Rolldown and Carry: Low Yields Do Not Mean Unattractive Returns For Institutional Investors
Contents Introduction 3 The Importance of Carry 4 Considerations for LDI 6 What Now? 7 About the Authors 8 Further Information and Disclaimer 9 March 2013 For Institutional Investors 2
Introduction Even in a low yield environment, it is possible to invest in low yielding assets and generate excess return 1. In fact, it is possible to generate excess return even when interest rates do not fall. Consider Japanese Government Bonds (JGBs). Similar to our situation today in the UK, the economic environment in Japan over the past twenty years has been characterised by sustained deleveraging and persistently low interest rates. Since 2002, 10 year JGBs have yielded only 1.22% p.a. 2 ; this does not sound like an attractive asset by any traditional measure. However, their total returns exceeded yields by almost 1.00% p.a. (actual value is 0.96%) over this same period with a volatility of 3.88%. This equated to a return of LIBOR +1.86%. In terms of risk-adjusted returns, this made JGBs, in fact, a very attractive investment indeed, even though their yield was low. If, for example, they were leveraged such that their volatility was 10%, then JGBs would have delivered LIBOR +5.06%. While some of their excess return was generated by further declines in interest rates, much of it was generated by what is known as carry, as rates were already low and stayed low over the period. Within the context of UK LDI, carry has some important implications. In the current low rate environment, much attention and focus is placed on the outright level of interest rates; indeed, it is the metric on which most pension schemes set their triggers. An often overlooked aspect of today's interest rate environment, though, is the significant impact that carry can have on a pension scheme's liabilities and its funding position. If the current interest rate environment persists, then pension scheme liabilities could continue to grow as a result of carry, even if interest rates remain static and do not decline further. In this short discussion paper, we define this concept and outline the key issues that pension schemes should consider in today's interest rate environment, as well as how they can avoid the negative effects of carry and capture the benefits. 1 Defined as spread to LIBOR 2 Geometric mean 10 year yield, measured annually, from 31.12.2002 to 31.12.2012 March 2013 For Institutional Investors 3
The Importance of Carry Carry is best understood in the context of an unfunded portfolio, such as a portfolio of gilts purchased on repo or an LDI swap overlay. It is defined as the mark-to-market of the portfolio that results assuming that nothing changes in the market except for the passage of time. Carry is a function of the shape of the interest rate curve. When the curve is upwardly sloping (ie, longer dated rates are higher than shorter rates, as they are currently), then the market is implying that interest rates are expected to rise in the future. If interest rates follow projected forward rates (and these expected rises materialise), then carry will be zero. If forward rates are not realised, however, then carry will result and would be comprised of two components: (1) coupon income and (2) the markto-market effect of rolling down the curve. The first component of carry, coupon income, is simply the difference between what the pension scheme must pay and what it receives in an unfunded portfolio. Within an LDI portfolio, pension schemes typically pay a floating money market rate, such as LIBOR, within a swap arrangement in order to receive a fixed rate over an agreed time period. In receiving the fixed rate, the pension scheme is able to obtain the duration needed to hedge liabilities. In the current market, the difference between the fixed rate (swap rate) that the pension scheme receives and the floating rate (LIBOR) that it pays is significant. Below is a table that outlines the difference between the floating and fixed rates at various tenors, and the resulting coupon income. Table 1: Difference between receive and pay legs of GBP interest rate swaps (31.1.2013) Tenor Fixed rate Floating rate (6M Libor) Difference (Coupon income) Rolldown Total Excess Return 10 yr 2.12% 0.65% 1.47% 1.38% 2.85% 20yr 2.96% 0.65% 2.31% 0.67% 2.98% 30 yr 3.19% 0.65% 2.54% 0.24% 2.78% 40 yr 3.27% 0.65% 2.62% 0.08% 2.70% 50 yr 3.28% 0.65% 2.63% 0.04% 2.67% The second component of carry, roll down, is defined as the mark-to-market change that results from using different valuation rates as the swap moves closer to maturity. The final cash flow in a 30 year swap is valued at the swap s inception date using a 30 year rate, but after one year elapses, the correct valuation rate for this cash flow would be the 29 year rate. When the interest rate curve is positively sloped as it is currently, the discount rate used to value the cash flow becomes progressively lower over time the 29 year rate is lower than the 30 year rate and this trend creates a positive mark-tomarket. That is, the lower discount rate makes the Net Present Value of the future cash flow higher, resulting in positive mark-to-market. Below is the spot GBP swap curve and the 1 year forward swap curve. As the chart shows, the curves are positively sloped and if interest rates are not at the level that the forward curve projects in a year s time, then carry will result. March 2013 For Institutional Investors 4
Figure 1: GBP 6 month LIBOR swap curve and GBP 6 month 1 year forward swap curve, shown as zerocoupon rates (31.1.2013) 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% Current spot rates Spot rates 1Y forward 0.50% 0.00% 0 10 20 30 40 50 60 Maturity, years Source: Bloomberg Using the above curve, the cash flows of a standard 30 year par interest rate swap would generate approximately 0.24% of mark-to-market gain over the course of one year simply by rolling down the curve. In other words, a quarter of a percent or so is gained in Net Present Value just as a result of a slowly decreasing discount rate. Combining this 0.24% of roll down performance with the 2.54% in coupon income outlined in Table 1, the pension scheme would have generated 2.78% of excess return on this swap over the course of a year simply through the passage of time. Within the context of a pension scheme s wider portfolio and other possible investments it could make, a level of excess return such as this is quite respectable. The 2.78% of carry available on a 30 year par interest rate swap is well in excess, for example, of current investment grade credit spreads and is in line with many schemes assumptions on the excess return available on certain hedge fund strategies. March 2013 For Institutional Investors 5
