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FIXED INCOME OPPORTUNITIESIN A LOW YIELD ENVIRONMENT

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2015 • Q2 • MODERNINVESTOR.COM

FIXED INCOME OPPORTUNITIES IN A LOW YIELD ENVIRONMENT

RAVI RASTOGI

MERCER INVESTMENT

SAMU ANTTILA

LOCAL TAPIOLA

CHRISTOPHER REDMOND

TOWERS WATSON

THE PARTICIPANTS

PIERANGELO FRANZONI

SWISS REINSURANCE COMPANY

ADELINE NG

BNP PARIBAS INVESTMENT PARTNERS

ANTONIO CAVARERO

GENERALI INVESTMENT EUROPE

THE QUEST FOR A NEW HOLY GRAILUncertain is the best word to describe the current global economic situation. On the one hand, massive central bank interventions have skewed global markets and seriously tested everyone’s ability to forecast. On the other hand, the world’s growth engine, China, is facing one of the most challenging periods in its history, exemplified by recent equity market volatility.

But challenges bring opportunities. The opening up of Asian markets might become the new Holy Grail for institutional investors looking to diversify portfolios while increasing returns. Within the region, hard currency denominated investment grade Asia bonds seem the safest bet, especially in light of the upcoming launch date of the EU’s Solvency II Directive.

During the roundtable, we touched upon all these themes and tried to look forward, building a picture of the investment world to come. Just as the best outcomes are often the least predictable, here you’ll find answers that you wouldn’t expect.

LUCA ROSSICITYWIRE

DIPANJAN ROY

PRUDENTIAL

LUCA ROSSI

CITYWIRE

CURRENT FIXED INCOME ENVIRONMENTINVESTING IN ASIA FIXED INCOMEINVESTMENT OUTLOOK

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SAMU ANTTILACHIEF INVESTMENT OFFICER

LOCAL TAPIOLA

Samu Anttila has worked in various positions in the insurance industry for 15 years and during that time has generated deep knowledge on Solvency II. He began his career as an actuary, then moved to head of market risk management. He is currently the chief investment officer of LocalTapiola Life and is also responsible for ALM operations within the LocalTapiola Group. Previous to his current position, he worked for ING Insurance as an insurance risk officer.

He holds a master’s degree in actuarial sciences and is also a fellow of the Finnish Actuarial Society.

ADELINE NGHEAD OF ASIAN FIXED INCOME


Adeline is responsible for Asia fixed income portfolios at BNPP IP, based in Singapore. In addition to leading the Singapore-based team, Adeline is also an alpha specialist for Asia (ex-Japan), covering hard currency credits and local currency interest rates and she has a regional co-ordination role vis-à-vis the other local fixed income teams within BNPP IP in Asia.

Previously, Adeline worked at Fortis Investments and ABN AMRO Asset Management (AAAM). She joined AAAM as a portfolio manager in December 2001 and was subsequently appointed as head of Singapore fixed income in November 2005, then head of asia fixed Income in April 2008. Prior to joining AAAM, she was the regional assistant vice president – investments with John Hancock International (Southeast Asia), overseeing global and Asia fixed income investment in Asia. Before joining John Hancock, she was the deputy head of fixed income with OUB asset management, where she managed Global and Asian fixed income portfolios. She was among the pioneers in managing global sovereign emerging market collateralized bond obligation funds in Singapore.

ANTONIO CAVAREROHEAD OF FIXED INCOME ITALY

GENERALI INVESTMENTS EUROPE

As head of fixed income Italy for Generali Investments, Antonio Cavarero coordinates a team of 10 portfolio managers with €190 billion of fixed income assets under management and domiciled in different European countries.

Prior to joining the Generali Group in May 2014, Antonio gained extensive experience in the fixed income industry working for several top-tier global investment banking companies such as Deutsche Bank, Citi and Société Générale for over two decades. He last worked as a senior inflation trader at Deutsche Bank in London.

Antonio holds a MBA from the University of Turin and a degree in economics from the University of Pavia.

BIOGRAPHIES

PIERANGELO FRANZONIHEAD OF ASSET ALLOCATION

SWISS REINSURANCE COMPANY

Pierangelo joined Swiss Re in June 2008 as head of investment strategy. He is currently head of asset allocation within Group Asset Management, overseeing the asset allocation function with a focus on strategic asset allocation, new markets and investment solutions. Additionally he is head of asset management/CIO and a member of the Management Team of Swiss Re Corporate Solutions, the direct corporate insurance business unit of Swiss Re.

He has previously been chief investment officer of MPS Asset Management Ireland, the quantitative investment management company of the world’s oldest and Italy’s third largest bank, Monte dei Paschi di Siena. He also served as head of risk management with Monte Paschi Asset Management of Milan and ALM modeller with Riunione Adriatica di Sicurtà (Allianz), where he began his career as a fixed income portfolio manager.

He has been involved for years in academic activity as an adjunct professor of finance for Insurance & Pension Funds at the University of Brescia, Italy. He holds a degree in economics (Italy) and an MSc in econometrics from Southampton University (UK).

