FIXED INCOME DISLOCATIONS:Risks and implications for investors

IN THIS PAPER WE DISCUSS... − Negative swap spreads: this time it’s different

− From ZIRP to NIRP: Interest rate policy turns negative

ANDREW SCOTTSenior Portfolio Manager

GLOBAL FIXED INCOME FORUM

Until recently, negative swap spreads and negative interest rates were theoretical constructs that were not expected to persist in market pricing. Yet, we have witnessed negative United States (US) 10 year swap spreads to bonds and an increasing number of central banks turning to negative interest rates in an effort to stimulate economic conditions. AMP Capital’s Global Fixed Income team recently presented research on the factors driving negative swap spreads, the impact of negative interest rates on nominal bond yields and implications for investors. This paper summaries the key findings.

MAY 2016

NEGATIVE SWAP SPREADS: THIS TIME IT’S DIFFERENTWHY SWAP SPREADS ARE IMPORTANT

Swap spreads, the spread between a government bond yield and the yield on an ordinary interest rate swap of the same tenor, are commonly used as a cheap hedge for risk assets. Swap spreads are also reflective of basis risk in duration management. Since September 2015, US 10 year swap yields have persistently stayed below the yield on US 10 year bond yields, creating negative swap spreads.

While there are many factors driving swap spreads, it is difficult to identify reliable and observable drivers. However, one consistent driver of swap spreads is volatility in risk assets. This is depicted in Figure 1, which shows the 10yr USD swap spread and our proprietary Blended Credit Spread - which is our aggregate measure of global credit spreads. While the ratio between the two changes, there is a directional relationship – as credit spreads widen, so do swap spreads, and the same is true in reverse. A similar relationship is observed for equity volatility. Consequently, up until 2015, swap spreads have historically been regarded as a fairly reliable hedging tool.

INSIGHTS.IDEAS.RESULTS.

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FIGURE 1: Directional relationship between credit spreads and swap spreads

Source: AMP Capital, Bloomberg

THE RELATIONSHIP BREAKDOWN: A CONFOUNDING REALITY

In 2015, the relationship between swap spreads and risk assets comprehensively broke down. As credit spreads widened and equities fell, swap spreads failed to widen as expected; instead, they narrowed before turning negative. Consequently, swap yields went below US government bond yields.

In the past, there have been brief periods where swap spreads have been negative, for a week or two, although these have been associated with atypical events, such as when the Fed announced an extension to quantitative easing (QE) and US Treasuries reaching new lows. This time it’s different - 10 year swap spreads have been negative since September 2015 and show no signs of normalising. This is confounding for two key reasons:

> A swap is a string of short-term LIBOR rate-sets (or other reference rate rate-sets), and effectively represents unsecured bank funding risk. By contrast, US government bonds are a risk free asset.

> Swaps are issued by banks and are therefore subject to counterparty risk.

We acknowledge, however, that 30 year swap spreads (30 year swap yields versus 30 year government bonds) have been negative since 2008, for well-document reasons related to life insurer and pension fund demand for longer dated assets.

FIGURE 2: US 10 year swap spread to bond – negative since September 2015

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s WHY HAVE NEGATIVE SWAP RATES PERSISTED?

We believe that a confluence of structural factors has led to the persistence of negative swap spreads:

> Structural changes have impacted the way the market works, for instance, US banks now predominantly place their swap trades through a clearing house, which effectively negates bank counterparty risk. There are a number of other structural changes that have contributed to falling swap spreads, including aggressive buying of mortgage backed securities by the Federal Reserve since 2008, without any associated swap hedging.

> Banking reforms such as Basel I - IV has made bank capital scarce and with additional constraints on balance sheets, there has been a shift in the funding environment. This has, in turn, had a flow on effect to the repo market, which uses government bonds as collateral. The mechanism is technical and is worthy of a separate paper in its own right.

