 By Paul Henderson, Director and member of the Client Strategy team within BlackRock Solutions
Predicting economic change and its impact on portfolios has never been easy. But it has rarely been as difficult as it is now given the unusually wide range of possible paths for the world’s economies and the flood of liquidity from central banks. This is especially true in the fixed income market where investors now face potential outcomes that may amount to large scale ‘regime changes’. Navigating this uncertainty requires careful planning. So what are the actions that investors can take?
Heightened asymmetry
The main concern for fixed income investors is the potential end of the long bull market. As nominal yields cannot ordinarily fall below zero, the potential outcomes appear to be asymmetrically distributed: there is more room to rise than fall. Moreover, because nominal yields are currently at historical lows, the potential distance that rates could fall is smaller than ever. In formulating an appropriate response, investors need to consider factors such as:
• Priced in expectations: By examining bonds with different maturities, it is possible to calculate the market’s assumptions about the future path of yields.
• The wider portfolio: Typically, investors also allocate to more than just fixed income, and will therefore need to consider the behaviour of other assets and liabilities in the portfolio.
• Fixed income divergence: A worsening of the euro crisis, for instance, will have very different effects on bond yields in the US, Germany and Spain.
• Opportunity set: What other fixed income (or wider) investment themes might now offer a more reasonable risk/return trade-off?
• Liabilities: As liabilities can be thought of as a short position in fixed income, the investor as a whole might actually benefit from a rise in yields if the liabilities fall in value faster than the assets.
• Real yields: Liability payments are often linked to inflation. For these investors, the value of their liabilities is related to the real, rather than the nominal yield. Real yields can fall below zero; yield asymmetry arguments are less strong for real yields.
Practical scenarios
Traditional forms of analysis that use normal distributions tend to underestimate the likelihood that highly asymmetrical outcomes will occur, but by considering scenarios outside the market’s central expectation investors can gain powerful insights into these ‘fat tails’.
Take for instance a UK pension scheme where the assets only cover 60% of the value of its liabilities. The trustees are aware that they need to find a balance between taking sufficient investment risk by allocating to ‘growth’-type assets in order to close their deficit, but not taking so much that adverse market moves could seriously threaten their solvency. The trustees also allocate to assets that match the behaviour of their inflation-linked liabilities, but because the plan is underfunded and capital has been invested in growth assets, the trustees have matched only about 30% of the real yield risks. Assume now a scenario where inflation increases significantly. This would mean that both the inflation-sensitive assets and liabilities rise in value, but because the inflation-related liabilities have not been fully matched, the assets appreciate by a much smaller amount than the liabilities, causing the overall funding ratio to drop. Not matching the liability risks results in a portfolio dominated by only one bet: a short position in real yields. It illustrates why investors need to be aware of the dynamics of their overall portfolio, what risks they have and how their portfolio might perform in a certain scenario.
The need to take a broader perspective also holds true in the case of a life insurer which provides savings policies for retirement. Not matching the interest rate sensitivity of these liabilities would be very expensive in terms of capital charges and its assets are therefore mainly invested in fixed income. It typically holds large amounts of corporate bonds, earning the additional yields that these bonds pay over government bonds. If all the interest rate risk of the liabilities is matched, the behaviour of credit spreads will in effect determine the profitability of the insurance company. How can this investor be better positioned to take advantage of this low yield environment, while still taking account of the capital charges that different investments might imply?
To answer this, let’s look at two opposite outcomes– a hypothetical ‘best-case’ scenario of high growth and a ‘worst-case’ scenario of a renewed credit crunch. The high growth scenario could be marked by a rally in risk investments and a contraction of credit spreads. The credit crunch scenario would probably be almost the opposite, with an all-round ‘flight to safety’, where credit spreads widen. The potential for corporate bond spreads to compress further in the upside scenario is limited as spreads have already come down significantly, but there are no limits on the spread widening that would occur in a worst-case scenario, implying a clear asymmetry risk. If we were to include high yield and emerging market bonds in the portfolio, however, the asymmetry becomes less clear-cut as these asset classes still offer higher spreads. While insurers need to be conscious of the capital charge attributed to each of these asset classes, this suggests that these investments may represent a better return on capital trade-off in these particular scenarios. This insurer may therefore look to widen its opportunity set.
Clearly, these scenarios are not meant to project expected outcomes in the future. Nevertheless, they are useful tools to help assess how portfolios might move in different future states of the world. They also highlight some of the risks that might be hidden from view. Together with the factors for consideration we discussed above, they can help investors think about and plan for what is likely to be a very different future.
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