Low interest rates and the challenges for long-term Eurozone investors

Transcription

1 Low interest rates and the challenges for long-term Eurozone investors May 2016

2

3 Table of Contents Low interest rates and the challenges for long-term Eurozone investors What will the European Central Bank do this summer?...2 How will the Corporate Sector Purchase Programme be implemented?...3 Some structural effects investors should be aware of...5 Displacement effects and opportunities for investors...6 Consequences for investors...7 Action points for investors...9

4 Low interest rates and the challenges for long-term Eurozone investors 2 Low interest rates and the challenges for long-term Eurozone investors The European Central Bank s rate cuts and quantitative easing have pushed the already low yields on European bonds even lower. Holders of cash are being penalized and over a third of government bonds now trade at negative yields. In March 2016 the European Central Bank announced further measures to stimulate the flow of credit to the corporate sector, including an extension of its bond buying programme to corporate bonds. In anticipation of this activity, investment grade credit spreads have compressed further. Investors no longer receive adequate compensation for spread-widening and illiquidity through bond yields and need to look for a greater diversity of returns as well as a more dynamic investment approach. As we pointed out in our Five-Year Capital Market Outlook, the risks of adverse market outcomes are increasing. We are recommending that investors review their approaches toward liability hedging, downside protection, greater alpha generation and diversification. With the prospect of historically low overall returns in mind, more efforts should be made to eliminate dead assets (i.e. where investors are not being adequately paid for taking risks) and to reduce unnecessary costs. What will the European Central Bank do this summer? On March 10, 2016 the European Central Bank (ECB) announced a range of measures designed to boost corporate lending and to prevent deflationary expectations from taking hold in the Eurozone. Interest rates were lowered further: the rate on the main refinancing operations of the Eurosystem was decreased by 5bps to 0.00%, the rate on the marginal lending facility decreased by 5bps to 0.25% and the rate on the deposit facility lowered by 10bps to -0.40%. No further cuts are envisaged in the foreseeable future. However, the central bank announced more credit easing measures to be implemented from June 2016: Firstly, a new series of four targeted longer-term refinancing operations (TLTRO II) will be introduced, each with a maturity of four years, whereby borrowing conditions can be as low as the interest rate on the deposit facility (i.e. a negative 0.4%). Secondly, the ongoing 60 billion a month bond-buying programme will be raised by 20 billion a month. For the first time, investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the programme. Analysts have looked at the existing purchase programmes for Sovereign entities (PSPP), Covered Bonds (CBPP) and Asset-Backed Securities (ABSPP) as well as at the market conditions in eurozone corporate bonds to estimate how large the Corporate Sector Purchase Programme (CSPP) may be. Applying the eligibility criteria detailed below, the universe comprises about 770 billion in outstanding bonds. In the most optimistic case, half the 20 billion monthly purchases could go toward corporate bonds from June 2016, i.e. monthly purchases of 10 billion over ten months. This would amount to

5 Low interest rates and the challenges for long-term Eurozone investors 3 around 13% of the eligible universe. As it is unlikely such amounts could be transacted in the secondary market without causing structural distortions (see below), tapping the primary market will have to be an important component of the programme. However, while just over 10 billion a month of corporate bonds were issued in 2015, strong issuance by non-eurozone based companies meant that less than half of these bonds would have been eligible. Most analysts have concluded that in these conditions, the ECB and its central banks may struggle to achieve a 10 billion per-month volume. This means that a considerable portion of the additional 20 billion of purchases will go toward topping up public sector purchases, keeping government bond yields low for a considerable period of time. Figure 1: European vs. US government bond yields in % Q Q Q Q1 Q Q Q Q Q Q Q4 Q German Gov Bonds 8-15y European Gov Bonds 8-15y US Treasury 10y Source: BoA Merrill Lynch, Bloomberg How will the Corporate Sector Purchase Programme be implemented? On 21 April the ECB published details on how it intends to implement the Corporate Sector Purchase Programme (CSPP) first announced on 10 March. In its statement the ECB goes a significant step further than analysts had anticipated, particularly in two areas: 1) In contrast to the Public Sector Purchase Programme the CSPP will not have to observe the ECB s capital key, i.e. the national capital shares. Rather than country neutrality the corporate programme will strive to maintain issuer neutrality on the basis of the universe of eligible bonds. 2) The maximum holding in an outstanding issue will be