In addition to these structural factors, we observed a number of market stresses over 2015 that contributed to falling swap spreads to bonds:

> The US Federal Reserve raised rates.

> Corporate bond issuance rose substantially higher.

> Persistent sales of US Treasuries by emerging markets to counteract foreign exchange outflows.

CAN SWAP SPREADS STILL PERFORM AS A HEDGE?

Swap spreads can still be a useful hedge, but now more than ever, it will be important to consider: why the hedge is needed, what event is being hedged against and how swap and bond yields are impacted. Swaps can no longer be relied on to behave as they have, historically. We believe it’s useful to consider a number of hedging instruments, in addition to swap spreads, such as credit default swaps (CDS) and CDS options.

IN SUMMATION

> Negative swap spreads have persisted owing to structural changes that are expected to remain.

> A number of market stresses have also contributed to negative swap spreads.

> Use of swap spreads for hedging may still be effective but it depends on the type of risk that is being managed. Other alternative hedges could be considered along with swap hedges.

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Theoretical underpinning for negative interest ratesSince the global financial crisis, growth globally has been consistently below potential, which has driven a widening in the gap between the level of potential output and the level of actual output, known as the output gap. Persistently below-trend output has resulted in weak or diminished broad-based price pressure, which is reflected in inflation rates running below long-term averages, globally, for a number of years.

It’s our belief that the neutral real rate, which is the real interest rate consistent with full employment and stable prices, is now lower than in the past, and we surmise that the neutral real is closer to -1%. We demonstrate this through our analysis of the Taylor Rule, which is commonly used to determine the appropriate policy rate target. Key inputs to the Taylor Rule are the neutral real rate, inflation and the output gap. Figure 3 depicts the Taylor Rule estimates of the appropriate policy rate with an assumed 2% neutral real rate. Across the US, Euro area and Japan, none of the Taylor Rule estimates are negative. When we lower the assumed neutral real rate to -1%, as depicted in Figure 4, the Euro area and Japan’s Taylor Rule estimates are negative, which provides support to the negative interest rate policies being employed in those regions.

FROM ZIRP TO NIRP: INTEREST RATE POLICY TURNS NEGATIVE

FIGURE 3: Taylor Rule policy rate estimates - with 2% neutral real rate

Source: Bloomberg, AMP Capital

FIGURE 4: Taylor Rule policy rate estimates - with -1% neutral real rate

Source: Bloomberg, AMP Capital

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IMPLEMENTATION OF UNCONVENTIONAL POLICY

Unconventional policies were introduced following the global financial crisis; to stimulate demand and close output gaps. In an attempt to encourage higher inflation expectations and encourage bank lending, the European Central Bank resorted to negative interest rates in 2014.

The move to negative rates had flow on impacts through the currency channel and led to negative rates policies being employed across a range of central banks in the European region.

We have analysed the methods of negative policy rate implementation across a number of European countries. Negative interest rates are implemented in a range of different ways depending on the level of excess reserves in the system. Large volumes of excess reserves are typically symptomatic of an extended program of quantitative easing and liquidity injections. In most cases, the required reserves are exempt from severely negative interest rates while excess reserves are penalised when deposited at the central bank.

THE SUCCESS OF UNCONVENTIONAL MONETARY EASING ON THE ECONOMY AND BOND YIELDS

We use our proprietary measure of economic conditions, the Economic Pressure Index, to monitor key economic indicators across regions and over time. We have analysed the success of unconventional monetary easing on the economy through these indices:

>> United>States – While the US Federal Reserve did not move to negative interest rates, the use of other unconventional policies, such as quantitative easing (QE), has been generally positive. This has been most evident in the labour market, which improved significantly after the introduction of QE3 in 2012, and has led to stronger consumer spending. However, inflationary pressures continue to be quite subdued at the headline level and business spending is yet to recover, which is preventing growth from pushing meaningfully above trend.

