This session will use polling.

Transcription

1 This session will use polling. Access via: VCIA s Conference App or 3 OR 2 1 Go to the Polling Icon on the VCIA App Go to Click on the session you would like to join. 1. Vote for a Question 2. Ask a Question 3. Respond to Polls

2 Avoiding a Black Hole in Your Bond Portfolio David Korzendorfer, Bradley, Foster & Sargent, Inc. Edward Precourt, Marsh s Captive Solutions Group David G. Schwartz, YKK Insurance Company of America Carl Terzer, CapVisor Associates, LLC August 14, 2013 VCIA All Rights Reserved

3 VCIA SLIDES 2

4 Agenda Current fixed income market and where it is headed Bond basics: price/yield, duration Risks Enterprise risk concepts: strategic asset allocation Tactical portfolio management solutions: alternative asset classes ALM: bond immunization, cash flow matching Summary of what you can do to avoid the black hole 3

5 Polling Question Have you or your captive clients increased their risk appetite in the face of a prolonged low yield environment? A. Yes B. No 4

6 Polling Question Please order your concerns that may impact the bond market A. Credit crisis B. Equity market bubble C. Interest rates increases D. Public debt levels 5

7 Polling Question As captive owners/managers what do you see as the most significant Securities Market dangers/concerns to your portfolios? A. Portfolio value decreases B. Hit to surplus C. Impaired underwriting abilities D. Insurance Agency Ratings pressure E. All of the above F. None of the above 6

8 Current Market Environment U.S. Treasury Curve April 30,

9 20% 10 Year Treasury Yield and Annual Total Return % 15% 10% 5% 0% -5% -10% 01/31/63 01/31/68 01/31/73 01/31/78 01/31/83 01/29/88 01/29/93 01/30/98 01/31/03 01/31/08 01/31/13 8

10 20% Interest Rates & Price Only Return 10 Year Treasury Yield and Annual Price Return 15% 10% 5% 0% -5% -10% 01/31/63 01/31/68 01/31/73 01/31/78 01/31/83 01/29/88 01/29/93 01/30/98 01/31/03 01/31/08 01/31/13 9

11 Risks to Bond Portfolios Credit Risk: Downgrade and/or default Interest Rate (Duration) Risk Reinvestment Risk Prepayment (Convexity) Risk Inflation Risk Liquidity Risk 10

12 Polling Question Assuming that interest rates will eventually rise, what time frame seems most likely? A. Within 1 year B. Within 2 years C. Within 3-4 years D. Not for 5 or more years 11

13 Bond Market Mechanics Interest Rates and Prices Interest Rates Bond Price s Interest Rates Bond Prices 12

14 Polling Question By how much do you think interest rates will change in the next two years? A. Rates will increase 2% or Less B. Rates will increase 3 4% C. Rates will increase 5% D. Rates will remain unchanged or decline 13

15 Polling Question How do you rate your current risk tolerance? (1= Most Risk Adverse - 10= Most Aggressive) 14

16 YKK Captive Program Conservative: Principal preservation is primary objective Maximizing return with low risk profile is the secondary objective Continuation of low yield environment necessitates revisions Risks: Credit vs. Interest Rate 15

17 Duration: A Mystery Solved! Defined: a measurement of the portfolio s sensitivity to interest rate changes that approximates the % change in portfolio market value for a given % rate change Portfolio Duration = 3.5 years 1% Interest Rate Changes 3.5% Portfolio Market Value Changes 1% 3.5% 16

18 Change in Price With a 1% Rise in Rates A 2 Year Duration Price Declines 2% A 5 Year Duration Price Declines 5% A 10 Year Duration Price Declines 10% 17

19 Bond Portfolio Market Value (MV) $ 25,000, Bond Portfolio Duration (years) 4.00 OUTPUT Interest Rate Portolio MV MV Increase % MV LOST LOST % 5 $ 20,000,000 $ 5,000, $ 21,000,000 $ 4,000, $ 22,000,000 $ 3,000, $ 23,000,000 $ 2,000, $ 24,000,000 $ 1,000, $ 24,500,000 $ 500, $ 24,750,000 $ 250,

