Escalators, elevators, and interest rates—what’s next?
As someone who has worked in asset management for over 34 years and with captive insurance companies for 32 of those 34 years, I could say I have seen it all when it comes to market events and the effect the Fed has on both equity and fixed income valuations.
While the current level of interest rates are not at historical highs (Figure 1), they are likely at peak rates this cycle, with the Fed dot plot showing that rates are forecast to be lower each of the next three years (at least). Buying bonds with longer maturities—a strategy called extending duration—could potentially be a profitable move at this time, as there have been few occasions where the opportunity to profit from duration extension has seemed more obvious than right now.
Talking about duration
With rates at 16-year highs and the Fed likely at, or near, finished raising rates, the case for duration extension in fixed income seems promising. Managing fixed-income portfolios requires careful consideration of various factors, one of which is duration. What is duration extension?
In its simplest form, extending duration means selling short-to-maturity bonds or money-market funds and buying bonds with longer maturity dates.
Extending duration in fixed-income portfolios can offer potential rewards in the form of higher yields, but it also exposes investors to certain risks, including volatility of prices depending on which way interest rates move after the securities have been purchased. If interest rates trend lower—which is what the Fed is predicting—over the next few years, the potential for excellent total returns on fixed-income portfolios could rival that of conventional equity portfolios.
Conversely, if interest rates continue to rise, generally the prices of bonds fall to adjust to the higher rates. Let’s analyse the risks and potential rewards associated with extending duration in fixed-income portfolios in the current economic climate.
It is essential to understand the concept of duration. Duration is a measure of a bond’s sensitivity to changes in interest rates. It considers both the bond’s coupon payments and its final principal payment. Bonds with longer durations are more sensitive to interest rate changes, while those with shorter durations are less affected.
We saw this unfold—in a terrible way—earlier this year when Silicon Valley Bank appeared to have backstopped its overnight deposits with investments in US Treasuries maturing in 20 to 30 years. As rates rose, the value of those bonds declined by up to 20 percent, leaving the bank unable to meet redemption demands.
Responsibly managed banks—and captive insurance companies—spend a significant amount of time trying to “duration match”. This concept is where the maturity of bonds and other investments are “timed” to mature or generate enough cash to meet expected expenses and claims payments. Therefore, as an asset management advisor I find it essential to understand the frequency and severity of claims that could arise and require payment. A portfolio manager would prefer not to liquidate long-maturity bonds to pay short-dated claims.
The risks of extending duration
Extending duration increases the exposure to interest rate risk. If interest rates rise, the value of existing bonds with longer durations will decline, leading to potential capital losses. This risk can be particularly significant in a rising interest rate environment, or if particularly long-dated (over 10 years to maturity) bonds are in the portfolio.
Another significant risk is caused by inflation, and extending duration exposes investors to inflation risk. Inflation—increasing prices for goods and services—erodes the purchasing power of future bond payments, reducing their value. If inflation rises unexpectedly, the fixed income received from longer-term bonds may not keep pace with rising prices. In simple terms, a dollar today will buy more goods and services now than a dollar received five, 10, or more years from today.
On the other side of the equation is reinvestment risk. If you invest now you run the risk of what your fixed income will earn when it comes time to reinvest the proceeds when your bond matures. This cuts both ways: if you keep your investment maturities short, the rate at which the funds get reinvested changes drastically, and generally quickly.
We have a saying that interest rates go up on an escalator, and down on the elevator—or out of the window for a more dramatic visual picture (Figure 2).
One way to mitigate reinvestment risk is to extend duration by buying longer-dated securities. This way you earn the current rate for a longer period of time. If interest rates decline, the value of the portfolio will tend to rise as it holds bonds with what are now higher than market interest rates.
While keeping maturities of investments short-dated minimises the fluctuation in the value of accounts on a mark-to-market basis, it exposes the captive to greater reinvestment risk when rates start being cut. Bonds maturing from higher rates can be invested only at lower rates of interest, which may lead to lower overall portfolio returns. You can see how quickly rates dropped from past peak cycles in Table 1. The table shows historical periods of high rates, and how quickly they dropped from those peaks. Extending duration during these times would have yielded tremendous total returns in fixed income.
