A Matter of Interest

Transcription

1 A Matter of Interest Key Takeaways Asset values are often significantly influenced by interest rates Widely varying future assumptions can considerably alter valuations Unstable relationships can make quantifying interest rate exposure challenging Exploring Interest Rate Risk Across Asset Classes Interest rate risk is one of the major risks faced by financial entities, especially for pension funds and life insurance companies. The underlying source of this risk is the liability cash flows of the entity. Measuring interest rate risk on the liability side of the balance sheet is relatively easy in a static environment, using data based on a snapshot in time. The liability cash flows are mapped to an observable interest rate curve and the sensitivity of the liabilities can be determined based on the curve. However, it is more difficult to determine the interest rate risk inherent in various asset classes, since asset classes differ both in terms of the contractual obligation to pay out cash flows as well as expected cash flow growth. This becomes pivotal when considering the overall interest rate risk of a financial entity within an asset-liability study, which examines the net risk of assets minus liabilities. The relative ease of measuring liability interest rate risk can mask some crucial assumptions with regard to the projection of cash flows and the determination of the cash flow sensitivity to interest rates. Liability cash flow projections are based on assumptions that require professional judgment and are subject to regulatory and accounting standards. However, these assumptions can conceal the true risk of the liabilities. For example, liability calculations may: assume a static inflation rate utilize either government yields or swap yields for liabilities account for corporate credit spreads in the determination of the liability discount rate By understanding the assumptions used to project liability cash flows as well as the rates used to compute the liability interest rate risk, the investment fiduciary is better equipped to determine the most appropriate asset mix. The framework for understanding the interest rate risk of assets stems from the following formula, which represents the value of an asset (or liability) as the present value of the asset s expected income in perpetuity: where: Prepared by: Jonathan Jacob, CFA, FSA, FCIA Senior Vice-President Portfolio Risk Solutions MV= I r g MV denotes the market value of the asset I denotes the income of the asset r denotes the required return of the asset, and g denotes the growth rate of the asset s income The formula above is useful in understanding how the market value of a perpetual asset changes relative to its inputs. For the purpose of this framework it is also important to understand that r includes not only the risk free rate, but also the possible liquidity premium, risk premium, and other required returns from the particular asset.

2 Fixed Income The most obvious asset class to utilize for mitigating interest rate risk is fixed income, since the interest rate risk of a bond can be easily quantified using inputs available in the market. Bonds are also easier to understand as the growth component of our asset valuation formula is generally fixed to zero. This means that return variations are explained entirely by changes in interest rates, simplifying our general formula. Fixed income products provide an investor with a diversity of issuers to choose from, such as federal, provincial or corporate bonds. While federal government bond yield changes tend to be the primary source of information used in the financial press, provincial and corporate bonds provide additional spread or risk premium yield relative to federal bonds. The components of the required rate of return for government versus spread sectors can be seen below: R government bonds = risk free rate R corporate bonds = risk free rate + risk premium When considering interest rate sensitivity, government yields tend to be the most volatile since the risk premium for provincial and corporate bonds generally move in the opposite direction of the risk free rate. Approximately 2 years of market experience show yields declining during times of stress, such as sharp declines in the equity markets, due to a flight to safety (see Figure 1). Figure 1: Equity Performance vs. Changes in Bond Yield Change in yield (%) Negative Equity Returns 1-yr GoC yield - 1 yr change S&P/TSX YoY Returns Source: Bloomberg, Greystone Managed Investments Inc Rolling 12-month return (%) When this occurs, the market prices in additional risk for credit, resulting in higher spreads for provincial and corporate bonds (see Figure 2) even if their overall yield declines. Figure 2: Corporate Bond Spreads vs. Equity Returns Spread (bps) Negative Equity Returns Canada Corporate Bond Spread S&P/TSX YoY Return Source: BofA Merrill Lynch, Bloomberg, Greystone Managed Investments Inc. In terms of the framework of the perpetual asset equation, a perpetual bond would be valued as follows: I Coupon MV= = r g risk free rate + risk premium or spread The formula has been modified as I denotes the coupon of the bond, which is predefined and therefore the rate of growth of the coupon, g =. The r would constitute the risk free rate (government yields) plus a spread based on the credit of the underlying bond. The formula in our framework is a simplification since bonds have finite maturity, which leads to the ability to precisely calculate their sensitivity to interest rates. The simplification does not change the central premise of interest rate sensitivity but does explain why longer duration bonds have more rate sensitivity than shorter term bonds. In considering the mismatch between assets and liabilities, it is important to recognize that significant volatility of spreads in corporate bonds (such as the recent experience during the 28-9 financial crisis) can magnify changes in the surplus or deficit, especially when liabilities are valued using government yields. Fixed income assets are an especially Return (%) Page 2