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RAVI RASTOGIINSURANCE GROUP LEADER, EUROPE

MERCER INVESTMENTS

Ravi Rastogi, partner and insurance investment group leader, Europe, is responsible for spearheading the expansion of the Insurance Investment Group within Marsh McLennan. The group sits within Mercer’s Investments business and has been created to help the Insurance sector address the numerous investment and compliance challenges arising from the more restrictive regulatory environment and changing market expectations. The remit is to expand the business across the globe and together with a leading team of insurance investment professionals, to strengthen existing partnerships with other Marsh & McLennan Companies. The group is also tasked with developing a range of tailored services for the sector, including sophisticated risk management solutions and a delegated investment solution for captives.Ravi joins MMC from Towers Watson, where he was the EMEA leader of the Insurance Investment Advisory Group. Prior to this, he held senior pensions and insurance advisory positions for a number of leading firms. He has over 25 years of financial industry experience and is a qualified actuary.

LUCA ROSSIREPORTER

MODERN INVESTOR

Financial reporter for Modern Investor, where he covers the institutional investment industry with a special focus on alternative investments. Luca also reports for Citywire Global, writing about asset management companies, producing video interviews and chairing Citywire events around Europe. Prior to Citywire, Luca was a broadcast journalist at Arise News and TV producer at Bloomberg. In Italy, he covered politics for two years for a local broadcaster called Telenova. He holds an MA in financial Journalism from City University (London) and he’s fluent in English, Spanish and Italian.

CHRISTOPHER REDMONDGLOBAL HEAD OF CREDIT

TOWERS WATSON

Chris Redmond is global head of credit at Towers Watson, leading a 40+ international team conducting research of all credit managers and products, spanning traditional bond strategies, all aspects of sub-investment grade credit markets, illiquid credit and credit long/short strategies. Chris co-led Towers Watson’s build-out of direct hedge fund research into strategies outside of long-short equity in 2007, in particular focusing on discretionary global macro and credit long/short. Chris is a member of Towers Watson’s Global Investment Committee, the group of senior investment professionals responsible for Towers Watson’s capital markets views. Chris holds the CFA UK Level 3 Certificate in Investment Management and has a BA in mathematical sciences from St. Catherine’s College, University of Oxford.

DIPANJAN ROYSENIOR INVESTMENT STRATEGIST

PRUDENTIAL PORTFOLIO MANAGEMENT GROUP

Dipanjan Roy is a senior investment strategist with Prudential Portfolio Management Group where he manages the strategic asset allocation and contributes to the long-term economic views and assumptions for Prudential UK and Europe’s multi-asset funds. He has over a decade of trading and investment experience across different asset classes, managing investment mandates for large institutional investors in Europe and Asia.

He started his career in Hong Kong before moving to London in 2005. Before joining PPMG, he was in HSBC’s investment solutions group where his clients included insurance companies, pension funds, sovereign wealth funds and family offices. Dipanjan has a master’s degree in finance and a bachelor’s degree in computer science and engineering.

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LUCA ROSSI: This is a challenging time for fixed income investment, given the low yields and the very accommodative monetary policies. So my first question is, how are you adjusting your exposure to fixed income, given the current environment? PIERANGELO FRANZONI: It is indeed a challenging environment, both from a total return perspective and spread perspective. Having said that, asset liability management investors can better cope with yields volatility. Regardless of the business and the portfolios you are running, e.g. property and casualty or life and health, you have to stay disciplined in the approach. There are alternative sources of risk premia available in fixed income in general and the credit market in particular, such as liquidity. Alternative risk premia can be within the broader credit sector, within securitised products or within emerging market products. The key is to maintain discipline, not to look for higher yield at all costs. Having a good risk budgeting framework and approach to it is a fundamental component of a disciplined investment process. And, of course,

everyone is in the same situation so, it’s also a ‘relative terms’ game. As basic as it sounds, it’s important to diversify and get to some alternative sources of risk premia. That would be my simple recipe.

DIPANJAN ROY: The most important question, not only for institutional investors but also for central banks is: what is going to happen now with rates about to normalise? We are in an unprecedented situation where we have had massive monetary easing and central bank intervention for such a long time that there is the danger that people start thinking that this is the new normal. From a long-term investment perspective, it is necessary to retain the discipline to plan for the end of loose monetary policy. This is not the norm and eventually interest rates are going to rise. The key is to look at risk-adjusted returns from a strategic asset allocation point of view. The question is, are we being adequately rewarded for the additional risk we are taking? That is a test we need to apply very rigorously to each part of our portfolio. There are sources of returns, there are sources of yield. The

‘The key is to maintain discipline, not to look for higher yield at all costs’

PIERANGELO FRANZONISWISS REINSURANCE COMPANY

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CURRENT FIXED INCOME ENVIRONMENT

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crucial decision is selecting those investments that make sense from a risk perspective as well.