Some potential rewards of extending duration
By extending duration a captive can potentially “lock in” higher yields that are available now for longer periods of time. Longer-term bonds often offer higher coupon rates compared to shorter-term bonds. Interest rates haven’t been this high since 2007.
By buying or deploying assets today, investors can benefit from higher income payments over a longer period.
When the Fed starts cutting rates again—and it will—captives will be presented with a longer period of higher-than-market interest, and the potential for capital gains on their entire portfolio. In fact, compared to equity investing, the bond market is “batting 1000” for positive returns 100 percent of the time over six-month, 12-month, three-year and five-year time periods following the last seven Fed tightening cycles (Table 2). Extending duration now could potentially offset some or all of the capital losses many captives experienced during the sharply rising interest rate environment since March of 2022.
Source: First Trust
Additionally these positive returns were achieved with far less volatility than equities measured in the five-year returns “post tightening” (Figure 3).
Source: First Trust
Not only do longer-maturity bonds provide the potential for equity-like returns when the Fed tightening cycle ends and it start to lower rates, they also provide diversification by maturity to a captive’s fixed-income portfolio.
Longer-term bonds generally have different risk and return characteristics compared to shorter-term bonds. This diversification by maturity and asset class may help reduce overall portfolio volatility.
The considerations for extending duration
Before extending the duration in a captive’s portfolio, an in-depth analysis of the economic environment is vital in the decision process. If the economic outlook is “hot”, suggesting potential interest rate hikes or rising inflation, extending duration will be risky. We have all felt the inflation caused by the past two administrations pouring trillions of dollars of economic stimulus (free cash) into the economy to offset the shutdowns of the economy they themselves imposed. The Fed’s response was slow—until it wasn’t—and they proceed to raise interest rates 12 times, at a rate more quickly than ever before.
While Jerome Powell, chair of the Federal Reserve, has warned that rates could be “higher for longer” the dot plot shows otherwise (Figure 4). The chart shows that the bank governors who set rates all think rates are heading lower over the next few years.
Bonds generally appreciate as the Fed begins to lower rates and extending duration may present more attractive opportunities.
Captives have other considerations apart from investment returns. Captives with longer investment horizons (perhaps driven by long-tail risks) may be better positioned to withstand potential short-term volatility associated with extending duration.
Conversely, captives with high frequency or severity of claims generally have shorter investment timeframes and may not be able to extend duration significantly, regardless of the “investment case” for doing so.
Captives should keep in mind that extending duration introduces the additional risk of price volatility, mark-to-market valuation fluctuations, and the risk of loss if long-dated bonds need to be liquidated years before they mature. As such, captives must assess their cash-flow needs, as well as their ability to withstand potential capital losses by extending duration in their portfolios. Some of these risks can be offset by holding sufficient short-duration assets that could be used to cover claims and other short-term expenses.
I feel the time is upon us—or at least very near—to begin extending duration to take advantage of the highest rates in almost 20 years. That said, captives must consider all the risks incurred that can be caused by interest rate fluctuations, inflation, and reinvestment. Only after assessing the economic outlook, investment horizon, and risk tolerance can an intelligent discussion of duration extension be entertained.
As always, a balanced approach is necessary to strike the right mix of short and long duration fixed income as well as equities, alternatives and of course cash in captive portfolios and to balance risk and potential rewards.
Past performance is not indicative of future results. All investments involve risk. An investment in this strategy involves a significant degree of risk, including, without limitation, the risk of loss and/or volatile performance. All opinions expressed are current as of the date of this letter and are subject to change. Forward-Looking Statements: Any projections, forecasts and estimates (including, without limitation, any target rates of return) contained in this overview are necessarily speculative in nature and are based on certain assumptions. It can be expected that some or all of such assumptions will not materialise or will vary significantly from actual results. Accordingly, these projections are only an estimate. Actual results will differ and may vary substantially from the results shown. The risks associated with investing in fixed income include risks related to interest rate movements as the price of these securities will decrease as interest rates rise (interest rate risk and reinvestment risk), the risk of credit quality deterioration which is an issuer will not be able to make principal and interest payments on time (credit or default risk), and liquidity risk (the risk of not being able to buy or sell investments quickly for a price that is close to the true underlying value of the asset).