Strategy bulletin  

02/12/2015

NEGATIVE RATES IN SWISS FRANCS : WHAT OPPORTUNITIES ?

Swiss government bonds are in long-term negative territory, posing clear challenges, and hidden opportunities, for investors denominated in the currency. Grégory Lenoir, Head of Asset Allocation at Lombard Odier, addresses the key considerations for portfolio positioning.

The impact of the negative interest rates introduced by the Swiss National Bank (SNB) on 15 January 2015 is likely to continue to weigh on the performance of portfolios in Swiss francs for some years to come. In an uncertain environment, marked by a fall in the potential growth of the developed economies and the use of unconventional monetary policies, the SNB's decision to introduce negative interest rates to protect its economy makes the task of any asset allocation manager very difficult.

The repercussions of this decision on returns on assets are considerable. The move means that pension investors must give very careful thought to their asset allocation, and that banks must review their portfolio strategies given the completely new environment. Is it reasonable to invest in bonds that have a negative yield on maturity? What yield could be expected from the various asset classes? And, how can one be sure of the robustness of a portfolio when the main source of fixed income has disappeared?

With the yield curve of Swiss government bonds in negative territory for maturities of up to 13 years, building a multi-asset portfolio in Swiss francs can be tricky. The return-forecasting exercise, therefore, is not likely to reveal much. Compelled by the activism of its European counterpart, the SNB will have no other choice, in the next two years, but to keep its key rates close to their current levels, in order to limit the rise of the Swiss franc. Furthermore, its exit from this policy can only happen gradually. It is likely that, over the same time period, the US – the main driver of global growth – will be hit by monetary tightening, which is expected to be implemented in the next few months. Furthermore, the slowdown in the potential growth of the Swiss economy, due to the shrinking working-age population, calls for key rates of less than 1%.

The lessons learned from this forecasting exercise could not be clearer. The bond universe will be the first to suffer. Bonds will continue to deliver negative yields for many years to come, before following the upwards "sign" indicated by the key rates. Thus, whether the economic situation stagnates or improves, investing in sovereign bonds would involve, at best, a loss corresponding to the current interest rates (-0.36% at 10 years) or, at worst, a further, more marked decline when Europe normalises its monetary policy.

We think, however, that if the economy were to deteriorate, any further reduction in the long-term interest rates would be modest. Indeed, sovereign bond yields have never fallen to levels such as these, not even during the US Great Depression or Japan’s Lost Decade. The bond yield distribution offers a higher risk of loss than potential for gains.

In terms of asset allocation, the consequences of this forecasting exercise are manifold. The current climate, which is shaped by investors' search for returns, generally favours a fall in the risk premiums for equities. We therefore expect the equity markets' performance to be in excess of 5% year-on-year over the next decade.

So is there a place for sovereign bonds with a negative yield in a diversified portfolio? Are there good reasons for preferring this asset class over liquid assets, which are considered to be "risk-free"?

We simulated the behaviour of Swiss franc portfolios made up of 60% equities and 40% Swiss government bonds or liquid assets. Maintaining a bond component is relevant for maximising the risk/return ratio. But only if (i) the forecasting horizon is long enough (at least 10 years) to smooth out the losses associated with the normalisation of bond yields, and (ii) there is a sufficiently negative correlation between bonds and equities to ensure that any gains realised thanks to diversification offset the effect of negative yields. According to our calculations, only a correlation equal to or less than -0.7 between the changes in equities and bonds (i.e. almost diametrically opposed changes) would justify keeping a significant bond component in a balanced portfolio. However, these levels have only been seen in crisis periods such as in 2000, 2008 and 2012. The average correlation for the last 20 years was actually -0.3. It follows, therefore, that maintaining Swiss government bonds in a 60/40 allocation would only make sense in a scenario of severe deflation.

Increasing the corporate bond component to improve returns might seem a wiser move, but this would be at the risk of losing diversification and increasing the portfolio's sensitivity to the economic cycle. Consequently, the best route seems to be to look for alternative risk premiums.

Income-generating real estate in Switzerland, in the form of direct or "securitised" investment, continues to offer clear diversification qualities. With an average annual return of 1.5% to 3%, depending on the scenario, and a level of risk comparable to that of long-term bonds, this asset class must now form part of any allocation in Swiss francs.

At the same time, since the various economic areas are out of sync with each other, there is a case for increasing the allocation to hedged foreign bonds, which would make the divergence in monetary policy itself a source of diversification.

Lastly, the increased supervision of alternative asset managers now means that a portion of capital can be reallocated to this type of investment, whether for the purpose of seeking alpha or gaining access to illiquidity premiums. Thus it can be seen that negative interest rates also create opportunities.

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