Risk and Portfolio Construction: Keep calm and carry on
After years of ultra-low interest rates, bond markets in many developed economies are currently predicting that rates will rise fairly rapidly from their current ultra-low levels to a level closer to the historic average.
However, pensions schemes in particular should be aware that rates may well rise less rapidly than spot and forward interest rate curves currently predict. That potential difference between predicted and actual interest rate rises, creates both an opportunity to exploit the carry and roll-down for return, even during a rising-rate environment, and also to re-assess current liability-hedging positions.
In order to understand how the carry and roll-down trade works, a pension fund should compare the returns they would make from investing in a bond with what they would get keeping its money in cash. Let’s compare a five-year bond yielding 1.7% with a cash fund currently yielding 0.5%.
“If the investor chooses to keep their money in the cash deposit rather than a five-year bond, they are hoping that interest rates will rise rapidly enough to catch up with the bond so over the course of five years they will have also earned at least an average annual rate of 1.7%,” explains Phil Page, head of LDI at Cardano.
Five years of an annual rate of 1.7% will deliver you 8.8%. Five years at 0.5% will deliver just 2.5%: short rates would evidently have a lot of catching-up to do over the course of five years in order to justify the 1.7% yield on the five-year bond. Indeed, if we look at UK forward-starting one-year rates in swap markets today, we see that the rate starting in one year’s time is 1.2%, in two years’ time it is 1.9%, in three years’ time 2.4%, and the final year’s rate in four years’ time is currently priced at 2.6% (for a total of 8.8% over five years).
But what if we scroll forward a year and interest rates have not risen? The cash investor will once again earn only 0.5% in the second year – not the 1.2% implied by the forward-starting one-year rates 12 months earlier. With the one-year rate stuck at 0.5% for at least another year, it now has to rise even faster over the next four years to match the 1.7% yield you would have locked-in had you bought the five-year bond 12 months earlier.
“By holding the bond, the price paid guarantees the investor will make the annual 1.7% yield while the cash investor has no such guarantee,” as Page puts it.
This is how the carry and roll-down trade works: bond investors are better off than cash investors in an environment when interest rates rise less rapidly than the yield curve currently predicts.
This raises the obvious question: for an investor to put money into a carry and roll-down trade, they must think the curve is overstating the rate at which interest rates will increase. Clearly one can make a judgement about this and take a bet; but is there any evidence that interest rate markets have a systematic forward-rate bias?
There are a number of reasons why interest rates might not rise as rapidly as the curve currently predicts.
“Central banks tend not to increase interest rates in the smooth manner predicted by the interest rate curve,” says Page. “Real life is much less predictable.”
Looking at how central banks have raised interest rates in the past gives an indication of how severe the current level of forward-rate bias might be.
For example, the most rapid rise in interest rates in the US was from 2003 to 2006 when it increased from 1.3% to 5.6%. However, over the last 20 years, the most aggressive rate rise over any 12-month period was 2.25 percentage points.
In the UK between 2003 and 2006 the base rate rose by only 2.25 percentage points rather than the 4.3 percentage points increase seen in the US. The most rapidly it rose in any 12-month period in the last 20 years was by 1.25 percentage points, says Page.
The current UK interest rate curve predicts interest rates rising at very close to this maximum historic rate increase of 1.25 percentage points.
“I think that indicates there is currently a forward rate bias in the market,” says Page.
“Forward-rate bias is a behavioural finance phenomenon,” explains Paul Cavalier, head of Mercer’s fixed income boutique. “It’s the same reason why implied volatility tends to be priced at a more expensive level than realised volatility.”
Essentially, investors tend to overcompensate for the fact that the future is, by definition, uncertain.
“Even though the Bank of England has said it will raise rates gradually, investors want to be compensated for the unpredictable behaviour of the Bank of England with additional risk premia,” says Mike Amey, managing director and head of sterling portfolios at PIMCO. That results in the forward curve predicting rates rising more rapidly than the central bank indicates.
While it’s clear the carry and roll-down trade can be helpful for short-term traders and fixed income managers, it’s less apparent what impact it can have on pension funds, which tend to have much longer-term liabilities. But the carry and roll effect is not just confined to the very short end of the curve: it can be applied wherever the curve looks to be too steep.
Different parts of the interest rate curve are driven by different factors. “The shorter end of the curve tends to be driven by monetary policy while the middle part of the curve is driven by the medium-term outlook for the economy,” says John Towner, a director at Redington.
The longer end of the curve, however, tends to be shaped by supply-and-demand dynamics, particularly in the UK and the Netherlands where the regulatory environment encourages pension funds to buy long-dated bonds.
A fixed income investor looking to maximise the carry and roll down yield will want to be positioned on the steepest parts of the curve.
“At the moment, the steepest part of the UK yield curve is between five and seven years, while it’s pretty flat between 10 and 30 years,” says Nick Gartside, international CIO for fixed income at JP Morgan Asset Management.
Active fixed income investors can add value by adopting a dynamic yield curve strategy to maximise roll down and carry, adds Gartside.
Carry and roll down is important for pension schemes not only because it can allow an active fixed income manager to enhance returns but also because it can have impact on their liability-risk management.
A UK pension scheme’s liabilities, for example, can be thought as being equivalent to holding a short position in an inflation-linked bond.
“That effective short bond position means that if interest rates remain lower for longer or do not rise as fast as the forward curve predicts, the size of liabilities can still grow as result of carry and roll down in the same way that a long position in a bond would benefit from these same dynamics,” Towner observes.
If a pension scheme thinks there is a forward-rate bias in the market – and that interest rates are therefore less likely to increase as rapidly as the market predicts – there is an implicit cost to waiting to hedge liability risk.
“Of course, everything depends on the time frame you use, but in today’s market, pension schemes will only benefit from an unhedged position in interest rates if spot rates rise more rapidly than the forward curve currently predicts,” Towner says. “An unhedged position will suffer if rates stay static, move lower, or move higher more slowly than predicted.”