Interest rates in the US have been at or near record lows for the last several years. The US Federal Open Market Committee, which sets the level of short-term interest rates, has consistently kept overnight lending rates at zero in an effort to allow the economy to heal, businesses and consumers to reduce their debt burdens and the housing market to stabilise. In addition to keeping short-term rates at all-time low levels, the Fed increased the size of its balance sheet through what they term Large-Scale Asset Purchases, better known as Quantitative Easing.
By purchasing large amounts of US Treasuries and Agency Mortgage Backed securities, they were attempting to help suppress longer-term interest rates in an effort to spur the economy. The debate over whether this has had any tangible effect will go on for many years in academic circles, but we do know from experience that the economic recovery from the deep recession caused by the financial crisis, has been the slowest in post-war history.
The Federal Reserve will not, however, always be the largest purchaser of Treasuries, expanding their balance sheet to infinitely lofty levels; they will inevitably end their purchases at some point and move short-term interest rates higher. It is important to recognise that this can have an effect on a captive insurance company’s assets, given the traditional reliance on fixed income securities, but it needn’t be surprising or even necessarily damaging. There are ways to manage an asset portfolio of fixed income securities (or Bond Funds, Bond ETFs, etc) to mitigate the effects of rising interest rates.
For many captive owners, a natural and commonsense strategy for controlling for volatility of returns is to invest in, or remain in, ultra-short duration fixed income products, particularly when markets anticipate higher forward interest rates. But is that the right thing to do? While it may well be if one’s strategy is to produce only a positive absolute return and avoid any one-year period of negative returns, it generally also leads to lower income over the long-term, which matters more to most investors. The nature of bond investments, as income generating assets and the shape of the current and forward yield curve play important roles in total return over a longer time frame.
We will use an example that fits well for a captive insurance company. If Captive XYZ owns a two to three year average life investment or bond fund, under a scenario where the Fed becomes aggressive and raises rates eight times (once per Fed meeting for one year) to 2%, he will indeed incur a negative total return in year one due to a decline in Bond prices (yields rise/price falls). However, if one looks at a longer time frame, the two to three year investment will have experienced maturities and been reinvested at a higher yield along the way and over a four to five year spectrum, or full interest rate cycle, one would have positive total returns. Indeed, the original investment will always be positive if held to maturity and will not have experienced any permanent loss of principal! The obvious conclusion to this is that for fixed income investors, it is always interest income that matters most over the long-term, not short-term fluctuations in the level of interest rates.
Conversely, what happens if the economy continues to show unimpressive growth and the unemployment rate remains far too high? Should the Fed take much longer to raise interest rates over time because of a continued sluggish recovery, investors will have paid a steep price for remaining far too conservative by severely limiting the duration of their bond portfolios. They will have pinned themselves at low rates (or zero in a money market fund) for a very long time and not taken advantage of the higher interest rates offered for longer-term bond investments.
So are we saying close your eyes and buy bonds and just hope that rates don’t rise? We are not, but a well-diversified bond fund or bond portfolio (and investment policy) that is careful not to take excessive interest rate risk is an investment program that can generate higher income over time. Higher income over a longer time frame protects a captive from the one thing that CAN actually erode principal in purchasing power terms, inflation.
The answer, therefore, is generally not to place too great an emphasis on the future of interest rates and place greater emphasis on the captive’s ability to generate income from its investment portfolio. There is one time-tested and conservative way this is possible without taking a large amount of interest rate risk at what may appear to be the “wrong” time.
The fixed income investment universe is vast, with investment choices much more numerous than the equities markets. Within this universe, captives have tended to limit themselves to an investable universe that eliminates most of the potential income generation available to the average fixed income investor. The limitation that imposed is on “credit risk”, the risk that any given fixed income investment will experience a default. In our experience, many captives have historically limited themselves to the two highest rating categories, with some only allowing AAA rated assets in their portfolios. This is beginning to change, as short rates have been zero for so long and providers of letters of credit become more sophisticated, but it is changing very slowly. Some of this is natural conservatism, but we question whether limiting oneself to investing in securities with an extremely low level of credit risk is a level of conservatism that is actually more dangerous than one believes (remember inflation…).
In the corporate bond universe, for example, the historical default rate for all Global corporate bond issuers considered “Investment Grade” has not been higher than 0.41% per year in the last 30 years, with that figure achieved in 2008. The default rate for AAA securities is zero. Naturally, if AAA rated securities offered the same yield as the rest of the investment grade global corporate bond universe, one would choose the AAA rated one. The yields are not the same, however, they are vastly different, benefitting the non-AAA investor with better returns in nearly all periods of the last 30 years regardless of the interest rate environment and nearly always by more than 0.41%, the highest default rate. In fact, corporate bonds tend to outperform AAA investments and US Treasuries in periods of both mildly rising and rapidly rising interest rates. Why? Income. You simply get compensated correctly with better income, at most times (2008 excepted), for taking what has turned out to historically be a very low level of credit risk, as judged by the actual default record.
In conclusion, construct an investment policy that recognises the existence of both interest rate risk and credit risk, but be rational. Interest rate risk, for long-term investors that are able to hold till maturity is an opportunity cost only, not a principal loss situation and credit risk should be understood, professionally managed and be subject to reasonable limits, not draconian limits that impair one’s ability to earn income.