Low yield chapter 1

436 views

Published on

Published in: Economy & Finance, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
436
On SlideShare
0
From Embeds
0
Number of Embeds
7
Actions
Shares
0
Downloads
3
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Low yield chapter 1

  1. 1. The “New Normal” of LOW YIELDS 1
  2. 2. The Moderator • Soren Plesner, CFA, FRM, PRM • Founder, SPFK Financial Knowhow • www.spfk.dk • sp@spfk.dk 2
  3. 3. Fundamental Changes in Financial Markets in the Aftermath of the Crisis • The financial crisis that culminated in 2008-2009 was the most severe since the great depression • Near-collapse of the banking system + “The Great Recession” • Reactions from governments and central banks – Massive fiscal stimulus programs – Massive injections of liquidity into the banking system • Result: – Historically low interest rates on government bonds • Real rates are negative in many bond markets – Narrowing of spreads on corporate bonds – Emergence of new bubbles in the equity, real estate, commodity markets? 3
  4. 4. Historically Low Yields on T-Bills…. 4 0 2 4 6 8 10 12 14 16 18 1/4/1960 1/4/1962 1/4/1964 1/4/1966 1/4/1968 1/4/1970 1/4/1972 1/4/1974 1/4/1976 1/4/1978 1/4/1980 1/4/1982 1/4/1984 1/4/1986 1/4/1988 1/4/1990 1/4/1992 1/4/1994 1/4/1996 1/4/1998 1/4/2000 1/4/2002 1/4/2004 1/4/2006 1/4/2008 1/4/2010 1/4/2012 13-Week US T-Bill Rates (% p.a.) 1960-2013 Source: Federal Reserve Bank
  5. 5. Historically Low Yields on T-Bonds…. 5 0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00 1962-01-05 1965-01-05 1968-01-05 1971-01-05 1974-01-05 1977-01-05 1980-01-05 1983-01-05 1986-01-05 1989-01-05 1992-01-05 1995-01-05 1998-01-05 2001-01-05 2004-01-05 2007-01-05 2010-01-05 2013-01-05 US Treasury Yields, Constant Maturity, % p.a. Source:Federal Reserve Bank 10-YRCM 2-YR CM 30-YRCM
  6. 6. Negative (Real) Yields on 10-Year TIPS! 6 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 Treasury InflationProtectedSecurities, ConstatMaturity, % p.a. Source:Federal Reserve Bank 10-year CM 30-year CM
  7. 7. Selected 10-Year European Government Bond Yields 7 Source: IMF WEO, April 2013, Figure 1.3
  8. 8. Interest Rate Spreads 8 Source: IMF WEO, April 2013, Figure 1.3
  9. 9. Extremely Low Interbank Rates 9 0 2 4 6 8 10 12 3M Libor in Selected Currencies, % p.a. Source: FederalReserveBank CHF EUR JPY USD
  10. 10. Risk-Free Return og Return-Free Risk? • T-Bills and government bonds have traditionally been seen as “risk-free” investments • T-Bill rates have traditionally been used as the “risk-free” rate in financial models (e.g. CAPM, Black-Scholes..) • The 10-year T-Note yield has been a proxy for long-term risk-free rate of return • But are these instruments “risk-free” in today’s environment of extremely low yields? – Inflation risk? – Duration and interest rate sensitivity? – Sovereign risk? 10
  11. 11. Low Risk = High Duration! 11 0.0 50.0 100.0 150.0 200.0 250.0 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% Price Yield to Maturity Price/yield relationship of a 30-year, 4% bullet bond Durationis veryhigh at low yield levels! Slope of curve = "dollar duration"
  12. 12. “The Ghost of `94” 12 Could this happen again?
  13. 13. Reduced Buffer against Duration Risk • Bond return = yield + capital appreciation/depreciation • Babcocks formula: • We’ll do a couple of hands-on examples! 13 Yield Horizon Duration YieldReturn        1 Yield acts as “buffer against losses!
  14. 14. The “Hidden” Risks of Bond Investing • Yields very low  almost no buffer against losses • A bond’s duration (interest rate sensitivity) is very high, when yields are very low! • This is a very nasty combination for the short-term investor! • For the long-term (buy and hold) investor: – No risk of price deprecation – bond will mature at 100 – But risk of negative real returns (inflation risk) 14
  15. 15. Summarizing the Problems of Low Yields • Duration risk (short term investor) – Discussion: what could drive up interest rates in the short run? • Inflation risk (long term investor) – Returns are insufficient to secure purchasing power – Discussion: what could drive up inflation in the longer term? • ALM risk (pension funds) – High duration of liabilities – Real or nominal liabilities? – Guaranteed minimum returns? • ALM risk (banks) – Interest rate margins are squeezed • Asset managers – Fees under pressure • The financial system – Systemic risks - low yields  risks of “bubbles”! 15
  16. 16. But Some Will BENEFIT from Low Yields • House buyers (very low mortgage rates) – Discussion: should house buyers (or owner) choose variable or fixed rate? • Governments – Can finance their huge deficits at very low rates • Corporations – Can lock in very low rates (and spreads) • Equity investors – Low rates  higher valuations, c.p. – But is that already priced into the markets? 16
  17. 17. How Long Will the Low-Yield Environment Last? • The only correct answer: Nobody knows! • Will mainly depend upon: – Economic growth – Inflation expectations • Three scenarios – Return to growth and increase in inflation  “the Ghost of 1994” – Many years of low/moderate growth and subdued inflation  many years of extremely low interest rates (“Japan scenario”, “lost decades”) – New shocks to the financial system (Euro break up, sovereign defaults,…)  even LOWER interest rates? • Discussion: – What is your favorite scenario? – Other scenarios? 17
  18. 18. An Overview of Strategies for Enhancing Yields • Speculative Strategies – Use Leverage – Speculate in RISING rates (they will rise, sooner or later!) • Borrow fixed rate, short bonds, …. • Timing is everything! • Broader Fixed Income Investment Approach • Specialized Investment Strategies • Switch to other Asset Classes • Careful Portfolio Management – Improvement of risk-adjusted returns 18

×