The Journal Vol 4. Chapter 1
The Journal Vol 4. Chapter 1
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Navigating negative rates for resilient returns

The world of negative interest rates is here to stay. But can investors that are focused on preserving and growing the value of their capital meet their mandate in this new world? Russell Silberston, Head of Multi-Asset Absolute Return for Investec Asset Management, suggests some solutions to make portfolios more resilient in the face of negative rates.


Navigating negative rates for resilient returns

Russell Silberston, Head of Multi-Asset Absolute Return, Investec Asset Management

For those investors that follow traditional government bond indices, the outlook – particularly relative to their liabilities – is bleak. According to Bloomberg, on 30 March 2016, 57% of Bank of America Merrill Lynch’s World Sovereign Bond Index yielded less than 1%, 38.5% less than 0.5% and 24.6% had negative yields. In other words, investors who passively invest in line with this market-capitalised index are guaranteed to lose money on at least a quarter of their investment, even if yields remain unchanged for several quarters.

As central banks have ventured into ever-lower interest rates, forcing bond prices up, high-quality government bonds have actually been a fantastic investment in local currency terms. They have acted defensively, offsetting losses from the series of rolling financial-market crises resulting from the fallout of the global financial crisis. Looking forwards, however, current yields (or lack thereof) suggest investors need to think about alternative approaches to their traditional defensive asset class. Here we suggest a number of approaches that may help investors navigate this extraordinary situation.

Here we suggest a number of approaches that may help investors navigate this extraordinary situation and will hopefully provide attractive returns over the coming years, no matter what the market environment.

The problem

The vast majority of investors still follow some form of market-capitalised government bond benchmark. They do so because it makes performance measurement easy, it helps to define an investment style and construct a portfolio objectively. However, it is our belief that these advantages are outweighed by the disadvantages. First, the more a state borrows, the greater its representation in the index. This could prove misleading as a country with a conservative fiscal policy may have attractive yields, but little or no representation in the index. Second, the index will have its longest duration at the bottom of the interest-rate cycle, threatening future returns as yields rise. Third, a market-cap index rewards those markets with the most expensive currencies; and finally, these indices fail to recognise how the world is changing by ignoring fast-growing countries that have little outstanding debt.

Given 47.6% of the Bank of America Merrill Lynch World Sovereign Bond Index is comprised of countries that have imposed negative interest rates, investors really need to consider alternatives if they are to construct a portfolio that generates positive returns that keep pace with the cost of their liabilities.

As soon as nominal interest rates hit zero in many economies, investors searched for yield in lower-quality assets, such as corporate bonds or emerging-market debt. Unfortunately their returns were undermined dramatically when the US dollar rallied sharply, commodity prices fell and the value of emerging-market currencies collapsed. Investors with liabilities in stronger currencies were hit particularly hard. Once more, therefore, the search for yield proved that there are no easy options in investment.

A more resilient approach?

Negative rates are here to stay for the foreseeable future. For an investor from a country that has taken this route and can only hold domestic-currency-denominated assets, the only way to boost returns is radically shifting its asset allocation from bonds into equities, for example.

Investors that can allocate to other currencies, however, can generate attractive returns in the bond markets. For example, they can take advantage of the fact that shorter-dated government bonds have greater variability of returns than those with longer maturities. They can also exploit new opportunities by widening the investment universe out of the majors or boost returns by hedging currency exposure.

One rate to rule them all?: exploring shorter-dated bonds

Financial globalisation and the corresponding freer movement of capital have led to yields correlating across global markets. A principal component analysis determines that one factor has dominated much of the movement in global ten-year bond yields and its influence has increased in recent years. We believe this is a “world interest rate”, which drives all other government bond returns. This rate can be thought of as a simple average of US, German and Japanese yields. On a currency-hedged basis, therefore, it makes little difference if an investor buys Korean or Polish government bonds, the returns will be dominated by the world interest rate.

For shorter-dated bonds, however, returns are more dispersed, as domestic monetary policy imposes a greater influence than is possible at longer maturities. Greater dispersion of returns should mean more opportunities for active investors to add value.

SAFE investing: expanding the investment universe

International investors can also generate higher returns on their bond portfolios in times of negative interest rates by considering widening their investment horizon outside of major markets. We believe that this does not necessarily mean that investors have to take on more risk, but simply that they need to think differently about the risks that they are exposed to.