20 Asset Liability Management (ALM) A risk management function/method for: assuring sufficient and timing of portfolio liquidity to meet an insurer s obligations. testing or setting constraints on an insurer s interest rate sensitivity. Primary ALM tests Cash Flow matching Duration Matching (immunization) 19

21 Polling Question Are investment managers for your captive or your client's captives using ALM techniques in portfolio management? A. Yes B. No C. Maybe D. Don t know 20

22 Yield Curves & Credit Quality 21

23 YKK Solution Two different portfolio themes Conservative: strong foundation for claims paying ability More Aggressive: design to take credit risk, not duration risk, to enhance yields Portfolio management considerations 22

24 Polling Question How much of your portfolio would you be willing to invest in below investment grade securities? A. 0% B. Less than 5% C. Less than 10% D. Less than 20% 23

25 Considerations for Captives How to set appropriate investment objectives Risk = Volatility as measured in standard deviation. What is your definition of risk? Determining risk tolerance Apportioning your risk budget Assessing regulatory, accounting and other considerations Designing the optimal Strategic Asset Allocation Selecting investment manager(s) for implementation Construction of a liability-aware portfolios to maximize risk adjusted, after tax returns 24

26 Client Portfolio Optimization Efficient Frontier Analysis 90% Core FI; 10% S&P % Core FI & 25% S&P 500 Core Fixed Income Int. Gov. Credit 100% US Govt. Unoptimized Captive Portfolio Efficient Frontier line represents the best possible risk/reward portfolio combinations available in the marketplace Reallocating assets to a portfolio combination that lies on the efficient frontier optimizes performance for any risk/reward combinations, i.e. increasing return at the same risk level (up arrow) or reducing portfolio risk for the same return (left arrow) 24

27 Correlation Matrix 26

28 Strategic Asset Allocation Determinants of long term investment results Sources: Ibbotson and Kaplan entitled "Does Asset Allocation Policy Explain 40%, 90% or 100% of Performance?" (2000). 25

29 Strategic Asset Classes (lower correlation) US bonds High Yield bonds Convertible bonds US equities International equities Emerging market bonds/equities Commodities, REITs, MPLS Hedge Funds Private equity, mezzanine debt 28

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31 Enterprise Risk Management (ERM) Begins with analyzing the captive s business across the balance sheet High underwriting risk probably warrants a lower risk approach to investing Optimizing your investment program Strategic asset allocation optimization Dynamic Financial Analysis (DFA) DFA Lite Designs an investment strategy that correlates investments to underwriting activities 30

32 Current Mix Proposed Mixes New Mix zero Plus Plus Plus HY and Equity 5% EQ 10% EQ Plus HY Int'l EQ Cash Bonds Muni Common BA HY Intl Eq 5 Convertibles 5 Oil & Gas 5 EQ high div 5 31

33 2012 Allocation New Allocation Cash Bonds Cash Bonds Muni Common 36 Muni Common BA HY 35 BA Intl Eq 36 Convertables Oil & Gas Current Mix Proposed Mixes New Mix zero Equity Plus 5% EQ Plus 10% EQ Plus HY Plus HY and Int'l EQ Exp Ret Std Dev Sharpe

34 Net Income 6,000 Expected Net Income Improvement 5,800 5,600 5,400 5,200 5,000 4,800 CurMixAvg NewMixAvg 4,600 4,400 4,200 4, Year 33

35 Percentage Differential 3.00 Return Differentials In Tails Left Tail Right Tail Differential Year 34

36 Polling Question Have you or will you (or your clients) consider an analytically supported approach to this decision? A. Yes B. No C. Maybe D. Don t know 35

37 Take-aways The black hole for bond portfolios: rising interest rates Solution: duration management Solution: higher yielding bonds Solution: asset class diversification Other risks factors to fixed income securities must still be mitigated 36

38 Take-aways Tools/Strategies required: Bond portfolio immunization (ALM) Careful risk tolerance assessment for asset class selection Analytic tools, DFA or DFA Lite to optimized new allocation 37

39 Questions? 39

40 Rate this session on the VCIA 2013 App! Go to the Event Icon on the VCIA App Click on the session you would like to rate Scroll down the screen Click on: Rate Session