Long-Only Strategies to Mitigate Higher Interest Rates

May 2014

by Laura Lake, CFA Senior Portfolio Manager

Insurance Client Strategies

The Federal Funds rate has been near zero since December 2008. For over five years, investors have been anticipating higher interest rates. And for five years, investors have been waiting. The prospect of rising rates provides solace for insurance companies seeking to re-invest at more attractive levels in order to stem the erosion of book yields. But there is a catch, as higher re-investment yields come at the cost of dwindling unrealized gains. At Standish, we are discussing long-only strategies with Insurance clients that seek to protect portfolio gains from the impact of rising interest rates. At the extreme, significantly shortening duration or moving to all cash can lock-in gains, but it comes at the high cost of significantly reduced income. While there is not a magic bullet to preserve both gains and income simultaneously, there are a few strategies that can help mitigate unrealized losses at the margin. Potential ideas include:

Isolating Credit Spreads

Reducing Interest Rate Beta

Altering Accounting Treatment

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ISOLATING CREDIT SPREADSFloating rate instruments (floaters) have cou-pons comprised of two components – an ad-justable component that moves with a short term interest rate index, typically based off of LI-BOR, and a fixed component based on the cred-it spread of the issuer at time of issuance (Ex-hibit 1). The adjustable component minimizes interest rate risk, or Treasury duration, in these instruments leaving the price sensitivity almost entirely a function of changes in the credit risk of the issuer. This is often referred to as ‘spread duration’. While floaters have little interest rate risk, it is important not to view them as a cash substitute; they have credit risk and liquidity risk in the event they are sold prior to maturity.

Investment Grade When adding a strategic allocation to floating rate notes (FRNs), we recommend that clients consider incorporat-ing FRNs via a separate account. This allows clients to maintain the appropriate duration profile of their core hold-ings. If the FRN component is integrated directly into the core portfolio, the increased short duration allocation would be offset by a greater allocation to longer bonds in order to maintain portfolio duration. This barbelled curve position does little to mitigate the erosion of unrealized gains in the overall portfolio. Within a separate account, the FRN exposure can be managed independently and serve as a diversifier to the core portfolio. (see “Making Cash Balances Work Harder” Standish: September, 2013 for portfolio ideas).

Bank LoansLoans are sub-investment grade corporate debt instruments with floating rate coupon structures, secured against the assets of the borrower. This means that Loans are expected to offer a higher recovery rate in the event of default than unsecured obligations, such as High Yield Bonds. Because of their position in the capital structure and their short duration due to the floating rate coupon, Loans may display lower market price volatility than High Yield Bonds.

For insurers that can incorporate an NAIC designation of 3 or 4 into their portfolios and sustain a higher capital charge, the spread pick-up remains appealing. While spreads appear attractive on a relative basis, technicals are beginning to look stretched. Loan mutual funds had experienced 90 plus consecutive weeks of inflows through early April 2014. With an unprecedented allocation from retail buyers in this market, the technicals have been positive.

REDUCING INTEREST RATE BETAInvesting in asset classes with lower rate sensitivity may help hedge against rising interest rates. Holding all else equal, a lower beta means that as nominal rates move higher, yields in these sectors typically rise at a slower rate. Implicitly, portfolio interest rate sensitivity is reduced without explicitly lowering duration. A beta of less than 1.0 suggests that the sector will be less volatile than nominal Treasuries, whereas a beta of greater than 1.0 indicates that the sector will be more volatile.

Historically, Tax-Exempt Municipals and TIPS have been positively correlated with, but less volatile than, nominal yields which signifies a beta of less than 1.0. However, the beta relationship between movements in nominal yields compared with Municipals and TIPS may not always be as stable as investors expect.

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The Allure of Floating Rate NotesThrough the use of derivatives, credit spreads can be isolated by buying cash bonds and selling futures to remove the Treasury duration. However, given the various regulatory, accounting and operational constraints that insurance companies face, we believe oating rate notes (FRNs) offer a similar exposure pro le, making them an attractive addition to a short maturity xed rate strategy.

The coupon rate on FRNs has two components – an adjustable component that moves with a short term interest rate index, usually three month LIBOR, and a xed component based on the credit spread of the issuer at time of issuance. The adjustable component minimizes interest rate risk, or Treasury duration in these bonds, leaving the price sensitivity almost entirely a function of changes in the credit risk of the issuer, which is often referred to as ‘spread duration’.