CHRIS REDMOND: I’m very pleased to hear people talking about discipline. The rapid expansion in the number, size and variety of daily liquidity, higher-risk credit products suggests that not everybody is exercising discipline, and that’s a worrisome trend. Quantitative easing has been effective in pushing people along the risk curve in terms of assuming greater credit and illiquidity credit risk. Unfortunately, it seems very likely that this will eventually end badly for those not discerning between good and bad and exercising sensible risk discipline. Of course, not every investment is a lost cause, there are some interesting investment opportunities available – you just need to be selective. In my opinion, the critical questions investors need to be asking are: ‘What will this investment look like in three years’ time when maybe interest rates have normalised and the credit cycle has turned? Will this, in hindsight, prove to have been a good investment decision?’ While interest rates will likely rise over the medium term, where and how quickly could they create significant opportunity? Transitioning from a period of globally co-ordinated easing to a world where we now have some degree of difference across the board represents a material change. Notably the Bank of Japan and the European Central Bank still remain highly accommodative, while the Bank of England and the US Federal Reserve are beginning to enter a phase of monetary contraction. That strikes me as a fantastic opportunity for people with sufficient dry powder. Indeed, it might be a fantastic period with opportunities for active management.

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SAMU ANTTILA: That’s what we believe. We actually see that the beta, for example, the market risk, is actually important, the asset allocation is important, but we think that there are benefits pursuing active management and that’s what we are doing in our portfolio. We have also kept quite a strict discipline, but we have approached this declining interest rate environment with a huge duration cap in our portfolio. It has taken quite a lot of time to convince the board that we shouldn’t change the situation to close up the direction cap. Because it’s open, we should keep it open. We have also been transferring a bit from sovereign debt to investment grade and the high-yield environment.

So we have been shifting our fixed income positions to also include some additional spread risks.

ANTONIO CAVARERO: The current market situation comes from financial repression, whereby yields are kept low for the reasons we all know. I belong to the camp of those who see rates eventually increasing, let’s say, in a polite way and mainly in the US, but we should get ready for the worst. So hoping for the best, but get ready for the worst, with short medium rates in the eurozone remaining significantly low for a very long period of time. Diversification is probably the only way, in this environment, to cope with

the challenges we’re facing. Diversification comes with a few annexes. The first one is capability or being selective and having discipline, as was mentioned before. We cannot go anywhere just because there is a better yield, but we have to look everywhere. My motto at Generali Investments is: ‘I leave no stones unturned.’ Anything where there is even just the idea of a potential rational solution, I will look into. I know it’s more time-consuming, I know it requires more effort, but I think that in this environment it’s the only way to go. Another word that comes with this diversification story is ‘regulation’. The regulations imposed on the insurance sector are not really fitting with the macro environment. For

reasons that are very legitimate, we are asked to be very cautious on our investments. Well, actually, given the macro situation, and also given some indications coming from central banks, we should have a bit more leeway to do a few of those things that would allow us to diversify and invest efficiently, while at the same time fitting well into central banks’ plans to revamp the real economy. Of course, always with the highest respect of the money given to us by our clients.

RAVI RASTOGI: I am seeing a few key themes in the market. The first one is to extend the universe of analysis, so looking at more types of credit, more types of geographies, more types of

‘Diversification is probably the only way, in this environment, to cope with the challenges we’re facing.’ANTONIO CAVARERO

GENERALI INVESTMENTS EUROPE

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subordination, trying to then examine what they are through a risk-adjusted and capital-adjusted return framework, which we sometimes refer to as a RACAR framework. So the movement out of sovereigns into something that might be high-yielding is because on a risk adjusted and capital-adjusted basis, it makes more sense. The asymmetric risk that exists in bonds and the fixed income universe can work both ways: it’s not just default, sometimes it can just be market movements as well. That has brought fixed income, in a way, to be viewed in the same way as other, more conventional, risk premium assets. In fact, some of the disciplines and some of the expertise that might have been more prevalent in equity markets are starting to come into play at the lower quality end of the credit curve markets as well. Institutions are also realising that good governance and good practice demands that they be able to explain why they don’t invest in something, as well as why they do. They have to be able to explain that to their colleagues, to their boards, to their shareholders and their policy holders; even doing nothing is making a decision. Some of the exogenous liquidity that we’ve had in the system has also had an interesting effect. Although the insurance industry can think of itself as reasonably homogenous, other institutional investors, who have slightly different time frames and different regulatory constraints, have also ended up fishing in the same ponds of opportunity. So you have a classic crowding-out mechanism.

LUCA ROSSI: Let’s hear the opinion of a fund manager. Adeline, what’s your general view on

the fixed income environment at the moment?

