Focus on risk management – Union Investment tests limits of models in low rate world

Experts at Union Investments’ recent risk management conference in Mainz faced an urgent task – what figures and assumptions are appropriate for risk models during times of persistent near-zero interest rates, not least in a year their clients’ average target returns are generally above 3%.

In a poll taken at the conference in mid-November, 52% of delegates hoped for returns of 3.5% or more from their portfolios this year, and 24% wanted over 4%. Only 8% said they would be satisfied with 2% or less.

(Such findings were not far from the average of 3.4% recorded last year.)

Now, the Eurozone’s benchmark refinancing rate is just 0.75%. Jens Wilhelm, member of the board of managing directors at Union Investment responsible for investment strategy said “a lower interest rate environment is something we will have to live with for the foreseeable future.”

Andrew Bosomworth, a managing director and head of PIMCO portfolio management in Germany, says: “Significant downward revision to the 2013 GDP growth forecast and downward revision to HICP point to a further rate cut next year.

“Discussion on unintended consequences of cutting the Deposit Facility rate below 0% suggests the [ECB] Governing Council is cautious about making this move. We agree. Negative official interest rates act as a strong encouragement to get money into another currency, not to where the liquidity in the euro area is most needed.

“Germany, which is least in need of stimulus, would benefit most from a weaker euro induced by a negative Deposit Facility rate, southern Europe would benefit the least. Better to focus on easing financial conditions where they are tight, not where they are least needed. Rate cuts won’t help much.”

In this climate, 10-year Bund yields have topped 2% on just four trading days this year. Real yields on many Bunds, gilts and Treasuries are negative.

Alexander Schindler, head of Union Investment’s institutional business, names low rates and low yields as the greatest threat to his clients.

For risk modelling experts, low rates present another kind of business challenge, namely whether the models they have built for healthier periods and healthier economies in the past are still suitable – that is, relevant – for today’s ‘lower for longer’ rates environment.

Thorsten Neumann, managing director at Union Investment responsible for risk management and the investment process, says: “The question is, can we just use current data, or should we look towards [data from places such as] Japan? It is a touchy subject whether we should take different approaches for assessing risk models, but you always have conversion to the mean.

“We always have forecasts heading towards 3% to 4% interest rates, but if forecasts suggest rates will stay so low for so long, it becomes a question of whether you rely on a model that says we will revert to the average? That is the risk. You have to distinguish between the mean scenario, and how much can we bear?”

To decide this, for Neumann, involves discussions between people, not further statistical analysis.

Forming appropriate risk models for debt and spread products today is crucial.

Jens Wilhelm told delegates instruments that may once have been of only peripheral interest to investors had become more important in a yield-starved world.

He pointed to various investment grade and sub-investment grade companies whose bonds yield 4% or more, from Russia to Germany.

“These are companies we might normally add, but they would not be our main focus, so the question is, what should we add to get out of the interest rate trap? It is clear you will have to strike a balance. We are still caught in a crisis with Greece, even if the risk overall is definitely lower than last year.”

Speakers at the conference said risk models could be a risk themselves if they were inadequate for the prevailing climate, or used faulty data.
It seems the task of how to avoid such a risk, not least in the fixed income complex, is a ‘work in progress’.

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