31 May 2013Accounting & tax analysis

Captive investment portfolios: when cash doesn’t cut it

What are the key issues captives must address in their asset management strategy in the current investment environment?

In today’s ultra low-yielding world, many a captive’s investment strategy must not only address the typical liquidity and preservation of capital requirements for its daily operating cash and claims payment, but also needs to consider ways to attain a higher level of income in order to make up a funding gap (or in an attempt not to increase it further).

But conservatism generally still rules, and while higher returns can potentially be more easily achieved on longer-term or surplus cash by extending duration or venturing into other asset classes (such as equities or emerging markets debt), options are more limited when looking to minimise the risk of capital deterioration and maintaining liquidity at the same time.

We believe this is the main reason short duration products are gaining traction with liability-driven investors worldwide. These products typically aim to provide higher income than money market funds over a time horizon of six to 12 months, while maintaining low interest rate risk and a high quality profile.

What issues do captives need to be wary of in the fixed income space at present?

With short yields presently as low as they are, and likely to remain this way for an extended period of time, captives may typically attempt to ‘reach’ for additional income in one of two ways: duration and credit. The first option, extending to longer-term securities or products, brings on additional risks with the higher rates. As such, it requires captives to properly assess the time horizon associated with funding needs in order to manage capital depreciation.

The second option—moving towards lower quality, higher yielding securities—may lead to potentially higher volatility and credit risk. Captives on the hunt for yield must consider and address these risks, typically by maintaining an overall short duration posture as well as investing in highly rated securities. We currently have a favourable view on corporate credit fundamentals and as a result are overweight within our portfolios.

We believe short duration portfolios can continue to benefi t from a yield curve that remains steep inside of fi ve years. That said, because absolute yields on government securities are so low, we prefer credit over duration as a key driver of performance. This supports using short duration as part of a captive’s asset allocation, but only within a strict risk management framework that avoids overextending duration.

Is it possible to go beyond a defensive strategy in the fixed income space? If yes, how?

If you define a defensive strategy by investing solely in money market mutual funds, the answer is, generally, yes. How much additional risk can be taken depends on the captive’s ability to identify expected liabilities that fall beyond a six-month time horizon, or what we often refer to as ‘strategic cash’. We believe captives can take measured steps to increase returns by extending duration, but should do so within a pre-defined risk budget,provided their investment policies and guidelines allow them the flexibility to do so. We believe this strategy should be driven by investments in corporate credit, which tends to be more predictable, using duration as a secondary source of returns.

How can captives marry liquidity with improved returns? Is such an approach possible in the current environment?

If managed properly, the additional price volatility associated with a longer duration can typically be offset by higher income over the longer investment horizon, and has the potential to produce increased returns. Risk management techniques such as stress-testing and scenario analysis can help a captive make informed decisions around how much duration it can comfortably add to its portfolio.

Given its importance, we work closely with clients to carry out such analysis. Establishing a pre-set risk budget and staying within those parameters can help a captive to make informed risk versus reward decisions, and may be more likely to achieve the desired outcome of increased returns, capital preservation and liquidity.

A captive can potentially achieve a better balance of risk and return by matching very short-term liabilities with money market funds, butalso identifying ‘strategic cash’ that can be invested in a slightly longer duration product aligned with its risk appetite.

How can captives reduce the impact of the current low interest rate environment? Can they prepare for a potential interest rate shock?

Even for the most conservative captives, one way to potentially reduce the impact of the current low interest rate environment is by increasing credit exposure and extending duration within a pre-defined risk budget. This may be achieved by using cash segmentation to create a mix of investments that more accurately reflect or match the timing of the captive’s underlying liability profile.

Portfolio stress-testing and scenario analysis can help captives prepare and budget for a potential interest rate shock by defining a maximum risk budget and identifying the timeframe needed to recover in a worst-case scenario. In that context, setting reasonable expectations around the potential impact of a sudden rise in interest rates is generally the key to making informed decisions around portfolio duration positioning.

With appropriate risk management tools and a clear understanding of the downside, a captive might find itself comfortable taking on more riskthan it might have originally thought prudent, and reconsider its asset allocation model with the potential to achieve superior returns.

Faith Outerbridge is head of HSBC Global Asset Management (Bermuda).

Jerry Samet is senior portfolio manager, fixed income at HSBC Global Asset Management (USA).

Jason Moshos is portfolio manager, fixed income, HSBC Global Asset Management (USA).

For further information please contact our Global Asset Management department at

HSBC Global Asset Management (Bermuda) Limited (“AMBM”) of 6 Front Street, Hamilton, Bermuda, is licensed to conduct investment business by the Bermuda Monetary Authority. AMBM is a wholly owned subsidiary of HSBC Bank Bermuda Limited (the “Bank”), a member of the HSBC Group of companies. The term “HSBC Global Asset Management” refers to a group of companies in several countries and territories throughout the world that are engaged investment advisory and fund management activities and are ultimately owned by HSBC Holdings plc. The material contained herein is not intended to provide professional advice and does not create any contractual or legal obligations on the part of AMBM or any other HSBC group company. It should not be relied upon in that regard. Readers should seek appropriate professional advice where necessary.