ADELINE NG: I think many years of monetary accommodation and a low interest rate environment have made a lot of investors very complacent. Also, in the current low interest rate environment, a lot of people are trying to get the highest yield that’s out there, in between dealing with the events that could be ‘risk-on, risk-off’ triggers: Greece, slowing growth, ECB and BoJ, quantitative easing, the People’s Bank of China cutting interest rates. How do all these factors affect a fund manager like me, who is based in Asia, managing Asian fixed income? With the correlations of global markets, it does affect my asset class. Firstly, on the risk-adjusted return, or in today’s language, risk-adjusted carry for the portfolio, the blind-side way of searching for the highest available yield out there, you fix a solution for now, but you create a medium-term problem, where the credit deterioration will come and haunt you in the medium term. So it’s not the smartest way to do it in terms of protecting client interests. Also, many high-yield issuers are taking advantage of the low interest rates to issue bonds, of which a lot of them are new issuers. They may want to take advantage of the low interest rate, but they may not be willing to give you enough good covenants to protect you as a bond holder. So the words that I’ve been hearing about discipline across this table, that does come right down to the discipline of rigorous credit selection and analysis, and ensuring you get compensated sufficiently for the credit as well as covenant protection, rather than just a blanket buy for high yield. Last but not least, while interest rates

are low, volatility is high, which is as a result of central bank monetary policy, such as quantitative easing. So active interest rate and duration management become even more important for us, as you manage through the fluctuations in the interest rate. For investors that have a long investment horizon, rising interest rates can be an opportunity to invest and lock in at a higher yield, but of course, you probably have to pace your investment to make it to your favour along the way, rather than to view it as a risk.

LUCA ROSSI: Let’s focus on Europe for a second. I will read you this statement: ‘Investing in Europe-denominated sovereign bonds means destroying wealth.’ It was a comment made to me recently by the chief executive of a public pension fund. Do you agree?

SAMU ANTTILA: Well, it depends. It depends on which company you are in, as they have different sets of constraints. For example, in our case, where the liabilities are euro-denominated, we still see some value replication wise and asset liability management wise. So yes, I disagree partly on this one because we have to invest also in the sovereign debt.

PIERANGELO FRANZONI: Well, it’s difficult to argue against that when you have negative interest rates, like in Germany, and even more in Switzerland. Not to mention the risk to pay if you want to keep cash in a bank deposit. But this is exactly the effect of ‘financial repression’ by central banks. This has pushed investors into riskier asset classes, the so-called ‘portfolio

substitution effect’, although the regulation is pushing you to keep it right. As an insurance company, you are an asset liability manager investor, so you discount your liabilities with yield curves. Now, it becomes extremely important in terms of competitiveness of the core business, what curves you use to discount your liabilities and what risk you want to take on the other side.

SAMU ANTTILA: Asset-only wise, I agree, but on the market-consistent balance sheet wise, there might be some potential and I have to add that I’m not so nationalist, so we don’t have any Finnish government bonds in our portfolio at the moment.

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LUCA ROSSI: Turning to Asia, with a growing number of investors now looking into Asian fixed income, there is a strong argument that investing in hard currency and investment grade Asian bonds can increase the yield of a portfolio, while also diversifying the risk exposure of it. What’s your view? DIPANJAN ROY: From a strategic asset allocation point of view, it definitely makes sense to look at Asian bonds, particularly for European investors because of the diversification benefits. We have been actively allocating to Asian fixed income for a while now and it’s been a major source of positive outperformance. When we look at the Asian fixed income market, there are a few salient points that come to mind. The first one is the sheer size: over the past 10 years or so, we have seen almost a six-fold increase in Asian fixed income. This is both on the hard currency and the local currency side. So it would account for almost 10% of the total bond market now. To put that into context, that is as big as Latin America, Eastern Europe, Middle East and Africa

combined. So just from an opportunity set point of view, this is too large for any global multi-asset allocator to ignore. The second striking fact is the deepening of the market. We have seen an increase in trading volumes, compression of the bid ask spreads and higher liquidity. From a risk perspective, we have seen a lot of structural reforms, including government initiatives, regional initiatives, higher currency reserves being held by governments in Asia, liberalisation of the investment regime. All of these changes contribute to a lowering of the systemic risk and, for those of us with sufficiently long memories, we see a low risk of recurrence of what happened in the late 1990s with the South East Asian crisis. I think those risks have been adequately addressed by a lot of governments in those regions. From a valuations perspective, we notice that the spreads in Asian bonds are often higher than the comparable spreads of US and European bonds with similar credit ratings. Now, there are lots of reasons for this, there is the political risk, there is the difficulty in navigating these markets, but I feel that part of it

CHAPTER 2

INVESTING IN ASIA FIXED INCOME

‘At the moment we are quite cautious while investing into emerging market debt or Asia in general’

SAMU ANTTILALOCAL TAPIOLA

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‘We need investment expertise and local knowledge to search for the right country, the right sector, the right issuer, and that is obviously a challenge.’DIPANJAN ROY

PRUDENTIAL PORTFOLIO MANAGEMENT GROUP

is also because of the unfamiliarity and maybe even the wariness of investors to look at those kinds of investments. It’s not all positive, one word of caution is that Asia’s a very diverse market. So ‘Asian bonds’ is a catch-all phrase, describing a wide variety of investment opportunities. We need investment expertise and local knowledge to search for the right country, the right sector, the right issuer, and that is obviously a challenge. However, I think overall, for the Asian bond asset class, the risk/return profile is definitely very attractive.

