(March 3, 2014) — As investors become increasingly concerned about future interest rate rises, aiCIO considers asset allocation solutions that don’t require derivatives.

Some investors are turning to real assets and other alternatives to hedge against interest rate rises. But for many, the proportion of assets they can assign to alternatives is relatively small, leading them to seek other ways of negating the impact of a rate rise.

Traditionally, particularly in Europe, the use of derivatives has been a popular way of solving the problem. But derivatives don’t work for everyone—many have raised concerns about the cost implication under regulatory initiatives such as the Financial Transaction Tax, for example.

Fund managers have recognised these concerns, and have responded with a surge of products designed to mitigate interest rate rises, without having to resort to derivatives.

CLOs

Collateralised Loan Obligations (CLOs) might have picked up a bad reputation during the financial crisis, but the new generation of packaged loans has been forced to become more transparent than their predecessors by financial regulators.

CLO issuance has soared on both sides of the Atlantic. The US CLO market posted $81.81 billion in issuance during 2013, up dramatically from the $54 billion issued in 2012. This issuance was the highest since the pre-Lehman heyday of 2006 and 2007, according to S&P Capital IQ/LCD. By comparison, Europe saw €7.5 billion of CLOs being issued, according to Fitch Ratings.

Figures for 2014 are expected to tail off slightly in the US because of the Volker Rule’s retention stake item—which requires managers to retain a stake in the CLO whether held in the form of CLO tranches or of equity interest in the underlying CLO portfolio.

Europe will also see a slowdown: Fitch estimates €3 billion to €4 billion will be issued in the continent this year.

Part of the reason CLOs have become popular is because they are floating rate notes that will increase in line with interest rates.

A typical CLO will take say, 200 floating rate notes, and then tranche out the priority of payments. An AAA-rated CLO will be the most senior level package, protecting the investor the best if any of the companies were to default, but the return rate would be lower than a lower rated package.

At the lowest priority end, a C-rated bond could return as much as Libor + 700, if you’re prepared to take the risk.

The good news is sophisticated houses are able to produce arbitrage from even the highest rated CLOs, thanks to the complexity risk involved in putting the CLOs together.

“In the last 12 months we started to see some investors—pension funds, insurers—say ‘Actually I need to buy highly rated assets, but I don’t want to be buying highly rates assets which are fixed rate or have spreads at all-time tightness’,” says Neil Godfrey, managing director at Babson Capital.

“If I’m buying a CLO AAA bond today, I’m [getting] around Libor + 140 to 150. There aren’t many AAA assets that can produce that. It shows there’s inherent value, and that value comes from complexity risk.”

Babson Capital raised somewhere around $600 million for separate accounts that are allocating to senior tranches for institutional investors in the UK last year.

The segregated account approach allows investors to tailor the CLO to something they feel comfortable with. “There’s a few who will, say, they only want 5% of the portfolio in single A’s, or they want the ability to buy European and US CLOs, or they want to have at least 60% in the AAA and the rest they’ll let the manager have latitude between A and AA. There’s no hard and fast consistency at the moment,” Godfrey explains.

“Every investor has a slightly different tolerance. We’re thinking very much about creating a fund, which would be our best mix of those AAA, AA, and A bonds, which we hope would show a Libor+ 180 to 220 type return range.”

CLOs are not without risks, and it is important for investors to be confident their manager has packaged together a transparent CLO which only contains the assets they want in it.

There are potential macro problems with the packages too. “Were we to find ourselves in a 2011 scenario, you might find some of that liquidity and pricing ability isn’t there,” says Godfrey. And, as previously noted, issuance is expected to fall this year. 

Convertible Bonds

As with CLOs, convertible bonds are experiencing something of a resurgence. Data from Dealogic shows issuance in 2013 reached heights not seen since 2009/2010. In the US, annual global issuance topped $47 billion last year, while in Europe deal value reached $32 billion.

These bonds, which are effectively a bond that converts into an equity once a strike price has been hit, provide investors with significant appreciation potential, recurring income through coupons, and safety of principal as well as the potential equity uplift—as long as the issuer remains solvent.

Marc Basselier, senior fund manager at AXA Investment Managers, says he expects more activity in the convertible bond market this year, with increased investment opportunities given growth expectations in the US and attractive valuations in Europe.