>> Eurozone – There has been an overall improvement in economic conditions in Europe following the introduction of quantitative easing. The labour market has strengthened, which has driven an improvement in consumer spending. However, capital investment continues to be quite soft and there is a strong disinflationary impulse, implying that the output gap is still very significant.

>> Japan – following the introduction of Abenomics in 2012, our EPI’s showed an improvement in business activity, consumer spending, and overall GDP growth. Since mid-2015, we have seen considerable weakness in the Japanese EPIs and whilst it may be too early to gauge the impacts of negative interest rate policy on activity data, the initial signs are in no way comparable to the positive impact that we had from the introduction of Abenomics.

UNCONVENTIONAL MONETARY EASING DOES NOT LEAD TO LOWER BOND YIELDS

It is important to observe that unconventional monetary easing does not cause bond yields to fall. Given that a nominal bond yield is comprised of a real yield and inflation expectations, monetary easing that is credible and effective and creates an expectation of higher future inflation should lead to higher nominal bond yields.

This was evident in the US, where bond yields rose following the announcement of each round of QE, as depicted in Figure 5. The rise in nominal bond yields was driven by increased inflation expectations, which was reflected in higher breakeven inflation rates in inflation-linked bonds.

Our view is that the trend decline in US nominal bonds, from 2008 through to early 2013, was driven by falling real interest rates, which in turn was associated with the decline in the real equilibrium rate owing to weaker economic drivers.

FIGURE 5: US quantitative easing announcements and bond yields

Source: Bloomberg

Higher bond yields following unconventional policy was also observed in Japan following the introduction of Abenomics in 2012. As the bond market regained some confidence in the Bank of Japan’s (BOJ) ability to generate inflation, inflation expectations moved from 0% to 1% and nominal bond yields rose. By contrast, the BOJ’s introduction of negative interest rate policy in early 2016 has seen inflation expectations fall back towards 0%, which has driven nominal bond yields lower. We believe that by moving to negative rates, the BOJ has switched to a policy tool with clear limitations. Secondly, by moving away from asset purchases, the BOJ has allowed the market to infer that they have potentially reached their limit on that as well.

We contend that the decline in nominal yields is related to market perceptions that monetary policy has failed or reached its limit. Consequently, the major risk for bond yields is not that rates go further negative; rather, the risk is that the market perceives that monetary policy has reached it’s limit and reprices inflation expectations lower.

Notably, inflation expectations tend to represent the most substantial component of nominal yields. As such:

> In order for real rates to fall, either nominal rates need to fall or inflation expectations need to increase.

> If nominal rates are near their lower bound, the only way to lower real rates is by increasing inflation expectations. Importantly, we assert that the real neutral rates required to achieve full employment are lower today than historically.

BEN GORRIEPortfolio Analyst

STEVE HANNAFORDPortfolio Manager

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IMPACT OF NEGATIVE INTEREST RATE POLICY ON ASIAN FIXED INCOME

Slowing growth out of Asia, continued rate cuts, low global yields from QE and negative interest rates have caused Asian nominal yields to push lower. However, nominal yields are still relatively high in much of Asia and Asian central banks are still on an easing bias. In contrast, most other emerging market countries have had to hike rates amidst slowing economic growth in an attempt to manage their capital account and currency.

Real yields have also fallen across the world, though in Asia, the falls in inflation have outpaced the fall in nominal yields, resulting in higher real yields. Consequently, many Asian central banks have scope to continue to ease policy, making Asian bonds very attractive for foreign investors searching for yield.

There has also been a reallocation away from other emerging markets to Asia. The repricing of the Fed hikes in 2015 caused some weakness in emerging markets bonds, but Asia generally outperformed other emerging markets, despite volatility around China capital outflow risks. Now, with a more dovish Fed emerging in 2016 and further policy forays into negative yields in Europe and Japan, there has been a general recovery in emerging market bonds and flows have reaccelerated into Asia and also into emerging markets.