PIERANGELO FRANZONI: We started our discussion talking about diversification and, of course, for a global asset allocator, this is an important asset class, it’s a sizeable asset class, it’s deep in certain parts of it. It’s also true that we have witnessed some spread widening, in particular in the last few months, which

makes it more attractive from a valuation perspective. I am glad that you asked specifically about Asia credit because labels such as ‘emerging market credit’ do not reflect the complexity and diversity of regional markets. Asia credit provides interesting opportunities, but if you really go for the high quality, the same credit quality, you actually end up with similar spreads as US investment grade corporates. Again, I really believe that it is important in terms of portfolio diversification, and it has been a winning proposition to go into hard currency Asian debt. I am actually starting to be more interested now in the local credit markets as a way to enhance the asset liability management: if you have liabilities in local currency, I think there is an opportunity to increase your investment income and return.

SAMU ANTTILA: In our case, when our liabilities are purely

euro-denominated, we have to think about what to do with the currency issues, and if you think about the Solvency II regulations, that currency capital requirement is actually really high. So it’s 20% or 25%, if I remember correctly. Is it actually worthwhile taking that currency risk into your balance sheet? Then, if it’s not, you have to think about what happens when you’re hedging the risk and then you actually are switching the underlying interest rate curve to a euro-denominated curve. Then it comes to the question of diversification, so what we get is additional spreads. From that perspective, we don’t get that if we hedge the currency, so we don’t get as high additional return, but at least we get some kind of additional return and, on top of that, we get some diversification impact. So that’s what we are thinking about, but at the moment we are quite cautious while investing into emerging market debt or Asia in general.

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LUCA ROSSI: What’s the largest risk when investing in hard currency Asian fixed income?

CHRIS REDMOND: The underlying exposure to US and European interest rate risk is among the larger risks and is certainly subject to unattractive risk asymmetry. So, the US Treasury could be a slightly flippant answer to your question. However, digging into the constituents, I believe the risks are by definition very idiosyncratic. For example, an important consideration is the extent to which a government or corporation is permitting an asset liability mismatch, issuing in hard currency while receiving tax or corporate revenues in local currency. This sort of risk can be considerable and is an important consideration when assessing the market and managing portfolios. As such, I view the key risk as implementation, i.e. ensuring investors are gaining best-in-class access to an opportunity that is characterised by idiosyncratic risks and specialist insight is required. It is critical to understand whether or not that six-fold increase in the market size reflects greater accessibility to international investors, or whether it’s about leverage and consequently a deterioration in debt metrics. It’s clearly a bit of both, which suggests there are some good investments and some bad investments. There are many, many ways you can go about implementing Asian fixed income in terms of mandate, manager and investment style. You can do it within an emerging debt complex and try and find a manager capable of being a Latin America expert, a Central Europe expert, a frontier markets expert and an Asia expert. Maybe that’s achievable, however it certainly involves significant

skill and breadth. You could go and say: ‘I want to explicitly own the decision to have dedicated exposure to the Asian market and I’ll find a local expert.’ But even then, you need an expert in Korea, Malaysia, Thailand etc. The governance can quickly become too burdensome for the client or, indeed, for the manager to actually be able to collate all that bottom-up information in a coherent way. Finally, do you say: ‘Actually, the best mandate is one where I have a manager picking between developed markets and emerging markets?’ It’s more about the intersection between the developed world and the emerging world. This is essentially an extended classic global fixed mandate, but instead applying a top-down global macroeconomic approach across an increasingly integrated world. Coupled with a total return style that encourages the manager to be highly selective, this creates an intuitively appealing solution. In an ideal world, I want my best-in-class manager to look at Europe and specific Asian countries and to decide which countries to invest in.

LUCA ROSSI: Ravi, you told me previously that the demand for good ideas in Asia exceeds the supply of them. Can you expand on that?

RAVI RASTOGI: I think there are lots of buyers of Asian fixed income: there are domestic buyers of Asian fixed income, and issues in local currency can clearly satisfy that demand; and then there is also demand driven by the lack of yield in the developed world, which is producing a desire in developed market investors to extend their traditional universe. The fact that you have a

six-fold increase and the Asian market is still only about 10% of the global market, and if you consider the demography and the centre of gravity from a GDP point of view, it’s going to have to grow that much faster. Given investors want to anticipate and invest ahead of when things become fairly priced, I think these factors together mean the demand for Asian fixed income probably exceeds the supply.

ANTONIO CAVARERO: The word ‘diversification’ has been mentioned many times and this is one of the main occasions where this word can be applied. Being ironical, one of the unintended consequences of QE is that sometimes, instead of putting money into the European economy, we insurers are actually financing Asian opportunities. That makes sense, I mean, from a diversification perspective, it absolutely makes sense. I think Asia is and remains the main source of growth still for a while and therefore it is rational for people like us to be invested there. Clearly, it requires an extra level of due diligence because we are mainly a European house, it’s not our courtyard, therefore it requires a higher, let’s say, a more attentive, a more careful due diligence, but it’s definitely something that has to be done. Again, it’s part of the process, as I said before, we leave no stone unturned, we look everywhere for occasions where we can serve our liabilities, serve our customers, providing them with performance together with the appropriate level of risk.

