Generating all weather returns in the new global environment
“Bubble” has become a commonly used expression to describe government and high quality corporate bonds, following an epic 35-year bull market which has driven yields to record low levels. For conservative investors, high quality bonds have done a tremendous job of serving the dual mandate of capital preservation and income generation for more than three decades, earning a healthy annual return over this period,
with significantly lower volatility relative to stocks.
Most Cayman captives are U.S. dollar-denominated and managed according to conservative investment mandates – i.e., they hold a lot of high priced, low-yielding U.S. dollar-denominated bonds. What happens to high quality bond portfolio returns when rates rise? Think negative.
Assuming that the sovereign bond bull run has ended, captive insurance managers may well get a wake-up call in the near future, when reviewing fixed income portfolio returns at future board meetings. Carl Richards, a Certified Financial Planner and creator of the weekly Sketch Guy column in the New York Times, depicts the danger of making investment decisions based on recent history:
Captive insurance managers and owners should avoid predicating purchase decisions on historical returns and base asset allocation decisions on future return expectations. Low-interest rates and expectations for below average returns mean captives should consider diversification opportunities into other areas, namely dividend paying equities, alternative yield structures, capital protected structured notes or structured cash alternatives. Capital protected or buffered structured notes, issued by high-quality banks, are not understood as well as they should be by captive owners and captive managers in general and can add value in the current investment environment, as they can offer the risk and return profile of both bonds and stocks, like a balanced portfolio, which can be a logical next step for captives currently investing in low yielding bonds with potentially higher inflation in the future.
For those with a similar view, we explore these alternative investment options to generate yield and diversify conservative portfolios without taking undue risk.
The conservative conundrum
Captives are conservative and strive to safely generate enough investment income to cover operating costs, maintain statutory reserves and pay claims as needed. What has historically been a relatively straight-forward conservative mandate to manage is becoming an ever more-challenging proposition in today’s low rate environment. Some investors view the current bond market as abnormally risky and are concerned that recent bond losses could deepen if interest rates continue to rise in the U.S. Zero interest rate policy (ZIRP) has come at the expense of savers and conservative investment portfolios, now struggling to generate inflation adjusted real returns.
As we move forward into this world where bond markets will inevitably face headwinds, where else can conservative investors look to place their money? These record low interest rates – and in turn, historically high fixed-income valuations – have frequently generated two questions from investors: First, should investors continue to buy fixed income given the potential bond bubble they have heard so much about? Second, what other ways can investors generate income in today’s low-yield environment without being burned down the road?
As of August 31st 2016, the below tables show central bank rates and 10 year government bond rates of some of the world’s largest economies.
In Europe and Japan, short-term rates have gone into negative territory, as Governments try to encourage spending and investing. Thankfully, negative rates are not expected in the United States. To the contrary, they are going to move higher at some point.
Our view continues to be that the next U.S. Fed rate hike may come as soon as Dec 2016, with further hikes into 2017, as the Fed is focused on global economic and financial developments, not solely the monthly gyrations in U.S. employment data. These hikes and the uncertainty around timing, will inevitably drive market volatility, which creates challenges—but also opportunities—for investors.
Traditional solutions and future headwinds
Captives will traditionally hold a large portfolio of cash and fixed income assets (on average 70 percent or higher), such as investment grade bonds and U.S. treasuries, to provide some yield with solid capital preservation. A smaller allocation will be made to equities (on average 30 percent or less) to generate additional long-term capital growth and additional income. Traditionally, these portfolios have performed well
due to good fixed income and equity diversification, amidst a backdrop of falling interest rates and inflation, and strong global growth rates over the last 25 years.
With an estimated $13 trillion in negative-yielding debt worldwide, it’s worth noting that the U.S. continues to remain an attractive place for global fixed income investors, so it’s not all doom and gloom. Given cash is still yielding close to 0 percent, a well-diversified portfolio that takes selective risks can still generate returns. In our opinion, traditional bonds should continue to be a part of a balanced portfolio for long-term investors.
However, we are in a new global investment environment, where investors are faced with significant headwinds. From 1956 to 2006—a full half-century—the U.S. economy expanded at an annual pace of 3.5 percent.
Unfortunately, over the last decade GDP has slowed to only 1.6 percent annually. While economic growth has been a bit above 2 percent throughout the recovery, this is less than half of the run-rate typically experienced during expansionary periods. A similar pattern of deceleration has occurred in virtually every major economy around the world1. Slow growth combined with rising rates over the medium term, will have a material negative impact on traditional portfolios. Let’s look at how rising rates will impact a captive’s fixed income portfolio. There are two components that make up the yield of a corporate bond – the risk free rate as measured by a government bond of the same term and a credit spread that accounts for risks specific to a particular issuer. Even if government bond yields are falling, investors in corporate bonds can lose money. This is exactly what happened in 2008.
