The biggest challenge in a generation faces all those involved in financial markets, with ultra-low interest rates likely to remain a fact of life for a decade or more.
This has already prompted greater risk-taking as investors seek higher yields and triggered the liquidity shock of March 2020, which was eased only by colossal central-bank intervention.
Particularly acute is the challenge this poses for defined-benefit pension schemes, given that downward pressure on yields makes it ever-harder for them to fulfil the promises they have made to their members.
More broadly, financial markets may come to expect and to rely on unlimited central-bank support for an indefinite period.
These were the major points to emerge from the AQR Asset Management Institute Insight Summit on investing in a low-yield world. But the master-theme, which ran throughout, was the likely persistence of very low real interest rates for many years, a persistence exacerbated but not caused by the Covid-19 economic shock.
Hélène Rey, Lord Raj Bagri Professor of Economics at London Business School and a member of France’s macro-prudential regulation authority, used the historical context as the basis for forecasting what may be to come.
Usually, she said, the depiction of interest-rate patterns is dated from 1980. With US rates since then, she said, “there is a pretty impressive decline”.
But, she added: “If we go back in history, and here I’m starting at the end of the 19th Century and cover the 20th Century and the beginning of the 21st Century, we can see that the recent evolution in real rates is actually not that remarkable.
“There had been a lot of action before the 1980s in terms of real rate movements. And it is likely that maybe we can actually learn from history.”
Briefly taking a very long backward look, she noted there was some evidence of a downward underlying trend in rates from the 14th Century onwards, but added that the modern economy was so different from that of the late Middle Ages that: “I’m not going to delve into that,” and would confine her analysis to the 20th and 21st Century.
Looking at the fundamental forces that determine movements in real interest rates, she identified, first, the supply of and demand for funds. “So when we have periods of high savings and relatively weak investment demand, real rates tend to be low. And why could we be in such a period right now?”
Professor Rey first separated the possible factors already in place before the Covid-19 epidemic. They included:
She added two further possible explanations. “There has been an increase in wealth inequalities in a number of places. This, again, might lead to a decrease in real rates by increasing savings, because rich people have a higher marginal propensity to save.”
Finally, there is the global savings glut, in which fast-growing emerging markets, offering fewer opportunities for domestic investment, ship their capital to advanced economies such as the United States, driving down real rates.
Having identified these six suspects, however, Professor Rey declared them all “not guilty”. The real culprit, she said, was the boom-bust cycle, as seen in both 1929 and 2008.After both “busts”, she said, a period of de-leveraging and weak aggregate demand leads to lower real rates.
How long will these persist? The average has tended to be ten years, during which real rates have run at minus 3.1 per cent.
The Covid-19 shock comes on top of this. Centuries of historical data, she said, suggested that, after a pandemic, “real rates tend to go down…in a very persistent way”, not reaching their trough for 20 years.
As if in anticipation of this “lower for longer” environment, fixed-interest managers are moving into riskier investments, according to Scott Richardson, Principal and Co-head of Fixed Income at AQR Capital Management and Professor of Management Practice at London Business School. Even nominal, rather than real, yields are at historic lows, he said, making the search for excess returns for active managers a huge challenge. “Active fixed income as a group,” he said, “does not seem to be generating alpha. So I certainly think it is not the case that active fixed income is easy.
“What is systemic across a lot of active fixed income managers is the extent to which they’re out of benchmark exposure, loading up on what is essentially credit risk.”
These alternative assets to conventional bond investment, he said, include bank loans, emerging-market debt, emerging-market foreign exchange and high-yield corporate bonds. He warned: “I believe completely that, if you’re able to identify a less liquid asset, you should receive a higher return from being exposed to that. But within public credit markets, you cannot find evidence that the less liquid corporate bonds, in particular, generate a high excess return.
“That could be a bit of a problem but it is an empirical fact.”
Furthermore, these “out of benchmark” assets have enough in common with equity risk as to undermine the ability of the fixed-income portion of the portfolio to offer diversification to equity risk.
Despite the ultra-low yields, added Professor Richardson, “bonds are still worthy of allocation”. He said: “With a well-implemented systematic approach, it is possible and feasible to generate truly diversifying excess returns within the fixed-income asset class.”