LUCA ROSSI: Adeline, you are the expert here, so why should an institutional investor invest now in

Asian hard currency fixed income?

ADELINE NG: Perhaps I’ll just start with the risk aspect first because people would expect me to tell you how good Asian fixed income is. So I’d rather move the elephant in the room out of the equation. When people talk about risk for Asia fixed income, China is usually a topic. This is the biggest economy that is making the largest amount of reforms globally. China approached reforms on a voluntary basis. It approaches them from a position of strength, as it has $4 trillion FX reserve. It is very different from some countries in Europe, such as Greece, or the other PIGS countries (Portugal, Ireland and Spain), as they reform as a result of creditors and country lenders forcing them. Growth is slowing because China voluntarily reformed for the good of the economy in the future, but given this is a titanic balancing act between growth and reform, it is definitely walking on a fine line. If growth is too strong, like the 9% or 10% in the past, it has no motivation to reform because it’s a bed of roses. If growth were to crash down, hard landing at 5% or 6%, it has no time to reform because it will be busy firefighting. We think the new normal is 7% because that’s balancing the two equations. Instead of focusing too much on the risk aspect of it, we should ask ourselves: ‘Does China have the policy tools in its pocket to mitigate the risk that could come as a result of the reforms?’ On this front, I like to compare China to the Fed and the ECB. Even after a few cuts, their interest rates are still high domestically: if you adjust it for inflation, real interest rates are still 6% to 7%. So China has a lot of room to move on the monetary front. To me,

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the risk about China is whether the policymakers would be slow to use the policy tools when the time comes. That’s probably the risk I’d like to touch upon. At the point of rates normalisation, usually investors would want to shun fixed income. Instead, we are seeing interests ranging from central banks to insurance and to pension funds, calling on us, talking about Asian fixed income. Some are often surprised to hear in the last rate hike cycle in 2004-2006, where the Fed hiked interest rate more than 400 basis points, Asia fixed income delivered a positive absolute return as credit spread compressed by about 150 basis points. And in the current environment, we do not foresee an unexpected blow-up in terms of the interest. Also, fundamentally, Asia stands out from the growth angle as the bright spot in the emerging markets and clients are looking at investing in growth. If you look at a lot of the indices, they are constructed by market cap, meaning that if you issue more debt, you have a higher percentage in the bond indices. You might not realise that Asia contributes more than 50% of global emerging market GDP, but only represents about 20% in most of the global emerging market indices. So I think the central bank-type of investors, or even insurance companies and pension funds, say: ‘I want to be investing in growth. It’s not just about a pure search for highest yield, I want also to not trade out in terms of fundamental credit quality.’

‘In an ideal world, I want my best-in-class manager to look at Europe and specific Asian countries and to decide which countries to invest in.’

CHRISTOPHER REDMONDTOWERS WATSON

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LUCA ROSSI: Which are the countries that you favour at the moment in terms of Asian fixed income? DIPANJAN ROY: Our approach is to look at investment opportunities from a long-term fundamental perspective. So we look at the countries where we see favourable metrics, like level of indebtedness as a percentage of GDP, the growth rate, whether the drivers of this growth are exogenous or endogenous, what level of the debt is held domestically and what level is held externally, level of household debt, credit growth, forex reserves as a percentage of their debt servicing costs. These metrics are relatively long term. There is obviously the short-term valuations, which will change, but from a long-term perspective, when US interest rates rise, which are the countries that are most vulnerable to a withdrawal of foreign capital? To some extent, our task is made easier by the fact that we had a preview in 2013 in the taper tantrum. So we saw a lot of the fragility being exposed and it also helped the countries themselves because a lot of nations like India and Indonesia have enacted structural reforms to get their finances in order. I

think a lot of those countries are in a better position now than they were in 2013, but our long-term perspective is driven by where we see growth and where we see that growth being domestic demand-driven, rather than external export-driven. If we were to see a deterioration in the external economic environment, we want countries that are reasonably insulated from it. Obviously, there will be some impact, no-one will be completely immune, but we do not want exposure to a lot of countries that are, for example, dependent on exports to Europe because a prime reason for going into Asian fixed income is diversification away from Europe.

ANTONIO CAVARERO: In this particular moment, it’s also important to stay away from the wrong side of the commodity cycle; therefore, to try to be more involved in those countries that are benefitting from low prices of commodities and not the other way round. This leaves, for instance, India as a nice spot, and still China, even if after the recent movement you probably need to be a bit more cautious. Then there’s the FX. Being a different currency, when Solvency II is at full

‘Institutions are realising that good governance and good practice demands that they be able to explain why they don’t invest in something, as well as why they do.’

