Foundations and other institutional investors are looking for investment alternatives in the current low-interest-rate environment. Markus Hill* spoke on behalf of FONDSBOUTIQUEN.DE with portfolio manager Dr. Stefan Tilch, Deutsche Oppenheim Family Office AG, about the current conditions on the capital market and possible investment approaches.
Hill: Many institutional investors are very insecure. Bonds are often seen as “safe” investments. What led to the significant price losses across all bond segments in May and June?
Tilch: The first half of the year was relatively positive on the bond side until the end of May. Although there was always negative political news such as the Cyprus crisis or the turbulence surrounding the elections in Italy, the bonds were on the whole moving in calm waters.
This changed abruptly at the end of May. The chairman of the US Federal Reserve (Fed), Ben Bernanke, announced somewhat surprisingly on May 22nd a paradigm shift in monetary policy, namely that the Fed will gradually phase out the purchase of securities starting this year until mid-2014. What market participants failed to realize was that this announcement was linked to several economic conditions, the achievement of which is by no means certain.
Nevertheless, this had far-reaching consequences for the global bond markets. There was an unexpectedly strong sell-off across all bond classes. The yield on 10-year US Treasuries rose from 1.6% to 2.6% within a few weeks. The yield on 10-year German government bonds reached its annual high of 1.81% at the end of June.
Hill: “This situation led, for example, to price losses of 3.5% for 10-year German government bonds at the peak. Especially foundations that plan with annual distributions were badly surprised here.
Tilch: I think most market participants were caught on the wrong foot by the sharp rise in interest rates. By the end of June, the situation had eased somewhat, so that most bond portfolios probably ended the first half of the year with a “red zero”. Even the Fed was somewhat surprised by the market reaction and verbally rowed back in the following weeks. After all, an excessively rapid rise in interest rates cannot be in the interests of the US Federal Reserve, as otherwise there is a danger that the economy will be stalled again at an early stage, especially in the real estate sector.
Nevertheless, this event also had its good points, as bond investors had become somewhat too complacent in the first half of the year. Institutional investors, in particular, rushed into new issues, and most of these bonds achieved price gains, some of which were incomprehensible. Issuer or liquidity risks were largely ignored.
Hill: What are the developments in the bond markets?
Tilch: We expect the bond markets to recover slightly in the coming weeks. In our view, there is a whole range of reasons that speak in favor of declining yields. First, the US economy is struggling with some challenges. The automatic debt brake on national budgets has only had a full impact on the economy since the second quarter. There is still a hidden reserve of unemployed people who had resigned themselves to the labor market and are now looking for work again with improved economic prospects. This year, the global economy is developing more weakly than initially forecast. In China, in particular, growth remains well below expectations. In Europe, most indicators are pointing to a bottoming out, so that a slight economic revival may occur in the coming months.
However, above-average growth rates are still a long way off for Europe. This has prompted the European Central Bank to announce that it will leave interest rates in the eurozone at the current level for a longer period. These factors speak in favor of falling bond interest rates and price recovery in most segments. However, this does not change the fact that the US Federal Reserve has initiated the turnaround on interest rates and that rising interest rates can be expected in the next 6-12 months.
Hill: But won’t corporate bonds then be even riskier than government bonds? After all, corporate bonds have lost even more value in recent weeks…
Tilch: The announcement by the US Federal Reserve also led to significant price declines in the global markets for corporate bonds. Corporate bonds were hit twice: firstly, prices fell due to the general rise in interest rates, and secondly, the widening of credit risk premiums caused an additional loss in value. This development is worrying because in 1987, 1994, 1999, and 2005, sharply rising interest rates led to a reduction in credit risk premiums and thus to a relative outperformance of corporate bonds. In the past, the decisive factor was how quickly interest rates rose. In contrast, an abrupt rise in interest rates such as this year hits corporate bonds twice as hard, as illustrated. If, on the other hand, a moderate rise in interest rates is expected in the second half of the year, corporate bonds will become more attractive again.
Hill: In the current market environment, are exchange-traded funds for corporate bonds an alternative to individual securities for institutional investors?
Tilch: ETFs offer a broadly diversified bond portfolio with a low-cost structure. But there are also some disadvantages. Most ETFs are still so-called synthetic replicas of the benchmark index. From the investor’s point of view, this means that in addition to the credit and market risk of the ETF, he also takes on counterparty risk, as the index replication is usually done via swaps with third-party providers. Their creditworthiness remains hidden from the ETF buyer, who is also unable to assess the associated risks. ETFs with physical replication/sampling of the reference index are therefore preferable in our view.
Another risk factor is the so-called “Survivorship Bias”. It means that insolvent securities are removed from the benchmark index, thereby oversubscribing the return of the index. There is also another phenomenon that makes the ETF riskier than single stocks. A new study by the EDHEC-Risk Institute on the subject of “Corporate Bond Indices” shows that there is a conflict of interest between issuers and investors in the composition of the indices. Issuers will issue bonds with longer maturities when interest rates are low and vice versa. Therefore, the corresponding ETF will also show a significantly higher duration in a low-interest-rate environment and vice versa. This significantly increases the duration risk from the investor’s point of view, thus counteracting duration management. Furthermore, according to this study, there is a contrast between the market liquidity of an index and its duration stability. This means that a broadly diversified index for corporate bonds is usually illiquid and vice versa. An investor who uses ETFs to complement his bond portfolio should be aware of these risks.
Hill: How should foundations behave in the current low-interest-rate environment?
Tilch: The classic conflict of objectives between preserving the foundation’s assets and optimizing returns is a constant challenge for foundation investors. In the current market environment, the return target of “3% after costs plus real capital preservation” already exceeds the return potential of most bond segments. In addition to the use of bonds for investment purposes, other sources of return must be tapped. Equities are an important component of asset allocation, although their share is limited due to the risk tolerance of most foundations. In addition to equity investments, active asset management is essential to achieve an appropriate target return.
Hill: Shouldn’t foundations be better off using passive strategies in managing their assets?
Tilch: Passive strategies can be an alternative if the foundation management is relatively free in its investment decisions and has the necessary experience in implementing passive strategies. Many foundations are managed according to individual sustainability criteria. If the foundation’s assets are invested in an index, there is a risk that the index will also contain securities that do not meet sustainability criteria. Many foundations have additional restrictions concerning the issuer group, the minimum rating allowed, or the term. Experience shows that almost all indices contain individual securities that violate investment guidelines. In this case, the foundation board must consider whether the chosen investment strategy complies with the guidelines. So-called endowment funds, which are managed according to sustainability criteria, are an alternative.
Hill: What expertise do you have in managing foundations?
Tilch: We have been advising foundations in investment and strategy consulting since the early 1990s. Besides, we advise foundations and other non-profit investors in the areas of asset strategy, management, and controlling / reporting. We currently advise more than 20 foundations in the area of asset management. The total volume amounts to approximately 500 million euros. We offer foundations individual asset management from a volume of 5 to 10 million €. Besides, we also manage two mutual funds as standardized asset management, which are suitable for small to medium-sized foundations and are managed according to clearly defined sustainability criteria.
Hill: Thank you very much for the detailed information. Of course, there is healthy competition, also in the area of family offices. In the area of mutual funds, there are many interesting offers in the area of endowment funds or “asset management approaches”. In the meantime, a small fund advisor and fund selector industry is developing here. It is interesting to note that a solution for “smaller” endowment assets is also offered here. If you exchange ideas with one or the other family office, you will notice increased flexibility concerning target groups and investment volumes. Many small and medium-sized foundations may find new partners here in the future – at home and abroad.