6 Low interest rates and the challenges for long-term Eurozone investors 4 much higher than in the ongoing programmes, i.e. up to 70%. These two principles give the ECB and its implementing central banks much greater flexibility to achieve their quantitative targets. Which bonds will the ECB and its central banks buy? As a starting point, the eligibility framework for Eurosystem collateral will be applied. This means securities can be: a) fixed, floating rate or zero coupon, b) cannot be subordinated or hybrid debt, c) will have to have at least one investment grade rating from one of the four leading agencies (S&P, Moody s, Fitch or DBRS), and d) if the issuer is not euro area domiciled, it has to have a guarantor that is established within the EEA. The corporate bond purchase programme will deviate from the last point as it specifically targets corporations established in the euro area. However, in the latest statement it was clarified, that bonds issued in Euros by Eurozone-based financing entities of non-eu corporations are also eligible. Excluded from the programme will be bonds issued by banks and asset management entities. The rationale for this is that ECB also acts as banking regulator in the Eurozone and needs to avoid conflict-of-interest situations. However, bonds issued by insurance groups and by financing subsidiaries of industrial firms will be eligible. The purchases will be implemented by six Eurosystem central banks: the Banque de France, the Bundesbank, and the central banks of Spain, Italy, Belgium and Finland. In principle, all maturities between 0.5 years and 30 years can be purchased. There is no other pricing restriction than the ECB s deposit rate, i.e. central banks could buy bonds with a current yield-to-maturity as low as -0.40%. The ECB s goal is to maintain strict issuer neutrality. The purchases will be structured to mirror a benchmark that will be constructed on the basis of the above mentioned eligibility criteria. The benchmark will be neutral in the sense that it will reflect proportionally all outstanding issues qualifying for the programme. The weights will be fixed on the basis of the market capitalization of the bonds outstanding per issuer or issuer group (in case of a holding structure).the purchase limits will be derived from the weights, ensuring broad neutrality but also providing some flexibility for the ECB to build up its corporate portfolio over time. There are no liquidity or minimum-issue size restrictions for the ECB and no meaningful restrictions on maturities (0.5 to 30 years). Investors will no doubt study the transaction reports once the ECB starts publishing them in order to understand what the impact on relative pricing on particular bonds may be. In order to fill the issuer buckets, the central banks may become forced buyers of certain bonds, with prices drifting away from what market participants consider fundamentally justified. In the primary market, the central banks will most likely follow the approach they have used in Covered Bonds and Asset Backed Securities. When new issues come to the market, they may put orders in for 20% of an issue amount without price target, for example, thus avoiding becoming a price setter. In its Covered Bond programme the Eurosystem central banks can bid for up to 35% of an issue. The CSPP allows a maximum holding of 70% of the amount outstanding of any single bond issue. Hence the participation in single new issues could be higher than so far observed in the other programmes.