We take a cautious approach to credit because we want our government bonds to behave defensively and perform well against declining expectations of economic growth. So we focus on markets that have a foreign-currency long-term credit rating of A- (or equivalent) and higher. Conversely, we have observed that securities with ratings below this threshold act more like growth assets and, therefore, their performance is positively correlated to market sentiment.

It is also important to have reasonable liquidity, so we avoid countries that have in excess of $50 billion debt outstanding.

Additionally, there are other considerations to ensure that bonds do generate genuinely resilient returns:

  • Stability: we look for stable, low- volatility markets, as measured by the normalised three month yield variation;
  • Access: we look for a large, liquid market, as measured by total outstanding debt;
  • Feasibility: we look for a high concentration of issuance with less than five-year maturity;
  • Efficiency: we look for efficient markets with low dealing costs, as measured by bid-offer spreads and estimated daily volume.

Each of these variables is ranked into quartiles and a simple average is calculated, where the fourth quartile is a deep, liquid, accessible market.

“Generating higher returns from bonds does not necessarily mean taking on more risk, but they need to think differently about the risks to which they are exposed.”

The market is not great at forecasting interest rates

If we accept that there is more variability of returns in shorter-dated bonds, then a resilient portfolio – which provides returns that are consistent regardless of the market environment – could take a passive approach to longer-dated duration by simply holding liquid US treasuries, German bunds and Japanese government bonds. To deliver absolute positive returns a resilient portfolio’s manager can take advantage of market inefficiencies and seek out active returns in the one-to-five-year sector. Having identified a possible universe, an investor then needs to outwit the market at forecasting interest rates. Fortunately, the market (and indeed policymakers) are particularly bad at this and there are always opportunities to add value across a wide universe of countries.

“The yield achieved by hedging the currency risk can become a significant component of total return.”

Lead into gold?: Hedging for resilience

While there is no escaping negative yields for domestic bond investors that cannot invest in overseas assets, for international investors, hedged returns in those countries can be attractive. The yield achieved by hedging the currency risk can become a significant component of total return. Since January 2014, 1-3 year Swiss government bonds denominated in francs have returned 0.74% in local terms, but 2.77% in US-dollar terms. Yields were already negative at the start of this period and were -71 basis points at end-2015. By contrast, 1-3 year US Treasuries have returned 1.89% over the same period in US-dollar terms. Why has this happened?

By buying foreign government bonds, an investor implicitly takes a long position in the foreign currency in which they are denominated. However, it is possible for investors to hedge this exposure through forward foreign-exchange contracts. This is a widely used mechanism in which two parties agree to exchange a set amount of one currency for another at an agreed exchange rate in the future. However, to avoid risk-free returns, a relationship known as covered interest rate parity must hold. If the foreign market’s interest rate is higher than that of the domestic market, the forward price of the foreign market’s currency will be lower than its spot to reflect the higher interest rate earned, thereby removing the possible riskless return. Consequently, yields on foreign bonds become closer to an investor’s domestic market return.

By hedging the currency risk in this way, hedging yield becomes a significant component of total return that must be considered when international investors determine expected total return and assess performance. For example, in the topsy-turvy world of negative interest rates, despite US interest rates being close to zero until recently, hedging costs relative to Swiss francs are positive, and therefore earn a US-based investor a significant pick up over domestic interest rates.


If an investor had forecast large-scale quantitative easing and negative interest rates a decade ago, they would have been met with incredulity. Now, however, the truly unconventional has become mainstream. Unfortunately, return expectations have not yet taken this reality on board and most models still embed a reversion to the historical mean. Although the US has begun the slow task of normalising monetary policy, most other major policy makers have a loosening bias and it is now hard to envisage monetary policy reverting back to where it was before 2008. How are bond investors to build resilient portfolios in such a challenging world? Here we have set out our thoughts on a possible solution that can provide an unconstrained investor the opportunity to at least beat negative returns. It isn’t easy, but by considering smaller countries, taking active interest rate risk and thinking about hedged returns, it is at least possible to still earn positive absolute returns from high quality government bonds.

Resilience in an age of uncertainty

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