RAVI RASTOGIMERCER INVESTMENTS

CHAPTER 3

INVESTMENT OUTLOOK

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speed, FX will be something that will need to be managed properly from a capital perspective under Solvency II. Under this aspect, and given the expansive stance from the ECB, which I think will be there for a while, the concept of the euro as a funding currency should be more widely accepted. There is still some fine tuning there to be done and probably some education by the banking sector to make those companies aware they can also issue in euros. In the end, this would let them access a wider investor base with benefits for everybody.

CHRIS REDMOND: A question we think about is which instrument to select to maximise chances of profiting from future superior global macroeconomic fundamentals in Asia. The world I oversee at Towers Watson is a relatively small one versus some: it’s a credit world. But you could invest in equity, infrastructure, hard currency, or local currency. Our analysis and assessment of government policy has historically pushed us towards assuming exposure via the currency. The currency has been a key capital markets transmission for superior growth and you’ve got significant ‘bang for your buck’ there. Our conviction in this view weakened, given the revaluation that occurred. More recently we’ve had an exceptional period of strength in the US dollar, causing terms of trade in certain Asian countries to change quickly. This has required investors to be more dynamic, supporting the use of more active management. So the goal of wanting exposure to the Asia story is probably the correct one, however, perhaps it is too

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of the key macro challenges – and exploiting that while ultimately achieving the key goals and satisfying the needs of all key stakeholders. One thing that worries me and I think is a risk is that I’ve heard people mention diversification a lot. Diversification has been poorly rewarded over the last five years during a period defined by the exceptional and non-traditional monetary stimulus. The best strategy was to own a Treasury and the US equity market. Could that continue? Global stimulus remains very significant given the scale of the BoJ and ECB programmes. Under my central macro scenario, we will see diversification better rewarded, however, it might not be. A lot of people seem to be banking on diversification to act as a major risk tool and that creates risk in itself. Of particular concern is the extent to which various strategies deemed ‘diversifying’ are attracting significant interest from institutional and retail investors, potentially pushing up valuations and in extremis undermining the diversifying properties of the asset class/strategy.

PIERANGELO FRANZONI: The key words I heard today that are important to me are ‘discipline’, ‘diversification’, but also, the need for local expertise when you tap certain of these opportunities is important. In terms of the challenging decisions or risks, well, on the one hand, right now, the challenge is to stay positive, not only thinking about everything that can go wrong. We have lived during the last few years in a financial landscape where many things could have gone wrong and actually, surprisingly, not so much did. On the other hand, I would say policy normalisation is going to be the first challenge,

simplistic, or not sufficiently specified. It is important to spend appropriate time focusing on which instrument, which asset class, which style of management to choose. Even in the last five years there was significant benefit in starting with a strategy focused on Asian currency appreciation, only to become broader, plus more active and dynamic in investment approach and instrument selection.

RAVI RASTOGI: Maybe, to amplify that point a little bit, it comes back to the issue of governance. We’ve heard a few stories today about what may have been relatively siloed discussions within insurance companies between asset management, liability management etc, or different countries managing their assets differently within the same insurance group. Within that universe of fixed income, it’s great there are these different geographic, different credit rating demarcations for a better focus and better outcome. But every so often, you’ll come to an area where there’s another dimension. So, within Asia, there’s property, there’s fixed income, there’s equity. Is the decision-making team deciding across geography, but within the same asset class, or within the same geography, across asset class? Having that kind of two-dimensional matrix, and you can have more than two dimensions on that, is actually quite interesting from a macro point of view, because even if you don’t necessarily have the implementation expertise in-house, you should be able to have a view on a macro basis. Then, you have to overlay the implications from a capital point of view.

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LUCA ROSSI: Adeline, what are your expectations of Asian default rates, compared with European and US default rates for a similar credit rating?

ADELINE NG: You might not like the numbers I’m going to quote. I think between perception and reality there is a bit of a gap. Why do I say that? Last year – 2014 – the Asia default rate was about 1.4%. Over the last 10 to 15 years’ accumulated, Asia has actually had a zero default rate in the investment grade, compared with the levels of between 1.5% and almost 5% in the US and Europe, depending on whether you’re looking at the single A or the triple B component. So usually, I get asked: ‘Is the default rate really that good in your part of the world?’ My reply is: ‘OK, forget about investment grade because you have the transition, in fact, from investment grade to high yield before you go to default. Why don’t you look at the high yield default rate, and let’s not even compare with the developed markets, let’s compare with the more global emerging markets.’ You might note that last year, high yield default rates were less than 2%, about 1.5%. Latin America is about 4.9%. Eastern Europe about 3.2%, so the broad emerging markets are at about 3% default rate. If you look back historically, Asia high yield had a zero default rate in 2003, 2004, 2005, 2007 and 2011. That sounds a little bit hard to believe. And, in fact, this is not something Asia takes for granted. In fact, if you look back historically into the early 2000s, the default rate was close to double digits. Why? Asia was, at that point, going through the Asian sovereign crisis. So it hit the sovereigns first, starting with Thailand and moving