3 efficient and reliable method of acquiring defined interest rate risk across the maturity spectrum. Unfortunately, the yield of fixed income assets tends to be lower than the yields of the other assets to be considered below. Commercial Mortgages Commercial mortgages present similar characteristics to those of corporate bonds, with higher spreads and lower spread volatility. This makes commercial mortgages an ideal investment for an investor seeking to manage interest rate exposure. The real estate underlying a commercial mortgage represents security for the repayment of the mortgage and is an upgrade over the unsecured nature of many corporate bonds. The real estate backing of commercial mortgages increases the likelihood of principal recovery in the event of default. The interest rate risk of commercial mortgages can be readily calculated based on the contractual coupon payments and the repayment of principal. The benefits of mortgage investments come with drawbacks: a smaller maturity spectrum and less tradability. To match liabilities with commercial mortgages alone would be difficult since commercial mortgages are not usually apportioned to investors by dividing an issue, the method used in the world of bonds; rather, in most cases, a single lender provides the entire amount required by the borrower. Furthermore, mortgages with maturities beyond 1 years are less common, making it difficult to use them for hedging long-tailed liabilities. Finally, as a private asset, mortgages are not purchased or sold instantaneously, making entry into and exit from the market a process that requires time to execute. Notwithstanding the above drawbacks, commercial mortgages can be used in place of short-maturity bonds. Such investments represent an ideal complement to a fixed income portfolio to match liability interest rate risk, given the higher yields available, similar sensitivity to interest rates, and collateral enhancement. Equities Equities have historically constituted more than half of a pension fund s portfolio due to superior long-term performance. Typically, an asset-liability study will not consider the interest rate risk of the equity investment. Unfortunately, over the past 25 years sharp drops in equity markets have usually coincided with a drop in bond yields, which led to the widespread belief that equity markets were positively correlated with bond yields (or negatively correlated with bond prices). This belief did not consider the fact that bond and equity prices were either positively correlated or uncorrelated prior to the Greenspan-led U.S. Federal Reserve (Fed) (Note: Alan Greenspan took the helm of the Fed in 1987). If equity sensitivity to rates is considered within the perpetual asset framework, the equation would be: I Earnings MV= = r g risk free rate + spread earnings growth The formula has been modified as I denotes equity earnings, and g represents earnings growth. The r would constitute the risk free rate (government yields) plus a spread based on the perceived risk of the underlying equity. Utilizing the framework formula provides a deeper understanding of how rates may impact equities. When economic uncertainty is prevalent, even though the risk free rate may decline, the required risk spread may increase and the expected earnings growth rate may decrease in such a way that the denominator of the framework equation increases. This would lead to a decrease in equity prices even though the risk free rate has declined; this is consistent with the equity market experience over the past 25 years. However, if rates move due to an increase in inflation, the result could be similar to the experience in the 196s and 197s, where the change in the risk free rate is greater than the change in the other components of the denominator, leading equity prices to move in the same direction as bond prices. The belief that equity and bond prices tend to move in opposite directions also suffers by limiting the discussion to indices. Equity indices, by definition, represent the aggregate performance of many underlying sectors and industries. Indices that tend to be defined by market capitalization are also style agnostic, unless one uses an index that is defined by parameters representing a particular investment style, such as dividend yield. Dividends may be considered similar to interest payments even though, as opposed to bond interest coupons, the payment of dividends is not a contractual obligation. Certain industries such as Oil Pipelines, Telecommunication and Real Estate Investment Trusts (REITs), where dividends tend to be higher than the broad market, have been shown to outperform the market when rates decline and underperform when rates increase. Again, the framework formula aids in understanding why this is the case: equities in these industries possess Page 3