Data suggests that the increase in total bond flows from European domiciles into foreign bonds has been substantial. Japanese net purchases of foreign bonds have also increased significantly since mid 2015. Our analysis of bond flows indicates that negative interest rate policy favours bond markets with high real yields, low sovereign risk premia and limited capital account stress. Indonesia, India and Thailand have been key beneficiaries of bond flows. We expect that as low yields persist globally, Asian bonds will continue to be attractive for foreign investors.

AUSTRALIAN FIXED INCOME BENCHMARK ANALYSIS

The fall in Australian bond yields over the past five years has driven the duration of the Bloomberg Australian Bond Composite Index up from 3.5 years to 4.7 years as at 30 April 2016. Credit spread duration has fallen from 2.5 years to 2 years and the representation of credit by market value in the benchmark has declined from 18% to 13%.

In portfolio risk terms, these shifts in the characteristics of the benchmark have resulted in a 50% increase in VAR from 195bps in 2011 to 285bp currently. The implication for bond managers and those setting strategic asset allocations is that unquestioning use of the benchmark over the past 5 years has resulted in a gradual increase in beta risk.

We believe that the most appropriate benchmark is one that reflects the individual needs of a given client and the risk premia that the client is seeking to obtain. It is, however, useful to review the behaviour of benchmarks under varying market conditions. We conducted a stress test analysis of benchmark exposures in 2011 and 2016. The analysis showed a varied return distribution of the current benchmark under various scenarios and confirmed that there isn’t a benchmark that performs well for all events. A summary of our analysis is captured in Figure 6.

FIGURE 6: Australian Bond Benchmark stress tests*

Source: AMP Capital, Bloomberg * Bloomberg Australian Bond Composite Index

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NAM NGUYENPortfolio Manager

NEGATIVE YIELDS AND THE BANKING SECTOR

In assessing the effect of negative interest rates on the banking sector, we focus on the four key areas of impact:

>> Earnings – we consider costs, margins and asset gains

>> Asset>quality – this includes underwriting standards and assessing areas of expertise

>> Strategy – we review sources of non-interest income, the likelihood of M&A, and asset sales

>> Funding>– key considerations include deposit differentiation and franchise strength

There are a number of likely outcomes of negative rates on banks, including lower net interest margins, continued improvement in asset quality, greater focus on digitalisation and cost reduction strategies, net negative issuance in Europe, and a greater focus on cross sell and fee businesses.

DIVERGING MARGIN OUTLOOK

Our analysis of forecasted net interest margins for select Japanese and Asian banks revealed a sharp divergence. The China and Asian exposed banks we analysed are expected to have net interest margins compression but will be generally flat. Japanese banks, however, are expected to experience margin compression. Japanese banks are amongst our least preferred sectors, reflecting the downside risks to earnings, an increase in asset quality risks in Asia, and a highly levered sovereign.

European banks are less affected than Japanese banks because competition is not as strong and there is a greater skew to consumer/retail in Europe.

IN SUMMATION

> The neutral real rate is lower today than in previous cycles.

> Unconventional monetary easing does not cause bond yields to fall.

> The decline in nominal yields is related to market perceptions that monetary policy has failed or reached its limit.

> Given nominal yields are at their lower bound, the only way to lower real rates is by increasing inflation expectations.

> Asian fixed income continues to offer attractive yields relative to the rest of the world.

> From a credit perspective, we believe there are downside risks to Japanese mega bank ratings, and have a stable outlook on the European bank sector.

Important note: This document is provided for Australian residents and residents of countries where it would not be prohibited or against local laws to provide the information in this document (“Permitted Jurisdictions”). This document is not provided to any person who is a resident of any other country. The information in this document is only available to persons accessing the document from within Australia or another Permitted Jurisdiction. While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. © Copyright 2016 AMP Capital Investors Limited. All rights reserved.

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LINDEN SMITHSenior Credit Analyst