7 Low interest rates and the challenges for long-term Eurozone investors 5 The central banks will not disclose ex ante volumes for a month or quarter and it will not publicly list the bonds it wants to buy within a certain period of time. However, monthly reports will provide market participants with ex post information on the volumes purchased every week and every month. These reports will include a breakdown of secondary and primary purchases. The ECB and its national central banks would act similar to buy-and-hold investors, who often have to achieve certain liability hedging goals and generally display little price sensitivity (e.g. insurance companies and pension schemes who target cash flows with coupons and redemptions). The ECB has said it will not exclude bonds with negative yields (as long as they exceed the ECB deposit rate), which implies that it would be a buyer of last resort for institutional investors wanting to offload such bonds. We cannot predict the exact behavior of the implementing central banks, i.e. to what extent they might also trade bonds, for example in case of severe pricing dislocations or specific credit or reputational risks. In its press release on technical details the ECB says: The Eurosystem will conduct appropriate credit risk and due diligence procedures on the purchasable universe on an ongoing basis.such trading will, in our view, be minimal as the main purpose of the operation is to expand the availability of corporate credit and the central banks will buy and hold the bonds. Notwithstanding a pickup in new issuance, this will extract some further liquidity from the market, with bid-ask spreads even moving 10% to 20% wider. Figure 2: Credit Spread USD vs. EUR Issuers in bps Q Q Q Q Q Q3 Q Q Q Q Q Q USD Corporate OAS Spread Euro Corporate OAS Spread Source: BoA Merrill Lynch, Bloomberg Some structural effects investors should be aware of The ECB has thus far followed its market-neutral approach with remarkable discipline when implementing bond purchases. However, given the specific conditions in the Eurozone corporate bond market, a degree of structural distortions is possible:

8 Low interest rates and the challenges for long-term Eurozone investors 6 Pricing: The ECB s purchase operations have led to an increase in bond prices and drop in interest rates and yields. In the sovereign space, over 35% of Eurozone bonds 1 now trade with a negative yield. The most recent announcement on the purchase of corporate bonds triggered inflows into the market and boosted bond prices. As a result European investment grade and high yield corporate credit have become expensive relative to US equivalents. While the upside for further outperformance is limited, the vulnerability to adverse shocks has increased. The events in early 2016, when temporary outflows in increasingly illiquid markets led to a surge in volatility, may provide an example for the risks investors are likely to be confronted with going forward. Liquidity: As outlined above, liquidity may be impacted by the purchase programme as it makes certain bonds too expensive for return-seeking investors to buy. However, the crowding out effect is likely to be limited to smaller-size issuers, while the impact on the broad market should be quite small. Passive funds, that need to buy essentially all bonds included in the relevant corporate bond index, may be relatively more affected in terms of higher transaction costs than active funds, which are more focused on larger liquid issues and have the flexibility to avoid paying the scarcity premium. Maturity preferences: The authorities are likely to shy away from ultra-long maturities (with significant credit risk) and maturities below two years, meaning that more bonds in total would have to bought to achieve the target volume, as redemptions would have to be replaced. Thus, over time, spreads may rally most in the middle of the maturity spectrum. This is important for pension funds using a corporate curve as liability benchmark (see below). Displacement effects and opportunities for investors Investment into investment grade corporate bonds tends to be sticky, as they is seen as a core investment for many investors, and can provide some liability matching characteristics. However, in the search for yield, the market has seen a shift into European high yield assets, in particular the BB segment, with spreads tightening accordingly. We anticipate investors will shift into non-euro investment grade bonds (USD and GBP) as well. Where investment guidelines restrict asset managers from going off-benchmark, we expect they will engage clients with suggestions to broaden the mandate. However, taking incremental action may lead to suboptimal mandate design and risk management challenges. We recommend that investors reassess their credit allocations from a total portfolio perspective before initiating single portfolio or mandate changes to adjust to the revised market conditions. The elevated US dollar / euro yield gap is leading to greater cross-regional flows. Euro-based investors will seek more exposure to US dollar fixed income assets, while US dollar-based borrowers will step up funding in the euro bond market. Indeed, over the past 12 months the share of non-eurozone issuers in 1 On 6 April 2016 the figure was 35.7%, based on Bloomberg pricing of the bonds included in the JPM EMU Index.