4 earnings growth rates and required risk spreads that tend to be lower than the rest of the market since a large component of earnings are paid to shareholders and not reinvested in the company. This leads to greater sensitivity to the risk free rate. However, there are times where the required risk spread fluctuates significantly due to pressure from the equity market as a whole. In that case, the relative performance may not be sufficient to overcome the broad equity market move, so although these market components may outperform the market when rates decline, they could also decline in value on an absolute basis. Figure 3 shows the relative performance of the S&P/TSX Canadian Dividend Aristocrats Index vs. the S&P/TSX Composite Index (blue line). With the backdrop of falling interest rates (green line), the dividend index has generally outperformed the composite index. The notable exception was the period during late 26 8 when the tax rules for income trusts in Canada were changed and markets were impacted by the financial crisis. Figure 3: Relative Performance of Indices and Interest Rates Relative Index Level Dividend Index vs. Composite Index Source: Bloomberg, Greystone Managed Investments Inc. 1-yr GoC Bond Yield Finally, the non-contractual element of dividends may also lead to dividend increases when company earnings increase, leading to the conclusion that some portion of dividends may be considered inflation-sensitive. Although the relationship between dividend yields and bond yields is inconsistent (see Figure 4), an investment fiduciary may wish to consider the interest rate sensitivity of specific equity mandates Yield (%) Figure 4: S&P/TSX Dividend Yield vs. Canadian Corporate Bonds Yield Yield (%) Corporate Bond (YTM) S&P/TSX Yield Source: FTSE TMX, Bloomberg, Greystone Managed Investments Inc. Real Estate Direct real estate investments, similar to REITs, have exposure to interest rate risk. However, it may be difficult to determine the type of rates to which real estate is exposed and then to quantify the amount of interest rate risk. Our framework formula is modified to: I MV= = r g Net Operating Income (NOI) Capitalization Rate (Cap rate) Therefore, the changes in market value are based on net operating income and capitalization rates, which consist of the discount rate (r) and the expected growth of NOI (g). It is also important to note that market value does not include a debt/leverage component. If the net operating income for a portfolio is assumed to remain unchanged (g=) and there is no leverage used, then the market value is a direct function of the discount rate, which can be broken down as the risk-free rate plus a risk spread component similar to corporate bonds. Assuming the volatility of the risk spread to be low, capitalization rates should be highly correlated to the discount rate (long-term interest rates), which has been the historical experience of real estate portfolios in Canada (Figure 5). Page 4

5 Figure 5: Capitalization Rates vs. Government of Canada 1-yr Bond Yield % Spread All Property Average National Cap Rate 1-yr GoC Bond Yield both short maturity and long maturity rates. The result of such an analysis indicates that real estate market value is negatively correlated to long rates and positively correlated to short rates in a statistically significant manner. In the context of our guiding formula this is intuitive: LONG RATES: MV = Net Operating Income (NOI) Discount Rate (Long rate) - NOI growth rate (short rate) Source: CBRE Limited, Bank of Canada, Greystone Managed Investments Inc. Therefore, sensitivity of a real estate portfolio to interest rates can be approximated by utilizing a historical regression of cap rates to overall interest rates to determine the sensitivity of market value to a change in interest rates. The drawback of such an approach is in recognizing the simplifying assumptions embedded in such an analysis: The regression outcome may not be valid since Canadian real estate index cap rate data is limited to 22 and later years, and interest rates have been in a secular decline since Furthermore, current market conditions find rates at the lowest level of the dataset, and it may not be correct to assume that cap rate sensitivity to interest rates remains constant when cap rates are at 12% compared to 5%. Assuming net operating income (NOI) growth equal to zero ignores the implied sensitivity of lease costs to inflation. While supply and demand factors will dominate inflation in the determination of market lease rates at a property level or during brief periods of time, the NOI of a diversified real estate portfolio generally increases on a secular basis with inflation. This second constraint can be relaxed by recognizing that NOI growth, with a high exposure to economic growth and inflation, can be considered by utilizing short rates as a proxy. In other words, rather than performing a regression of cap rates versus long-term interest rates, a multiple regression of the market value of real estate can be performed against SHORT RATES: MV = Net Operating Income (NOI) Discount Rate (Long rate) - NOI growth rate (short rate) In general, when considering the sensitivity of real estate to interest rates, there is statistically significant evidence that real estate returns exhibit correlation to both short maturity yields (positive relationship) and long maturity yields (negative relationship). While this is positive from an asset-liability mismatch perspective, we can see that the computation of real estate sensitivity to interest rates is not an exact science. Infrastructure Similar to real estate, infrastructure has exposure to both real and nominal rates, which can be difficult to quantify. The main differences between real estate and infrastructure are subtle yet important; infrastructure deals usually include longer contracted cash flows (1 to 3 years) compared to real estate lease terms (5 to 1 years) and as a result are usually more levered. The framework formula for infrastructure can be described as: I Cash flow available after Debt Service MV= = r g Internal Rate of Return (IRR) Note that this formula does not provide for a cash flow growth rate (the g in our formula), as it is incorporated in the internal rate of return (IRR). Furthermore, similar to real estate, the formula does not precisely account for leverage, which is an important part of the infrastructure equation. The above equation makes the simplifying assumption that debt will remain on the asset in perpetuity. The longer-term nature of infrastructure contracts (or concession/off-take agreements) would lead to the conclusion that there is a greater correlation between infrastructure Page 5