Exhibit 1: Floating Rate Note Example

Citigroup Inc.

Issue Date: 7/30/2013

Maturity Date: 7/30/2018

Coupon Rate: 1.31%

Coupon Formula: 3m Libor + 104bp

Moodys Rating: Baa2

S&P Rating: A-

Fitch Rating: A-

Coupon Rate

Adjustable: 3m LIBOR

Fixed: 104bp

In Exhibit 1 above investors in this Citigroup FRN were paid 104bp above three month LIBOR at issuance, largely for the credit risk associated with Citigroup. Because this 104bp spread is xed at time of purchase, the price of this bond will move in response to changes in the perceived creditworthiness of Citigroup. So while FRNs have little interest rate risk, it is important not to view them as a cash substitute; they have credit risk and liquidity risk. While market pricing implies a low probability of Citigroup defaulting, Exhibit 2 illustrates the market volatility that may be realized in the event liquidity is needed in advance of maturity.

Exhibit 2: Historical Returns, Floating Rate NotesBarclays Floating Rate Note Index: Rolling 12 Month Returns

Source: Barclays as of August 31, 2013

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A Sample PortfolioBuilding a well-diversi ed portfolio containing only FRNs can be challenging given the lower levels of supply relative to xed rate bonds and the concentration in nancial issuers. Issuance has increased in 2013 though, and there is suf cient oat to build a signi cant allocation within a broader short duration portfolio. Year to date through August oating rate corporate bond issuance totaled $84 billion, or about 15% of total corporate issuance, compared with 6% of total corporate bond issuance in 2012 (JP Morgan) ABS issuance totaled $120 billion year to date through August, of which one-third has been oating rate (Deutsche Bank).

Exhibit 3 shows characteristics for a sample short duration portfolio with a substantial oating rate allocation. This portfolio is a mix of high grade corporate bonds and AAA rated ABS. FRNs – in both the corporate and ABS sectors - comprise more than half of this portfolio.

“We believe upward pressure on rates will continue as the Federal Reserve moves closer

to normalizing monetary policy.”

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Tax-Exempt MunicipalsFor tax-sensitive investors, Tax-Exempt Municipal bonds may prove to be a hedge for rising interest rates. At Standish, our research has shown that in-termediate duration Municipal bonds have a beta of approximately 0.6 relative to the 10-year Trea-sury over a 3-month rolling period (Exhibit 2). We expect that the lower volatility characteristics of municipal bonds may help mitigate the negative price impact of rising interest rates, particularly ver-sus other liquid fixed income asset classes, such as Treasuries. (see “Municipal Bonds in a Rising Rate Environment” Standish: June, 2013 for a discussion Municipal Betas).

TIPSTreasury Inflation Protected Securities (TIPS) are Treasury securities indexed to inflation in order to protect investors from inflation risk and the erosion of return. Given the Federal Reserve’s unprecedent-ed balance sheet expansion and ultra-accommoda-tive monetary policy, we believe that the markets’ inflation expectations do not fully reflect the future reality. Over the last ten years, TIPS’ 3-month beta has averaged around 0.7 compared to nominal Trea-sury yields (Exhibit 3). We would expect TIPS to out-perform nominal Treasury bonds as a result of their lower beta. (see “Revisiting the Interest Rate Risk of TIPS” Standish: January, 2013 for a discussion of curve positioning).

ALTERING ACCOUNTING TREATMENTInsurance companies generally classify their fixed income assets as ‘available-for-sale’ (AFS) under the FASB Ac-counting Standards Codification Topic 320, Investments - Debt and Equity Securities (FASB ASC 320). The AFS designation provides more flexibility to sell bonds before maturity relative to the ‘held-to-maturity’ (HTM) des-ignation, and also facilitates more income stability than the ‘trading’ designation. This served companies well as interest rates fell over the past three decades. It enabled firms to harvest gains or hold positions at relatively higher book yields to lessen the loss of book income. With quantitative easing finally coming to an end and rate hikes on the horizon in 2015, companies should revisit the merits of using the HTM designation for a portion of their fixed income assets. Bonds categorized as HTM do not require mark-to-market adjustments because interim volatility is not expected to be realized as the bonds are held to maturity.

