The “New Normal” of LOW YIELDS

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The Moderator

• Soren Plesner, CFA, FRM, PRM

• Founder, SPFK Financial Knowhow

• www.spfk.dk

• sp@spfk.dk

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Fundamental Changes in Financial Markets in the Aftermath of the Crisis

• The financial crisis that culminated in 2008-2009 was the most severe since the great depression

• Near-collapse of the banking system + “The Great Recession”

• Reactions from governments and central banks

– Massive fiscal stimulus programs

– Massive injections of liquidity into the banking system

• Result:

– Historically low interest rates on government bonds

• Real rates are negative in many bond markets

– Narrowing of spreads on corporate bonds

– Emergence of new bubbles in the equity, real estate, commodity markets?

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Historically Low Yields on T-Bills….

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13-Week US T-Bill Rates (% p.a.) 1960-2013Source: Federal Reserve Bank

Historically Low Yields on T-Bonds….

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US Treasury Yields, Constant Maturity, % p.a.Source: Federal Reserve Bank

10-YR CM

2-YR CM

30-YR CM

Negative (Real) Yields on 10-Year TIPS!

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-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

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3.50

Treasury Inflation Protected Securities, Constat Maturity, % p.a.Source: Federal Reserve Bank

10-year CM

30-year CM

Selected 10-Year European Government Bond Yields

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Source: IMF WEO, April 2013, Figure 1.3

Interest Rate Spreads

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Source: IMF WEO, April 2013, Figure 1.3

Extremely Low Interbank Rates

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3M Libor in Selected Currencies, % p.a.Source: Federal Reserve Bank

CHF

EUR

JPY

USD

Risk-Free Return og Return-Free Risk?

• T-Bills and government bonds have traditionally been seen as “risk-free” investments

• T-Bill rates have traditionally been used as the “risk-free” rate in financial models (e.g. CAPM, Black-Scholes..)

• The 10-year T-Note yield has been a proxy for long-term risk-free rate of return

• But are these instruments “risk-free” in today’s environment of extremely low yields?

– Inflation risk?

– Duration and interest rate sensitivity?

– Sovereign risk?

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Low Risk = High Duration!

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Pri

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Yield to Maturity

Price/yield relationship of a 30-year, 4% bullet bond

Duration is very high at low yield levels!

Slope of curve = "dollar duration"

“The Ghost of `94”

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Could this happen again?

Reduced Buffer against Duration Risk

• Bond return = yield + capital appreciation/depreciation

• Babcocks formula:

• We’ll do a couple of hands-on examples!

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YieldHorizon

Duration Yield Return

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Yield acts as “buffer against losses!

The “Hidden” Risks of Bond Investing

• Yields very low almost no buffer against losses

• A bond’s duration (interest rate sensitivity) is very high, when yields are very low!

• This is a very nasty combination for the short-term investor!

• For the long-term (buy and hold) investor:

– No risk of price deprecation – bond will mature at 100

– But risk of negative real returns (inflation risk)

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Summarizing the Problems of Low Yields

• Duration risk (short term investor) – Discussion: what could drive up interest rates in the short run?

• Inflation risk (long term investor) – Returns are insufficient to secure purchasing power – Discussion: what could drive up inflation in the longer term?

• ALM risk (pension funds) – High duration of liabilities – Real or nominal liabilities? – Guaranteed minimum returns?

• ALM risk (banks) – Interest rate margins are squeezed

• Asset managers – Fees under pressure

• The financial system – Systemic risks - low yields risks of “bubbles”!

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But Some Will BENEFIT from Low Yields

• House buyers (very low mortgage rates)

– Discussion: should house buyers (or owner) choose variable or fixed rate?

• Governments

– Can finance their huge deficits at very low rates

• Corporations

– Can lock in very low rates (and spreads)

• Equity investors

– Low rates higher valuations, c.p.

– But is that already priced into the markets?

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How Long Will the Low-Yield Environment Last?

• The only correct answer: Nobody knows!

• Will mainly depend upon:

– Economic growth

– Inflation expectations

• Three scenarios

– Return to growth and increase in inflation “the Ghost of 1994”

– Many years of low/moderate growth and subdued inflation many years of extremely low interest rates (“Japan scenario”, “lost decades”)

– New shocks to the financial system (Euro break up, sovereign defaults,…) even LOWER interest rates?

• Discussion:

– What is your favorite scenario?

– Other scenarios?

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An Overview of Strategies for Enhancing Yields

• Speculative Strategies

– Use Leverage

– Speculate in RISING rates (they will rise, sooner or later!)

• Borrow fixed rate, short bonds, ….

• Timing is everything!

• Broader Fixed Income Investment Approach

• Specialized Investment Strategies

• Switch to other Asset Classes

• Careful Portfolio Management

– Improvement of risk-adjusted returns

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