9 Low interest rates and the challenges for long-term Eurozone investors 7 the euro-denominated corporate credit indices has increased significantly from 38% to 42% of the Barclays Euro Corporate Index. The issuance is subsequently reflected in the respective benchmarks, leading to investment in such names. The net result are portfolio changes driven by opportunistic borrower behavior rather than investor preference. We would argue that this is a good time for eurobased investors to reduce their traditional home-market bias and embrace more globally diversified solutions in the fixed income market. An important consideration will be hedging costs, which may well limit the scope for investing away from the respective home market. Even though the ECB s support is focused on non-financial investment grade bonds, we expect that secondary effects will boost financials and sub-investment grade bonds, offering opportunities for crossover or unconstrained fixed-income strategies. In particular, there appears to be a good case for active positioning around the BBB-/BB+ rating threshold. The ECB s eligibility criteria require an investment grade rating from only one agency, while benchmarks usually look at an average of available issuer ratings for inclusion in investment grade indices. Borrowers now have a big incentive to achieve a BBB- rating from at least one agency to make their bonds qualify for the ECB s bond buying programme. This all offers alpha potential for higher tracking error or crossover managers should clients wish to remain in the euro fixed income space. The following graph shows the shifting dispersion within euro high yield. Figure 3: Euro High Yield BB vs B in bps Q Q Q Q Q Q3 Q Q Q Q Q Q EUR HY 'BB' EUR HY 'B' Source: BoA Merrill Lynch, Bloomberg Consequences for investors Higher funding gaps: Notwithstanding the heterogeneity of pension funds, underfunded pension funds with a mark-to-market for their pension liabilities, for example IFRS basis, are likely to see their funding

10 Low interest rates and the challenges for long-term Eurozone investors 8 gaps widen and their liability hedge ratios decline. This is because the interest-rate sensitivity of their liabilities usually exceeds the interest rate sensitivity of their assets, given the duration gap between the two. The effect could be smaller than expected, as it is not obvious that long bonds preferred for liability matching will be affected by increased ECB buying, and this will be more focused on intermediate maturities. While the greatest impact on the discount rate is caused by movements at the long end of the curve, changes to the curve s steepness (tightening more in the middle where most assets are held) should be considered when designing liability hedge ratios. In many cases, pension schemes use a mix of government bonds and corporate bonds in their matching portfolios. Some also use swap overlays and other Liability Driven Investment approaches to match the duration of assets and liabilities more precisely. Across the Eurozone, liabilities are measured on a number of different bases, however market-related discount rates are common, including AA corporate bond curve and swap curve measures. With government bond yields at very low or negative levels, the mismatch toward swap rates has become more severe. In order to reduce the gap, investors will either have to switch from physical assets to swap contracts or increase average yields by taking on more credit risk. Both options are challenging: 1) Moving out of government bonds into swaps introduces leverage and investors face the problems of diminished bank market-making appetite, clearing costs etc. We advise investors to approach this topic with due care. A paper on this topic will be published shortly. 2) Moving into corporate bonds implies taking on credit risk that could lead to further mismatches versus swaps. In theory at least, this is less of an issue for schemes marked against IFRS curves, however AA corporate bond curve-based liability values are often highly sensitive to the yield on a small number of long-dated AA issues and therefore the matching offered by euro investment grade corporate debt may be quite limited. Most importantly, the diminished return potential of the euro fixed income portfolio means that its contribution to asset growth is greatly reduced. Closing funding gaps via asset growth rather than raising scheme contributions will become much harder in future. Limited upside for euro credit managers: It is unlikely that buy-and-hold investors will sell their bonds to the ECB in any large volume. Excess demand in the higher ratings segment should make this area quite unattractive to active investment. Active managers will further funnel assets into the BBB segment, where relative value trades can still be made, however, managers may be forced away from smaller issuers into larger, higher leveraged issuers. Overall, betting on which bonds the ECB may or may not buy is not a natural skillset of most managers, making this a less rewarding activity. Clients could either adopt a low-turnover, buy-and-maintain approach, or a high alpha strategy by a very skilled manager (taking more concentrated or off-benchmark bets).neither option represents a complete solution.

