The Collateral Damage of Today s Monetary Policies: Funding Long-Term Liabilities

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1 The Collateral Damage of Today s Monetary Policies: Funding Long-Term Liabilities Craig Turnbull, Harry Hibbert, Adam Koursaris October Page

2 Change in Spot Rate (Q to Q3 2011) Monetary policy: the perspective of the long-term liability owner An array of controversial monetary policy tactics have been employed over the last three years in Western economies. Policymakers have focused on two related objectives: first, the delivery of a short-term macroeconomic stimulus and, second, providing liquidity to banks balance sheets - particularly given their short-term liability funding structures. What has occurred has been possibly the most aggressive monetary easing ever seen. The world s major central banks have now held short-term interest rates at historically low levels for a period of time unprecedented in living memory. Operation Twist, announced by the Federal Reserve in September, represents an explicit attempt to pull down longer yields (the ultimate goal being the support of American homeowners). Leading this development there has been repeated quantitative easing (QE) programmes from the monetary authorities in numerous economies as well as, again from the Fed, the controversial rhetorical guarantee of exceptionally low rates for at least two years. The rationale behind these policies is the support of the macro-economy through the provision of cheap borrowing to consumers and businesses. It is clear that politicians and policymakers have shifted their short-term objectives towards stimulating growth, and in doing so have incurred the cost of an increase in inflation risk. Some of the collateral damage of these policies is incurred by financial institutions (and individuals) with asset and liability profiles that differ from those typical of the banking sector. In particular, entities with liabilities that are much longer-term than those of banks, such as life insurance companies, defined benefit pension funds and individual savers are experiencing the negative (and possibly unforeseen) consequences. For institutions whose liabilities are set in real terms, these policies could represent a double-whammy a reduction in long-term nominal bond yields accompanied by a greater willingness to risk inflationary consequences. Below we examine how the cost of funding long-term liabilities has increased since the start of this period of monetary expansion in Implications for long-term liability costs The actions of policymakers have had the significant impact on yield curves that was intended. Consider exhibit 1 which shows how the risk-free government bond yield curves have changed between end-q and end-q in the US, UK and Eurozone economies. Exhibit 1: Changes in risk-free yield curves in US, UK and Eurozone; between end-q and end-q % -0.5% -1.0% GBP USD EUR -1.5% -2.0% -2.5% -3.0% -3.5% -4.0% Term The falls, illustrated above, in long-term interest rates have had a very significant impact on the economic cost of long-term liabilities such as those assumed by Defined Benefit pension funds and life insurers. For example, the change in the Euro government yield curve has seen the value of a 15-year fixed liability cash flow increase by 39% over the past 3 years. This has resulted in significantly larger DB pension fund deficits, demanding higher contributions from businesses and arguably adding further momentum to the shift from DB to DC pension provision. Page 2

3 Market-Consistent Net Asset Value (% of end-2010 assets) Of course, reductions in interest rates impact on assets as well as liabilities: if institutions had effective interest rate hedging strategies in place they would have been largely indifferent to these yield curve falls. But the reality is that most intermediaries do not hedge away all interest rate risk. Globally, the majority of DB pension funds and life insurance companies are short duration on a net asset-liability basis. In other words, the maturity of assets is shorter than the maturity of their liabilities. This is partly because they often choose to allocate significant portions of their asset portfolios to non-fixed interest asset classes that are not directly driven by movements in yield curves. Moreover, even where investing in fixed income securities, it may be challenging to match the cash flow maturities of liabilities with available market instruments. European life insurers offer an interesting example: Generally, their balance sheets have all of the above features long-term liabilities, significant investment in non-fixed-interest assets, bond investments with duration that is several years shorter than liabilities. There are also other inconvenient quirks in an attempt to enhance book yields and improve financial reporting, some of the fixed interest exposure may be held in bonds with callable features that reduce portfolio duration as interest rates fall (i.e. just at the time it is required). These characteristics result in a highly-leveraged, non-linear exposure to rate falls. Life insurers with these characteristics are likely to have been significantly impaired on a market-consistent basis over the last 3 years, and may find it difficult to maintain a market-consistent solvency surplus at current long-term interest rates. The chart below shows how we believe the net asset value of such a balance sheet behaves as a function of long-term rates, according to an illustrative Barrie & Hibbert ALM modelling analysis using typical pricing and guaranteed interest rate levels found in these products. Exhibit 2: Illustrative net asset value behaviour of European With-Profit Fund (Barrie & Hibbert asset-liability modelling analysis) 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 10-year government bond yield So the chart shows that a 5% 10-year government bond yield can be expected to result in a cushion where asset market values around 104% of the market-consistent liability valuation. But as the long-term interest rate falls to around 2%, it will be increasingly likely that some funds will find their asset values fall below their minimum liabilities. Note Solvency II will require assets to be sufficient to meet a solvency capital level significantly above the market-consistent liability value. Firm s solvency positions may be safeguarded by shareholder funds or other profitable lines of business, but the above chart highlights that at the current level of low interest rates, some typical forms of European With-Profit business will be economically loss-making. The specific figures above are based on an illustrative example, but the chart highlights the highly non-linear exposure of these businesses and its sensitivity to low long-term interest rates. As interest rates fall, the sensitivity to rate changes increases. A potentially mitigating factor is that these exposures generally arise in participating or with-profit business. As such, there may be scope for additional management actions (such as reduced policyholder profit sharing and reduced bonuses for new business) to be taken to improve the solvency position of these balance sheets. Also, individual companies may have put in place some interest rate hedging strategies to mitigate these risks (such as holding receiver swaptions or running dynamic duration strategies). Page 3