“When trying to hedge against interest rates rises, convertible bonds are a good solution because they are an equity-linked product. It’s more like an equity with a put than anything else,” he says.

“I’m not afraid of rising interest rates because 70% of the performance of convertible bonds comes from the equity part. Of course there will be some problems on the bond side, but it’s a very small downside.”

Certain sectors are likely to be at the forefront of new issuance, namely tech and healthcare, according to Basselier.

“These products are used by issuers as a way to finance growth at a very low cost,” he continues. “They’re not concerned about the holders converting from a bond holding to an equity holding because they are still growing.”

Recent examples include internet giant Yahoo, which issued $1 billion of convertible debt. The earnings per share are expected to grow by about 15% in 2014 according to Bloomberg consensus. Together with potential M&A activity, opportunities for revenue upside from video ads and Tumblr, as well as robust traffic trends, Yahoo’s convertible debt issuance has caught many an investor’s eye.

The biggest problem facing this sector is capacity—And for institutional investors, many will want to concentrate on high quality convertible bonds, making the potential market even smaller.

Some of Basselier’s clients are asking a lot of questions about the value of convertible bonds currently, and whether they could be seen to be too expensive today. Basselier rejects the notion: “I think the market in general is expensive, so convertible bonds might be seen as expensive, but not relative to other asset classes, such as equities. Fixed income assets are also really expensive at the moment: I don’t find convertible bonds that expensive, given the protection for the downside.”

Institutional investors keen to get on board with convertible bonds should look at global products only, rather than just European ones, as they were “the most interesting and a European-only products would have too small a market,” Basselier advises.

He has a further warning for investors: “I would be very careful about the ways some managers invest in very high yield convertible bonds. This is used by distressed companies to try to stay alive.”

Fixed Rate Notes Swaps for Floating Rate Notes

A problem for many investors is what happens to their fixed-rate paper when interest rates begin to rise. In addition, many pension funds are keen to continue derisking, but some of the bonds that produce decent returns are too long in terms of duration, prompting concerns about liquidity.

One option presented to the market by Investec Bank is the Impala bond, a way of swapping your existing fixed rate notes for floating rate ones issued by the bank.

As with convertible bonds, the major issue with this option is capacity constraint. Investec, as the issuer, has capped its Impala bond to $2 billion, with $500 million already issued so far.

Harris Gorre, head of financial products at Investec Bank, talks aiCIO through a recent insurer client’s deal, which has pledged to make a 25% allocation to its floating rate note products, of around £30 million.

“This is a client that’s come to us with a typical diversified portfolio of fixed rate debt, mainly investment grade, and they’re worried about their mark-to-market in the year ahead, their quarterly earnings reports and how those will reflect,” Gorre says.

“They’re looking at their existing credit and saying ‘If any of those issuers had longer dated bonds, we would not have traditionally bought them because of duration’, but now they can buy them via the Impala wrapper and put together what a manager would call a segregated mandate, or a single investor portfolio.

“Their basic strategy is they’re running a duration of around four years and they’re looking to get the duration to closer to three. So by putting 25% of their portfolio into zero duration diversified notes, it lowers their duration by a full 100 points.”

Duration’s not the lower figure here—the Impala wrapper comes at relatively cheap price. The net cost to the client comes in at around 10-12 basis points, clearly a big driver in a low yield environment, and far cheaper than an absolute return fund—a tool many pension funds are choosing at the moment.

Mid-sized pension funds are also looking at the Impala bond as a way to remain liquidly invested in the run up to a pension risk transfer, Gorre adds.

“Most trustees of these schemes are looking at three to five years before exiting, and the ability to sell to a buyout manager is really important. So they can’t load their scheme full of illiquid assets because when they come to sell, the market for buyers is more limited.

“For clients with a yield target, we’re offering them a mechanism to hit that yield target from day one, with perfect clarity. Today the portfolio is yielding 4% and in terms of what the market thinks is it can only go up, as the only way it can go down is if interest rates go down.”

These interest rate rise-friendly options won’t be for every investor, but in a low-yielding environment they might provide an attractive option for investors willing to invest the time and governance needed.

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