While there are circumstances in which bonds may be sold, auditors closely scrutinize sales and excessive activity may risk the ability to continue using the designation. Given most insurance companies’ desire for income stabil-ity, turnover is generally modest in high grade bond allocations. Therefore designating some portion as HTM may have little impact on the overall investment strategy. The challenge is identifying the bonds for which HTM is most appropriate. (see “Using ‘Held-to-Maturity’ in a Rising Rate Environment” Standish: April, 2014 for a discussion of what securities are most appropriate for an HTM structure).

Given the likelihood of higher interest rates in the near future, we believe these long-only strategies may help Insurance clients stem unrealized losses. While the balance between preserving gains and income simultaneously is challenging, these strategies represent a handful of options that can help protect portfolio gains at the margin.

xxxxExhibit 2: Muni-Treasury Yields Beta - 10 Year Maturity

Source: Barclays as of 3/31/14

6M Rolling Beta3M Rolling Beta################################################################################################################ 0.828 0.826######## 0.828 0.835######## 0.828 0.841######## 0.828 0.847######## 0.828 0.850######## 0.828 0.851######## 0.829 0.852######## 0.829 0.850######## 0.831 0.844######## 0.831 0.841######## 0.832 0.840######## 0.833 0.842######## 0.834 0.844######## 0.835 0.853######## 0.835 0.857######## 0.835 0.863######## 0.833 0.872######## 0.832 0.880######## 0.832 0.883######## 0.832 0.892######## 0.832 0.903######## 0.830 0.911######## 0.829 0.912######## 0.828 0.910######## 0.825 0.909######## 0.822 0.908

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3M Rolling Beta 6M Rolling Beta

Source: Barclays as of March 31, 2014

Source: Barclays as of March 31, 2014

Exhibit 3: TIPS-Treasury Yields Beta - 10 Year Maturity

Source: Barclays as of 3/31/14 -0.280.21 4.00

3M Days apart######## 0.858 2367 -0.02 1.00######## 0.874 1445 0.00 1.00######## 0.875 1196 0.00 1.00######## 0.875 964 0.00 3.00######## 0.873 1507 0.00 1.00######## 0.874 241 0.01 1.00######## 0.861 867 0.00 1.00######## 0.858 2130 -0.01 1.00######## 0.867 1783 0.00 3.00######## 0.871 98 0.02 1.00######## 0.849 2061 -0.01 1.00######## 0.856 217 0.01 1.00######## 0.841 1200 0.00 1.00######## 0.841 1372 0.00 3.00######## 0.841 1083 0.00 1.00######## 0.840 2096 -0.01 1.00######## 0.848 1117 0.00 1.00######## 0.847 1098 0.00 1.00######## 0.846 1750 0.00 3.00######## 0.850 835 0.00 1.00######## 0.847 674 0.00 1.00######## 0.842 41 0.03 1.00######## 0.809 693 0.00 1.00######## 0.804 1006 0.00 3.00######## 0.803 1988 -0.01 1.00######## 0.809 2449 -0.02 1.00######## 0.832 2358 -0.02 1.00######## 0.849 1821 0.00 1.00######## 0.853 1024 0.00 3.00######## 0.851 1687 0.00 1.00######## 0.854 2208 -0.01 1.00######## 0.865 594 0.01 1.00######## 0.859 542 0.01 1.00######## 0.853 1596 0.00 3.00######## 0.855 1913 -0.01 1.00######## 0.860 852 0.00 1.00######## 0.857 2494 -0.03 1.00######## 0.887 848 0.00 1.00######## 0.884 2007 -0.01 3.00

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- 3M Rolling Beta

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The comments provided herein are the views of the author, are a general market overview, do not constitute investment advice, are not predictive of any future market performance,, and do not represent an offer to sell or a solicitation of an offer to buy any security. Similarly, this information is not intended to provide specific advice, recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish). These views are current as of the date of this communication and are subject to rapid change as economic and market conditions dictate. Though these views may be informed by information from publicly available sources that we believe to be accurate, we can make no representation as to the accuracy of such sources nor the completeness of such information. Please contact Standish for current information about our views of the economy and the markets. Portfolio composition is subject to change, and past performance is no indication of future performance.

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