6 returns and long-term interest rates. Once again, there is difficulty in quantifying the correlation for a few reasons: A concession agreement may, depending on jurisdiction and sector, include an escalation of cash flows by an inflation factor, which means the correlation may be to real rates more than nominal rates. Due to the increasing interest from institutional investors in infrastructure assets over the past 1 years, the expected internal rate of return from these assets may be declining for reasons other than the decline in long-term interest rates. The greater visibility of long-term cash flows at high IRRs has made infrastructure assets a bedrock of many large institutional portfolios. There are, however, risks in infrastructure that may or may not be found in real estate. In infrastructure, investors are more likely to be exposed to political, technological and environmental resource risk; however, such risks can be mitigated and investors typically earn higher returns as a result. Although the ability to quantify the interest rate exposure of infrastructure (both real and nominal) is limited, it would be reasonable for an investment fiduciary to acknowledge in an asset-liability framework that infrastructure has a strong relationship with long-term interest rates. Conclusion The management of financial entities requires an acknowledgement of the risks of both the assets and liabilities. Interest rate risk for some assets and liabilities may be simple to quantify, but below the simplistic calculation are underlying assumptions that may not be explicitly recognized. For other assets or liabilities there may be a clear relationship between the return and interest rates, but quantifying the precise exposure may be difficult. Such difficulty may stem from an unstable relationship with rates, which depends on the economic environment or risk spreads. In an ideal world, the precision of interest rate risk measurement in fixed income would exist for all asset classes. In the world as it currently exists, the higher expected return of asset classes such as real estate and infrastructure may justify approximations of relationships with and exposures to interest rates. Ultimately, the asset allocation and assetliability mismatch must reflect the risk tolerance of the financial entity based on a complete recognition of all risk exposures, both measurable and unmeasurable. For more Greystone Thought Leadership, visit our website at or Scan QR Code to gain direct access to our website. Page 6

7 About the Author Jonathan Jacob is Senior Vice-President of the Portfolio Risk Solutions group at Greystone Managed Investments Inc., and is a member of the Greystone Asset Strategy Team. Jonathan s group evaluates portfolio risk and provides consultative advice in the construction of multi-asset portfolios. Jonathan is also responsible for providing risk-based investment solutions to clients and their advisors. Disclosures This document is for informational purposes only. It is not meant as investment advice and is not an offer, solicitation or recommendation to purchase or sell any security. There is no assurance that any predictions or projections will actually occur. Past performance is not necessarily indicative of future results. Commentary reflects the opinions of Greystone Managed Investments Inc. as of the date of the document. This document was developed from sources believed to be reliable, but is not guaranteed to be accurate or complete. Greystone Managed Investments Inc. All rights reserved. Page 7

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