Considerations for LDI Within an LDI context, though, the liabilities always come into play. Unfortunately, the same carry effects that benefit an unfunded fixed income asset portfolio also adversely impact a pension scheme s liabilities. If the current interest rate environment persists, liabilities would grow due to carry. Using a standard UK pension scheme liability profile 3, carry in today s market would be on the order of 2.5% p.a. If rates stay low, then this can quickly add up to a significant impact on pension scheme funding levels. Up to now, LDI strategies have mostly been implemented against a backdrop of declining interest rates. Given this, it is not surprising that one of the most common push-backs on LDI as a strategy is a view that schemes should wait for rates to return to higher levels before hedging. If, however, these rises do not materialise in a way that is expected by the market, as was the case in Japan, or if central banks keep money market rates ultra-low for a long time in order to stimulate economic growth, as they currently are doing in most of the developed world, then the carry on the liabilities can quickly add up to a significant level: if the current interest rate environment persists for the next three years (as it could in a "muddle though", sluggish growth scenario), then the 2.5% of annual carry on a scheme s liabilities would mean that, over this period, the liabilities would grow by almost 8% simply through the passage of time (excluding benefits paid and new accrual). In three simplistically set interest rate scenarios, high, lower, and static rates, then the case for hedging is strong in two out of the three; that is, in the low and static scenarios. Another way to look at carry within the context of LDI is that, even though yields are low, cash and money market rates such as LIBOR are even lower and thus are an attractive liability to have. The lower the better, in fact: in an LDI portfolio, a pension scheme s long dated liabilities are effectively converted to LIBOR liabilities, and it is then up to the pension scheme s assets to outperform that rate in order to generate the excess return needed to meet the scheme s funding objectives. While the effects of carry may encourage further liability hedging even in today s low rate environment, its nature could always change and become negative, especially if cash and money market rates increase as they did during the financial crisis, and if interest rates rise faster than is anticipated by the market. That said, if rates remain low for longer than anticipated, then its effects will certainly be felt by all pension schemes. While much attention is placed on the outright level of rates in most discussions about UK LDI, more attention will certainly be placed on carry if the current interest rate environment lasts for some time yet. 3 90% inflation-linked, duration 20, swaps flat; note that there is a (much smaller) offsetting carry effect from inflation on the liabilities; carry would have been even higher if a lower proportion of inflation-linked liabilities were used and/or it was calculated on a gilts basis. March 2013 For Institutional Investors 6
What Now? The upshot of this study is that carry is an important driver of performance in a low yield environment. It can have a significant impact on liabilities and this effect is often overlooked; from a risk management perspective, carry is an important factor and should be reviewed and measured as part of a pension scheme s overall risk analysis and its assessment of current hedging levels. While interest rates have seemingly moved in only one direction over the past several years, it is not surprising that some schemes have taken the decision to wait for higher levels before implementing LDI, but the 2.5% of annual carry cost is a very expensive price to pay for the privilege of waiting. Within an asset only context, on the other hand, carry shows that you do not have to invest in higher yielding assets to generate attractive excess returns. As the JGB example showed, it is possible to earn an attractive LIBOR plus return on low yielding assets. If our situation plays out similarly to that of Japan and interest rates remain lower for longer than currently anticipated by the market, then the carry available on low yielding assets, such as gilts and LDI portfolios, may, in fact, mean that these often spurned assets deliver some of the best risk-adjusted returns for pension schemes. March 2013 For Institutional Investors 7
About the Authors We would welcome the opportunity to discuss this topic further, please do get in touch to find out more. John Towner Director, Investment Consulting John joined Redington in November 2012 Previously, John spent nine years in the investment banking industry at Barclays Capital, Deutsche Bank, and Morgan Stanley. His main responsibilities included structuring and implementing strategic ALM transactions with insurance companies and pension funds in both the UK and across Europe In addition to his structuring work, John also provided pensions-related support in a number of UK M&A transactions Began his career at Bankers Trust in New York in 1996 within the fixed income asset management group Holds a BA (Hons) from Georgetown University in Washington DC and a certificate of post-graduate study from the University of Cambridge Contact: john.towner@redington.co.uk +44 (0) 20 3326 7143 Alexander White Analyst, ALM & Investment Strategy Alexander joined Redington as a graduate in August 2011 Works closely with senior consultants to provide investment consulting advice to a range of trustee and sponsor-side clients Holds a BSc in Mathematics from Robinson College, Cambridge and is currently studying for his actuarial qualification Contact: alexander.white@redington.co.uk +44 (0) 20 3326 7100 March 2013 For Institutional Investors 8
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