2. The Moderator
• Soren Plesner, CFA, FRM, PRM
• Founder, SPFK Financial Knowhow
• www.spfk.dk
• sp@spfk.dk
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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?
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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?
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11. Low Risk = High Duration!
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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"
13. Reduced Buffer against Duration Risk
• Bond return = yield + capital appreciation/depreciation
• Babcocks formula:
• We’ll do a couple of hands-on examples!
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Yield
Horizon
Duration
YieldReturn
1
Yield acts as “buffer
against losses!
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)
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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”!
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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?
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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?
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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
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