Falling interest rates, rising volatility

Financial markets do not like uncertainty, but as the new year begins, the future is looking more unpredictable by the day.

This is not a bond market that traders of yesteryear would recognise. Historically, the purchaser of a bond was like a bank, lending money to a borrower who in turn paid interest. Whether the borrower was a government, municipality or corporation, it paid interest over an agreed time period and returned the original face value.

Today, finding a safe return is increasingly difficult, with 10-year US Treasuries paying only 1.5 percent. According to Deutsche Bank Research, there is a near-record $15 trillion of debt with a negative yield, which is 25 percent of the total.

About 40 percent of government debt has a negative yield. For perspective, median G7 real government yields averaged 4.1 percent in the 19th century, 1.5 percent in the 20th, and 1.4 percent so far in the 21st. Since mid-2012 they have collapsed to zero. The negative real yields so common today are relatively rare throughout history.

Return of volatility
While equities investors tend to be familiar with the ups and downs of the stock market, bond investors are not immune. Bond market volatility has returned to levels not seen since 2016, when the UK voted to leave the EU and Donald Trump was elected US President.

Many strategists forecast that yields in the US would remain below 2 percent at the end of 2019 due to geopolitical concerns, uncertainty in Washington and the strength of the economy.

In Europe recession is starting to bite, and growth in Asia is also showing signs of slowing. Insurance investors are particularly concerned about an economic slowdown in the US and market volatility, according to the 2019 GSAM Insurance Survey that incorporates views of 307 chief investment officers representing more than $13 trillion in global balance sheet assets. Bond investors have also expressed heighted credit cycle concerns, shifts in perceived risks, and muted expectations for returns going forward.

Generally, the investment portfolios of captives are designed to capture investment yield while maintaining adequate cash for liquidity and working capital. Their portfolios often look like those of traditional insurance companies, being dominated by fixed income investments.

According to Marsh’s June 2019 captive insurance landscape study, “Securing Your Future With a Captive”, weighted asset allocation not including intercompany loans was 57 percent fixed income, 26 percent cash, 11 percent alternatives and 6 percent equities. This is a relatively conservative portfolio mix, and maintaining significant cash and cash equivalents point to a captive’s need for liquidity.

The lifecycle of a captive portfolio
A captive insurer’s investment objectives typically change as it grows. Newly established captives frequently maintain cash and cash equivalents in the form of money market funds. Once adequate reserves are established, the captive may begin to diversify by investing in debt instruments such as US Treasury bonds.

Larger captives are more likely to take on additional investment risk in the form of equities and alternative assets.

Looking ahead
In the current low interest rate environment, traditional insurance companies have continued to express interest in higher-returning, less liquid asset classes such as private equity, infrastructure debt and middle market loans.

Captives tend to be conservative in their investment objectives, but they often display a wider range of investment strategies. Many captives invest exclusively in cash and cash equivalents, while others employ larger allocations to equity and alternative investments, which could include hedge funds and private equity investments. Bond exchange-traded funds (ETFs) are increasing being used to manage short-term tactical exposures or achieve operational efficiency.

When “safe” returns are difficult to find, investors can be tempted to buy lower-credit quality investments to boost income and returns. These strategies tend to work well during an economic expansion but will be tested when the US economy enters a recession. It is often prudent to stay with quality and stick with the long-term investment policy.

Andrew Wang is managing partner at Runnymede Capital Management. He can be contacted at:  awang@runnymede.com