think that investors will have to seek income and protection separately.

  1. Regarding income, in the category of liquid investments, several solutions stand out. Low-risk equity is an interesting long-only approach, most notably because it consumes less risk budget than traditional equity for a similar return level. Liquid alternative beta solutions can diversify the income profile with strategies such as value, quality or momentum equity factors or long-short carry strategies implemented through FX or fixed income derivatives. Attractive income opportunities can also be found in less liquid investments. Private debt instruments have attractive features as the regulation-related constraints on the lending capacity of the banks are creating a supply and demand imbalance in favour of investors that have the ability and willingness to lock in their capital in exchange for an attractive risk-adjusted income.
  2. On the protection side, cross-assets trend-following methodologies are one of our preferred solutions. Such a strategy can be replicated in a liquid and transparent fashion and protect diversified portfolios.

However, we think other protection strategies will be pursued as well. Opportunistic hedges designed to achieve specific protection over the market cycle are preferred to pure rule-based tail-hedging solutions. Finally, trading strategies such as global macro have the advantage of combining some characteristics of momentum with the benefit of a discretionary overlay. In total, as far as downside protection is concerned, we think that the active management of the exposure to the direction of markets (beta) is the most important aspect.

How could this situation change?

Yields are negative due to deflation pressures generated by the deleveraging and ageing population process, and due to central bank actions to support activity. In this context, the return of inflation could be viewed as the worst case scenario.

Inflation could expose investors to significant losses on their bond allocation. Nevertheless, from a global perspective this would not necessarily be the worst outcome in the long run as it would reduce the burden of high debt. And, after initial adjustments to higher rates, the performance of bonds would recover due to higher yield and associated carry. However, we think the prospects for such a risk remains limited in the short term and that the real risk is that yields will stay relatively low for a long period of time.

The situation is undeniably challenging for all investors. In this article, we have suggested tactical or more structural solutions for global asset allocation. For each investor, the appropriate solutions will be greatly impacted by their return targets as well as their risk budgets. This is whether economically determined or imposed by a regulatory framework. And, it will probably require dynamic adjustments over time.

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