4 Cumulative Probability (%) It might be argued that insurers have taken the risks and suffered the consequences, but perhaps some sympathy is appropriate. Given the term and size of their liabilities, it is inherently challenging for these institutions to find matching assets, particularly when they are sometimes only partially funded (as is usually the case for DB pension funds worldwide). And for the Defined Contribution pension saver who is relying on future contributions to fund his pension, recent long-term yield changes imply that contributions should be one-third greater in order to secure the same expected retirement income. Mark-to-market blip? The above discussion has focused on the mark-to-market impact of yield curve changes on the economic valuations of long-term liabilities. We have seen that this impact has been substantial and consequential. But a risk manager might also be interested in how much of these changes in long-term yields can be attributed to changes in expectations for future short-term interest rate behaviour and how much may reflect movements in the term premiums embedded in yield curves. Whilst this de-composition of the yield curve change does not affect the impact of the market-consistent liability valuation, it might indicate that there are attractive risk / return trade-offs offered by funding the liabilities through deliberate duration mismatches: i.e. how do the relative expected returns of bonds of different maturities over the lifetime of existing long-term liabilities compare today? Put another way, is now a bad time to decide to lock in long-term interest rates? With hindsight, doing it three years ago would have been better, but on a forward-looking basis, do long-term rates look expensive relative to other points on the yield curve today? Can long-term liability owners form a strong expectation that investing in the short end of the curve will outperform a matching strategy that involves locking into current long-term interest rates? Barrie & Hibbert produce long-term term premium estimates for all points on risk-free yield curves as part of its regular real-world standard calibration output. These can provide some insight into the above questions. The chart below shows results obtained from a stochastic projection of the Euro yield curve over a 20-year horizon from end-september It analyses the annualised returns from holding cash for the next 20 years relative to buying the 20-year zero-coupon bond today and holding it to maturity. Exhibit 3: Barrie & Hibbert Standard Real-World Euro Calibration, end-q % -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% Annualised Difference between 20-year Cash Return and Buy & Hold of 20-yr bond This chart provides a number of insights: Given the end-q year zero-coupon bond yield is 3.1% and our assumption that nominal cash rates will not fall below zero, there is a natural limit to how much the cash strategy can underperform the buy-and-hold bond strategy. The B&H calibration suggests that the 0.5 th (lowest) percentile 20-year cash return is around an annualised rate of1.0%, implying a 2% per annum underperformance of the buy-and-hold strategy. On the other hand, there is no similar limit on how far short-term interest rates could increase. Intuitively, there is a material possibility of high-inflation scenarios arising over the next 20 years Page 4

5 which could result in high cash rates. The calibration suggests the 99.5 th percentile 20-year cash return is around 9% per annum, a 6% per annum outperformance of the buy-and-hold strategy. The above points show that there is a significant skew in the cash relative return probability distribution, with greater scope for large upside relative performance than large downside relative performance. However, this does not support the view that the cash strategy is sure to outperform the buy-and-hold strategy - the calibration implies there is a 60% probability that the cash strategy underperforms the bond strategy over the 20-year period. So our analysis does not suggest that the position of the long end of the yield curve is a short-term aberration that suggests substantial risk premiums may be earned by holding shorter duration positions. Importantly, the positive skew in the cash strategy relative to buy and hold is aligned with the view that, given the experimental nature of recent policy initiatives undertaken by central banks, there is uncertainty over what inflation will be over the coming years (and how interest rates will adjust to deal with it). Whilst central banks would like to maintain a low rate environment as the global economy moves into early phases of recovery, it is possible that they will lose their grip on inflation and inflation expectations. The full impact of quantitative easing will only be clear in several years time. In terms of the risk landscape facing investors today we can say with certainty that policymakers have demonstrated their willingness to risk inflation to buy growth, and this risk should not be ignored when making investment decisions. Executive Summary The actions of the world s major central banks over the last three years have been focused on short-term economic stimulus and the support of financial institutions with short-term liability funding structures (i.e. banks). The economic balance sheets of life and pensions sectors have suffered major collateral damage as a consequence of aggressive monetary policies that has driven long-term interest rates to once-in-a-lifetime lows. The economic cost of funding year liabilities has increased by around one third over the last three years, further imperilling the global DB pension fund sector and substantially reducing the income that pension savers can expect at retirement. Some forms of European life insurance business (unhedged withprofit business) have a significant and highly non-linear exposure to falling interest rates. The experience of the last three years is likely to have tested the market-consistent solvency of some European with-profit funds. At this time there is no sign that developed economy central banks will discontinue their stimulus policies and, if anything, efforts are being redoubled to further reduce long-term interest rates and create further stimulus through more quantitative easing at the cost of heightened long-term inflation risks. There is little to indicate this is a temporary position and long-term liability owners face a period adjusting to a new and challenging economic reality with implications for risk appetite, capital adequacy, product design and pricing. Page 5

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