11 Low interest rates and the challenges for long-term Eurozone investors 9 Action points for investors Given the combination of liability considerations and shift in key asset expectations, many investors will wish to reassess their asset/liability management at a top level before making any specific changes. This aside, investors should examine their portfolios and determine if a management style shift is needed for this new regime in credit. This may be an opportune time to shift into more compelling areas of credit, including: 1. Rotate towards non-euro corporate credit: Moving to non-european credit via global credit mandates or USD credit mandates, on a euro-hedged basis, can help portfolios preserve more capital should European bonds come under pressure. Like Figure 4 shows, these measures should provide yield enhancement, as well as more diversification. A skilled global credit manager can make relativevalue shifts between the two large bond markets, euro and US dollar. Investors should balance the manager skillset in this space with the ability to ensure local implementation requirements can be adequately met. Figure 4: Duration, yield and spreads of European, US and Global credit market 2. Increase skill: A review of the entire credit portfolio can showcase how much return or risk can be added. Alternative credit can diversify the opportunity set (high yield bonds, loans, securitized and emerging markets bonds) and provide access to specialist investment managers and thus tap into additional alpha potential. Adopting a barbell approach, i.e. more explicit hedging combined with higher return-seeking alternative credit can enhance the overall portfolio risk/return, while ensuring investors are not just chasing yield by increasing risk alone. A bespoke review of existing portfolios may therefore be a good starting point in assessing the potential of these strategies. Figure 5 shows a selection of opportunities. Barclays Euro Aggregate: Corporates Barclays US Aggregate: Corporates Barclays Global Aggregate: Corporates (unhedged, in USD) Duration Yield 1.06% 3.07% 2.56% OAS 122bps 146bps 143bps Source: Barclays Live Figure 5: Single B yields and spreads, CLO spreads (end of April 2016) Europe US High yield credit single B - OAS 551 bps 603 bps High yield credit single B - Yield 5.5% 7.3% AAA CLOs (as at April 16) 160bps 165bps Source: BoA Merrill Lynch, Bloomberg, Citi Velocity

12 Low interest rates and the challenges for long-term Eurozone investors Sacrifice some liquidity for higher returns: Shifting some liquid investment grade credit exposure into more illiquid investment grade credit (via structures such as CLOs, RMBS) or higher return-seeking illiquid credit (such as direct lending, real-asset backed or to European corporates) can increase diversification and returns. Bank disintermediation is driving growth in both structured credit and direct lending by institutional investors, while for a considerable time high entry barriers will keep credit scarce for borrowers, and spreads will remain attractive for investors who take on the governance challenges associated with investing in closed-end credit pools. In particular, unlike more liquid strategies, it is not typically possible to achieve an overnight switch to such an approach. Instead investors will need to determine their long-term requirements, and review opportunities selectively as and when they arise. Lower governance investors can circumvent these restrictions by outsourcing certain functions and engaging in strategic partnerships.

13 Low interest rates and the challenges for long-term Eurozone investors 11 Towers Watson Limited, part of the Willis Towers Watson group, has prepared this material for marketing purposes only. The analysis in this material is based on limited information about your circumstances. No action should be taken on the basis of this material as we have not been appointed to give you advice. The assumptions used in this material have been derived by Towers Watson Limited using a blend of economic theory, historical analysis and opinions provided by investment managers. They inevitably contain an element of subjective judgement. Any opinions or return forecasts on asset classes contained in this material are not intended to imply, nor should they be interpreted as conveying, any form of guarantee or assurance by Towers Watson Limited of the future performance of the asset classes in question. The Willis Towers Watson Investment Model is designed to illustrate the likely future range of long-term returns from different asset classes and their inter-relationship. No economic model can be expected to capture perfectly future uncertainty, particularly the risk of extreme events. This material is provided to you solely for your use, for the purpose indicated. It may not be provided to any other party without Towers Watson Limited s prior written permission, except as may be required by law. In the absence of our express written agreement to the contrary, Towers Watson Limited and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any third party's use of or reliance on this material or the opinions we have expressed. Towers Watson Limited and Towers Watson Investment Management Limited are authorised and regulated by the Financial Conduct Authority. Copyright 2016 Willis Towers Watson. All rights reserved.

14 Low interest rates and the challenges for long-term Eurozone investors 12 Copyright 2016 Willis Towers Watson. All rights reserved.