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| Andrew Burton, Head of Liability Management at RBS |
In the past year, yields on European debt have plummeted to a point where investors have every right to be nervous.
Thanks to more than USD3 trillion in quantitative easing, average new issue coupons and market yields on five-year European investment grade corporate debt dropped to as low as 1.7 per cent in the first quarter this year, compared with 2.8 per cent a year earlier, 3.9 per cent two years ago and 3.2 per cent three years ago. (Five-year German bund yields have dropped to 0.3 per cent from 0.6 per cent a year ago and 2.6 per cent and 2.0 per cent two and three years ago.) These record low rates will eventually rise and trigger losses for investors. How those losses affect an investor’s balance sheet and future yield earnings depends on their approach now. Either they have to be prepared to take a loss on their capital to boost future yields, or preserve capital and avoid a loss, retaining low, sub-market yields into the future.
Pension funds and insurance companies are being given cash by end investors now for the same reasons as when the market was in a high-yielding environment. These investors still need to track indices for performance, insurers need to match liabilities and end investors are happy to keep a portion of their capital safe in negative real yield assets rather than put it at risk in equities or high yield.
However, yields are likely to rise when central banks signal their intention to halt quantitative easing and the flood of liquidity into the market starts to reverse. The size of investor losses when rates do increase will depend on timing, the steepness of the increase and on the duration of the bonds held.
Take an investor that buys a 10-year bond today paying 2 per cent interest, which is below the rate of inflation. In four years’ time, let’s assume the market yield on the same bond (which has become a 6-year bond) rises to the more historic norm of 5 per cent. The investor now faces the prospect of earning sub-market returns on the bond until it matures in six years’ time. They are unlikely to be able to sell the 2 per cent bond to get better returns because the bond price will have fallen and they would have to sell below par value, booking a principal loss.
The deepest pain could be felt by European pension and insurance funds because they typically invest in long-dated bonds, such as 30-years, to match long-dated liabilities. The longer the maturity of the bond, the greater its exposure to a rise in rates.
One positive is that because these investors buy and hold, they may not run their books entirely on a mark-to-market basis, calculating profits and losses on a daily basis. The immediate up-front losses will not be crystallised or measured in the same way as a total return fund.
Some investors are starting to protect themselves by choosing to buy more floating-rate bonds, where yields rise with increases in the benchmark rate. The European corporate syndicated floating-rate note (FRN) market has been muted since May 2011, however in April 2013 alone FRN supply reached EUR1.85 billion with an average oversubscription of 4.2 times, signalling the strong demand for this format. Since the autumn of 2012, there has also been an uptick in the institutional funds redirecting cash out of fixed income and into equities, reflecting possible concern over rising rates.
Pension and insurance funds, however, are not as flexible as other institutional investors and will need to continue to invest in distinct fixed income maturity buckets and classes. Specifically, they must look for the most efficient returns they can find in the credit markets. For example, in the future there will be opportunities to swap old, low-coupon out-of-the money bonds for new on-the-money bonds paying current market coupons. However, that will mean crystallising a loss.
The issuer side is also interesting. Currently, issuers in the UK and the United States tend to be less worried about booking exceptional losses today and are more likely to value a boost to their future income by cutting future interest expense. These issuers are happy to buy at a price premium of 5 per cent to book value, old 10-year bonds today at a yield of 2 per cent and take the loss in order to raise longer-term funding at, say, 3 per cent. In the scenario where rates then rise, these issuers could then buy the bond and book an exceptional profit.
In mainland Europe, and in particular in Germany, issuers tend to be more focused on profit and loss volatility, even if the item is exceptional, and have been less comfortable with taking losses on buy-backs of bonds at a premium. Also, issuers that regularly pay sizeable dividends to their shareholders don’t want these often significant losses to run through into distributable reserves and hurt dividend cover ratios.
In the instance that rates rise in a few years’ time and bonds issued at par are now trading at a discount of say 85 per cent of par, the issuer can buy back the bond and in so doing crystallise a 15 per cent of par profit. This profit is likely to be taxable but perhaps of appeal to issuers that place a higher value on profit today and on building reserves.
Whatever their stand-point, both issuers and investors will benefit from thinking about this potential paradigm shift today so they are prepared for when rates start climbing.
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