How to give your captive financial flexibility

Investing in fixed income remains the bedrock of investing for Cayman captives. The key is designing an investment strategy and approach to take advantage of fluctuating interest rates while still providing income, capital security, and possible growth.

While nobody knows for sure what the future will bring, when it comes to financial markets, it’s clear that the US Federal Reserve is signalling higher interest rates into 2019. The next three to five years may well usher in an era of potentially low (or even negative) bond market returns, and as such, investors should explore strategies now, which may help to protect their portfolios while maintaining financial flexibility. With this preface in mind, let’s look at some of the options.

Staying short

Short-term bonds aren’t exciting, but they are conservative investments unlikely to see substantial losses in a bear market. In contrast, long-term bonds have much higher interest rate risk, and we have seen how rising interest rates have crushed performance results for those taking on lengthy duration.

In the period from May 1 to July 31, 2013, the bond market was hit hard as the yield on the 10-year note soared from 1.64 percent to 2.59 percent (prices and yields move in opposite directions). During this time period, the ICE 15+ year US Treasury Index (G8O2) was hit for a loss of 12 percent, while the ICE five to seven-year US Treasury Index (G3O2) declined 3.9 percent. In the same time period, however, the ICE one to three-year US Treasury Index (G1O2) fell just 0.1 percent.

This helps illustrate that while short-term bonds won’t necessarily make you money in a bear market, they are much less likely to suffer significant losses than their longer-term counterparts. Simply put: if you want to stay safe, stay short.

Speed matters

Not all segments of the bond market react in the same manner to the same set of stimuli. Over time, for example, sectors with higher credit risk—such as investment-grade corporate and high yield bonds—have demonstrated the ability to outperform when longer-term yields are rising.

The speed at which yields rise matters. If the expected downward adjustment in bond prices occurs gradually over an extended period, it’s very likely that these fixed income categories can deliver outperformance due, in part, to their higher yields.

However, if the bond market experiences a more rapid sell-off—such as those that occurred in the early 1980s, 1994, and the second quarter of 2013—then these areas are likely to suffer substantial underperformance.

Forecasting the direction of medium to longer-term interest rates, however, is indeed a drill that puzzles even the shrewdest of investors. If interest rates go up, you want to have investable cash to take advantage of the higher rates; but if rates move lower, you want to have some money invested at the higher rates.

The right plan

Investors should approach the market with strategies and approaches that are appropriate for either scenario. Many investors prefer index funds (ETFs) for their low costs and relative predictability, but a bear market is a reason to consider the following investment approaches.

Actively managed funds

Active managers typically charge more in fees than their passively managed counterparts; however, they also have the ability to shift their portfolios to reduce risk and capture values as opportunities permit. In this way, investors have the benefit of a professional manager taking steps to offset the impact of a bear market.

Unconstrained bond funds

“Unconstrained” is a term for funds that have the ability to “go anywhere” in terms of credit quality, maturities, or geographies. This is the next step from active management, since active funds can be limited to a particular area of the market, credit rating and currency, whereas unconstrained funds have no such restrictions.

A wider range of opportunities should, at least in theory, equate to a greater number of ways to sidestep a market downturn.

Floating rate bonds

Rather than paying a fixed rate of interest, these bonds have yields that adjust upwards with prevailing rates. While not a perfect guard against poor market performance, floating rate bonds can be expected to perform better than typical fixed rate investments in a down market.

A barbell strategy

One way to lock in alluring longer-term rates and retain the flexibility to reinvest if rates move upwards is to employ a portfolio strategy called a “barbell”. This strategy is worthy of consideration for your captive (see box).

Given current market conditions at the time of print, we see value in a barbell strategy—focusing on the short end (one to five years) and the longer end ( more than 10 years). In our view, uncertainty is highest in the intermediate part of the curve, but we expect the 30-year yield to stay relatively anchored around current levels, and are thus comfortable with the proposition of reinvesting at higher yields should the Fed maintain the march to higher rates, or the chance that bond prices rally should the Fed ease back in the face of flat yield curves.

Ultimately there is no right or wrong, just consequences of your decision. We recommend being flexible and open-minded to different approaches in light of today’s rate environment.

We suggest you review your strategy with your investment advisor to analyse a comprehensive set of outcomes to ensure the strategy is aligned with your investment policy.

Stephen Price is vice president & portfolio manager, RBC Dominion Securities. He can be contacted at: stephen.price@rbc.com