An investor who does not believe in the bearish scenario of corporate bond yields, climbing meaningfully from these levels, would be wise to do a quick walk through of what the math looks like below. The chart shows the impact a rising rate environment can have on an investment grade corporate bond portfolio, as exemplified by the iShares 1-10 Year Laddered Corporate Bond ETF (Symbol CBH). It shows the impact of a 1 percent rise in rates each year from today for the next four years (broken down between the impact on the principal value of the bond, and the change in income earned from reinvesting 10 percent of the portfolio each year at the higher rate). The holding period column below shows you the total return each year (excluding inflation which would likely worsen the real return significantly).
The table is not our interest rate prediction; however, it reveals that negative returns can be a painful reality in a rising rate environment. Where are captive managers to turn in this new world of low growth and low but rising interest rates?
Investment solutions can hold the key
Within institutional investing, it is typical to take a rigorous analytical approach to define investment objectives and asset allocation to drive the optimal composition of the portfolio. For captives, the objectives are conservative with the core focus on preserving capital whilst delivering a mix of capital growth, to service future liabilities, and yield, to service short/medium term cash claims needs.
The best institutional money managers identify the appropriate level of risk (the risk budget which is a mix of the inherent protection within the portfolio and the volatility of returns/market value of the portfolio), and design an investment approach that maximises the return for each cent of relevant risk (the efficient frontier**)
This may sound complex but, in reality, for captive managers, this simply involves considering rational alternatives to holding cash, bonds, equities and funds. For a portion of the portfolio, captives can look to more efficient vehicles to access or combine these asset classes whilst maintaining the agreed asset allocation and capital requirements.
Recently, best in class institutional managers have adopted a more forward-thinking approach across portions of the portfolio, looking to access the best elements of fixed income and equity investing and eliminating some of the inherent inefficiencies. In some cases, this involves: accessing markets more cheaply (i.e. ETFs or custom rules-based portfolios to remove investment bias, or eliminate market weighting impacts); embracing less directional investments that deliver returns better matched to liabilities (such as structured solutions to deliver yield or variable annuity profiles); or, combining assets to get the best of both worlds (the protection of bonds with the yield potential of equities). In effect, managers are looking to harness the returns whilst optimising the risk profile and limiting downside risk in the new investment environment.
Let’s run through several common captive scenarios and potential solutions (all pricing per 20.09.16):
- Captives looking for better returns than typical cash or fixed income investments, but wants to stay capital protected.
SOLUTION: 5-year Principal Protected Note based on the S&P 500 Low Volatility Total Return Index (held to maturity).
DESCRIPTION: Propose utilising a 5-year USD RBC note (AA S&P, AA+ Fitch) which combines 100 percent principal protection and a minimum guaranteed return of 0.80 percent per year at maturity.
In addition, the captive receives upside participation in the performance of the S&P 500 Low Volatility Total Return Index (Daily Risk Control 5 percent), if this is greater than 4.0 percent. The participation in the equity
return is 50 percent of the positive index performance (no negative performance) if held until maturity. Principal protected notes can fall in value between issuance and maturity, therefore clients who sell early
may lose money.
RESULT: Captive now holds an investment with no capital risk (unless the issuer defaults), a minimum return of 4.0 percent with potential additional capital growth linked to the low volatility S&P500 Total Return index. Combining defined minimum returns, no capital risk and upside outperformance if the US equity markets perform strongly.
- Captive considering a reduction of low yielding fixed income and adding to equity, but concerned about all time high equity valuations. Two solutions:
SOLUTION A: Smart Allocator Note, 5 year, USD, with predefined allocation between Fixed Income and Equity.
DESCRIPTION: The investment starts with a 20 percent allocation to the S&P500 and 80 percent to a fixed income return. The fixed income allocation yields an impressive 5.0 percent, significantly above the equivalent RBC AA (S&P rated) corporate bond (existing RBC 2021 USD, fixed at 2.5 percent). The note has the ability to reallocate from fixed income into equity over time, if the equity market falls, in effect buying on
dips in the market. The first trigger is at 90 percent, converting 25 percent from fixed income to equity; the second trigger at 85 percent converting a further 25 percent; the final trigger at 80 percent converting
30 percent to equity. If all triggers are activated, the average entry level on the S&P500 would be at a discount of 12.25 percent versus the initial level. The trigger levels are customisable to offer a flexible balance between the fixed income yield and equity entry point.
RESULT: Captive now holds an investment with significantly improved fixed income yield initially, and a predefined entry strategy to gain equity exposure at a discounted entry level.
The Fixed Income component yields 5.0 percent p.a., whilst the equity portion is allocated to the S&P500 Index. The equity allocation trigger levels are customisable to offer a flexible balance between the fixed income yield and the equity market entry point.
