By Nicolas Gaussel
Maurits Escher was the champion of enigma. This 20th century Dutch artist was a master of portraying strange or paradoxical situations. In Escher’s world, white birds transform into daytime landscapes while black birds become night-time landscapes, ribbons only have one side, motion is perpetual and so on.
In finance, the widespread and lasting establishment of negative interest rates in Europe directs us toward a new world where our thought patterns have been turned upside down. Outside of the imaginings of an “Escheresque” form of finance, financial theory and practice seemed to be based on the solid foundations of the time preference and making money “work”. Under these assumptions, negative nominal interest rates would have never been considered a serious hypothesis because it would trigger an unprecedented demand for cash and freeze financial markets.
Ironically, banks in Europe are still lending to one another despite the fact that negative interest rates at the short end of the yield curve have become a widespread reality. But this has profound implications for the business model of major financial institutions and involves a new challenge: how do you generate returns without taking too much risk?
The race to the bottom in bond yields has effectively led investors to take duration and credit risk. For years, bond markets have been associated to a haven for risk-adverse investors, providing a steady income flow without volatility. However, an extraordinary 30-year bond-market rally has pushed valuations to high levels. In Europe, the combination of systemic risk in the wake of the sovereign debt crisis, persistent deflation risks and the asset purchase programme of the ECB has pushed 10-Bund yields close to zero at end-April 2015. But early May 2015, the yield on the 10-year German sovereign bond rose unexpectedly by almost 70 bps in a matter of days. The Bund price lost 3.3% in a week, a move that has only been observed once over the previous 35 years (it was in 1990 a few months after the fall of the Berlin wall). The recent spike in volatility in European bond markets was thus a wakeup call for institutional investors. They face a difficult tradeoff: accept negative yields at the short-end of the curve or face higher volatility and potential midterm losses being exposed to the long end.
Expansionary monetary policies are raising a new set of questions regarding their impact on market liquidity and the extent of price distortions they are causing. Far from having clear answers to these questions, risk management is critical in a near-zero interest rate environment. As a result of the mounting uncertainties regarding the fundamentals of fixed income, innovation and tailor-made solutions might be an effective response. Several sets of opportunities are now made available to investors to better navigate these uncharted waters.
For instance, a strategy that invests in “asset-swapped” government or supranational bonds does not generate any additional credit risk and reduces the standard duration risk. It also allows positive yields to be maintained by combining the carry paid for by the asset swap with mark to market gains achieved due to the positioning of the strategy. Such strategies may still entail curve risk but at least contribute to diversify the sources of risk. Another option consists in investing in short-term bank securities, collateralised by shares. Actually, new regulatory constraints encourage banks to offload shares from their balance sheets, with a commitment to take them back in the future, via repo transactions. This new paradigm is putting pressure on equity repo rates, which are turning negative across the board. Combined with a negative Eonia, this gives rise to a situation in which short-term bank debt securities collateralised by shares offer a higher return than non-collateralised securities, even though objectively speaking they are less risky. This strategy offers the possibility to achieve a higher return than the yield generated by traditional unsecured short-term money market investments, while minimizing counterparty, liquidity and interest-rate risk.
Negative interest rates imply that investors need to focus more on risk management. Actually, expensive valuations imply that the historically low volatility of fixed income might not be indicative of future volatility. Institutional investors need new diversification strategies in order to avoid concentrating on duration and credit risks to increase returns. Several solutions appear attractive today.
Nicolas Gaussel is CIO at Lyxor Asset Management
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