on. Some countries went under the International Monetary Fund programme and then the next layer that got this was actually the corporates. So the corporates were suffering from high defaults in the early 2000s, in 2001. They had currency mismatches between what they were earning in local revenue and what they were borrowing in US dollars, and as their currency depreciated, they were having a hard time servicing these debts. There was also a maturity mismatch in terms of borrowing in the short term to fund their long-term projects. All these mismatches cost them a very expensive lesson going through the restructuring back in the early 2000s. So today, as the dollar strengthens, the question that I often get asked is: ‘Is it going to hurt your Asian companies?’ So I look at some of the Asian companies that were borrowing in US dollars and matched that with the EBITDA (earnings before interest, taxes, depreciation and amortisation). The gap is actually no more than 5%. So they have actually learned the lesson in a hard way. So I say: ‘Yes, it’s a lower default rate now, but it did not come easy.’

LUCA ROSSI: So to conclude, what’s the most important point that has come out of this conversation today? And, secondly, what’s the most challenging and difficult decision you will have to take or you will advise your client to take in the next 12 months?

ANTONIO CAVARERO: Solvency II comes with a multi-dimensional problem, a multi-dimensional challenge, where you have to put together regulations, yields, liabilities, liquidity, diversification needs, discipline – all

the things that we have been discussing so far. It is a complex equation to be solved, but it’s a challenge that comes at the right time for the industry, and I’m sure it will be solved very well. Regarding the decision for the next few months, I think it will be to understand where the macro cycle, particularly in Europe, is going to go, given the threats coming from situations like Greece, which, in my opinion, is only suspended. In general, understanding the evolution of macro dynamics from here remains key.

SAMU ANTTILA: For the next 12 months the most difficult question is the macro outlook. Is it this prolonged low yield and interest rate environment or is this actually going to be changing? Do we think we’re moving a little bit towards the average behaviour of interest rate? When we are looking at our strategic allocations under those two assumptions, they are quite different. So this is actually a huge decision we have to take. Then it’s actually hard to change it along the line, or then you are making losses along the way. The lesson from today is that even though we have different constraints, multi-dimensional situations, we are still facing the same problems: how do we diversify our portfolio, how do we actually get some decent returns on our assets? I think the major lesson for us is sharing knowledge about the current situation.

CHRIS REDMOND: To me, it’s all about maintaining that investment discipline, while being sufficiently dynamic and active to exploit the opportunities I think will come out of some

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maybe not so much in the very short term. Additionally, the European crisis is not over at all, maybe it’s entering a new phase, and although I’m positive in the short term, in the longer term there could be a challenge. Lastly, we were talking about China, how China is going to manage the way forward to a more market-oriented economy and open financial markets is an incredible challenge. Now what does all that mean? It means, again, to keep a strong discipline, focus on how to achieve the fair risk-adjusted return, and not catching the last train or investment idea.

RAVI RASTOGI: The thing I’ve picked up is that there’s a sense that there is benign, but definite, ambiguity about the rate cycle and what its impact will be. I think there’s also a genuine understanding that there’s a lot of heterogeneity present – both in terms of Solvency II’s impact on each insurance company, and within the asset class markets. But when you combine ambiguity and heterogeneity, that does create opportunity, and I think the message I want to be sharing is to actually harvest that opportunity. The biggest thing is to bring more deliberateness into the decision-making and have much better governance. I think that is the single most important element to provide a framework for insurers to be able to capitalise on the opportunities of ambiguity and heterogeneity.

DIPANJAN ROY: The most important message I got was that there are no easy answers. If we are in a low-yield environment, there is no obvious answer to where we can get the yield to match our liabilities. It’s a question that Pierangelo

mentioned: the financial oppression, where we are being forced to move along the yield curve; and I think Samu had mentioned that it’s not a question of getting a very high yield, but of getting a good enough yield. That is the way we need to look at it and I would say that is something that, in a risk-adjusted framework, is going to be the basis of any long-term investment decision. In terms of challenges – there are so many – we’ve already discussed the US rates and China. We have reasonable comfort about the US economy and its growth in the sense that the US economy is in a relatively stable position. The big question for me is what is going to happen to Europe. Are we going to see a situation where the ECB manages to drive the European economy back into growth, or is the Fed tightening cycle going to somehow diminish the effectiveness of the monetary loosening policies of the ECB? I think that is, for me, the big macro question.

ADELINE NG: The search for yield in the current environment of policy normalisation makes things even more difficult and, also, in an environment where capital has to be put up as a result of Solvency II, this is the key takeaway that I have on the discussion. My biggest challenge and the biggest decision I have to make is really to partner with our clients to see how we can help them to go through these challenges together, preserving their capital, which is very important, and also, on top of that, delivering the expected return that is consistent with their risk appetite.

‘Over the last 10 to 15 years accumulated, Asia has actually had a zero default rate in the investment grade, compared with the levels of between 1.5% and almost 5% in the US and Europe’

ADELINE NG


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