SOLUTION B: Phoenix Autocallable Note, USD, 5 year, 4.0 percent yield linked to S&P500.
DESCRIPTION: The note has a valuable buffer against any loss of capital if the S&P500 index falls, with no loss at maturity, unless the index has fallen more than 40 percent from the initial level. The note provides a regular coupon of 4.0 percent if the index has not fallen more than 40 percent on each annual observation date. If the index is above its initial strike level on an annual observation date, it will redeem early returning 100 percent capital and the relevant coupon. At maturity, the note will pay back the full principal if the index has not fallen more than 40 percent from initial level, otherwise the investor will participate in the downside of the index.
RESULT: Captive now holds an investment with an attractive 4.0 percent yield, and barrier protection to the S&P500 index. Providing an alternative yield structure.
- Captive looking for broad, medium term equity growth outside the S&P500, but worried about downside exposure and stock selection.
SOLUTION: 2 year, USD, MSCI World Participation note (capped, buffered).
DESCRIPTION: The note offers 100 percent participation in the positive growth of the MSCI World developed countries index, a well-diversified measure of mid/large cap stocks across the world excluding the U.S. and Canada. Exposure is provided via an ETF (EFA US) to maximse liquidity, whilst minimising fees. The maximum return is capped at 118 percent over two years, a healthy 9 percent per annum (simple). By capping the growth it is possible to combine this with a valuable buffer against losses on the downside, with no capital loss unless the equity investment falls more than 20 percent. At maturity, the note will pay back the full principal if the index has not fallen more than the 20 percent buffer, otherwise the investor will participate in the downside of the index.
RESULT: The note has an attractive non-linear profile, whilst delivering the broad diversification the captive requires. It offers a competitive return of up to 18 percent over two years if equity markets perform well, but combines this with a substantial 20 percent buffer to downside losses. Reducing volatility and lowering the investment risk profile versus traditional equity investing.
These are just a few examples and any of these structures can be adjusted to meet specific needs of the captive, whether that is complete capital protection, lower downside protection or volatility, or meeting a specific
yield requirement. Alternative structured solutions, for a portion of the captive portfolio, allow more flexibility to meet targeted investment requirements than what can be achieved in today’s traditional fixed
income and equity markets, which will be challenged going forward in the low growth and rising interest rate environment that we currently face.
** The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined risk budget or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are also sub-optimal, because they have a higher level of risk for the defined rate of return.
This commentary is based on information that is believed to be accurate at the time of writing, and is subject to change. All opinions and estimates contained in this report constitute RBC Dominion Securities Global Ltd. judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. Interest rates, market conditions and other investment factors are subject to change. Past performance may not be repeated. The information provided is intended only to illustrate certain historical returns and is not intended to reflect future values or returns.
Futures or options trading involves substantial risk, may result in serious financial loss, and is not suitable for all investors or portfolios. An investment in structured Notes may not be suitable for all investors. The full principal amount invested may or may not be guaranteed to be repaid at maturity. Investors should read the applicable Information Statement for an issue of Notes carefully before investing and should discuss the suitability of an investment in the Notes with their investment advisor before making an investment decision. The offering and sale of Notes may be prohibited or restricted by laws in certain jurisdictions. Notes may only be purchased where they may be lawfully offered for sale and only through individuals qualified to sell them. The information contained in this article is not intended as a recommendation directed to a particular investor or class of investors and is not intended as a recommendation in view of the particular circumstances of a specific investor, class of investors or a specific portfolio. You should not take any action with respect
to any securities or investment strategy mentioned in this article without first consulting your own investment advisor in order to ascertain whether the securities or investment strategy mentioned are suitable for your circumstances. This article is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. It is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof.
This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Global Ltd. Investment Advisor. This will ensure that your own circumstances have been considered properly and that any action is taken based upon the latest available information. The strategies and advice in this article are provided for general guidance. Readers should consult their own Investment Advisor when planning to implement a strategy.
Interest rates, market conditions, special offers, tax rulings, and other investment factors are subject to change.
RBC Dominion Securities Global Limited is a foreign affiliate of RBC Dominion Securities Inc. RBC Dominion Securities Global Limited is regulated by the Cayman Islands Monetary Authority. RBC Dominion Securities Global Limited is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. ®Registered trademarks of Royal Bank of Canada. Used under license. © 2016 RBC Dominion Securities Inc. All rights reserved.
*1-year-base leading rate for working captial, PBoC
Source – RBC Investment Strategy Committee, RBC Captial Markets, Global Portfolio Advisory Committe, Consensus Economics
*Eurozone utilises German Bunds
Source – RBC Investment Strategy Committee, RBC Captial Markets, Global Portfolio