In parallel with the move into riskier assets, the summit heard of the effect on financial markets of a sudden drying up of liquidity, as seen on both sides of the Atlantic in March 2020. Professor Anil Kashyap, of the Booth School of Business at the University of Chicago and an external member of the Bank of England’s Financial Policy Committee, spoke of the interconnections in the financial system “that can create contagion and liquidity demands”.
For example, derivatives trading on margin can cause a drain on liquidity on occasions when traders have to top up their accounts to take account of a fall in the value of their positions. In another example, investors in money-market funds may withdraw their cash, meaning the funds in question will need extra liquidity to meet those demands.
The trigger in March for a “dash for cash” and subsequent liquidity crisis was a potent mixture of economic anxiety and the Covid-19 pandemic. “A deterioration in economic prospects and heightened uncertainty due to Covid-19 saw investors move out of risky assets into safe assets as a result.
“There was also a heightened concern that the situation could deteriorate further, so it’s likely that some actors became more cautious about lending and retained funds on a precautionary basis.”
Movements in asset prices, he added, affected margin requirements in the derivatives markets. The chain effect of all this amounted, he said, to a “liquidity multiplier”, creating a demand for liquidity far greater than the needs of any one party in the chain.
Professor Kashyap said: “So how did this all end? Well, as we all observed, the central banks responded to this turmoil with massive force.”
“For instance, the Bank of England’s purchases of gilts increased by £200 billion in March and will total £870.5 billion. The Federal Reserve’s response was also enormous and came via the introduction of multiple programmes.”
The operation of the liquidity multiplier helps explain why the interventions needed to be so large, he said.
He warned: “Measurement of liquidity positions and funding flows is poor and is [an area] where more work could be done, including some that involves international co-operation.”
In the direct line of fire in the low-rate world are defined benefit pension schemes. Less common than in the past, they pledge to pay their members a guaranteed sum in retirement, usually linked to the salary they have earned.
For those managing the more common defined contribution scheme, there is considerably less pressure. Pensioners may be disappointed with their retirement incomes, but the schemes themselves are not responsible for rectifying this. But it is a different story with defined benefit schemes, which place the burden of ensuring the promised sums in retirement on the scheme provider.
The summit heard that the current low-return environment puts a serious question mark over the ability of many funds to fulfil their promises to scheme members.
Joshua Rauh, Professor of Finance at Stanford Graduate School of Business and a Senior Fellow at the Hoover Institution, declared his intention of providing “a historical balance-sheet perspective on defined benefit pension funds around the world, in light of the multi-decade declines in interest rates that we have seen”.
He noted: “Many pension systems do not accurately reflect the present value of promised pension benefits in their financial statements and in their various reports.”
Professor Rauh took as his theme “interest rates and borrower solvency”, noting that a common view of borrowers was that they are economic agents to whom a decline in interest rates is welcome, in contrast to the effect on creditors and savers. But, he added, this is not always the case.
“It depends,” he said, “on whether the existing debt can be refinanced. If one thinks about declines in interest rates and how they classically help borrowers and hurt creditors, the condition is that the outstanding debt can be refinanced and the new debt can be issued at the new, lower rates.”
Two examples, said Professor Rauh, were to be found in real-estate mortgages and in government bonds. But defined-benefit pension promises, he said, comprised a different type of debt. Here, “declines in interest rates actually hurt the borrowers, these borrowers being the firms or the governments that made these promises”, because this is a type of debt that cannot be refinanced.
“The cost to the borrower or the issuer, or, in this case, the sponsor, the entity that is making the pension promise, then rises with lower rates,” he said.
To illustrate this, he asked the audience to imagine a city whose police chief is approaching retirement with a defined-benefit pension, worth $100,000 a year. “Should interest rates fall,” he said, “the city does not have the right to go to the police chief and say ‘Now that interest rates are lower, these pension promises that we’ve made to you are much more valuable. We’re going to renegotiate these promises.’
“They obviously cannot do that with pension promises.” As a result, the present value of the pension promises on the city’s balance sheet will rise.
Had the city fully funded the pension obligations, said Professor Raugh, and used derivatives to hedge against the sort of eventuality that came to pass, these effects could have been completely avoided. “Yet defined benefit pension systems are generally, in many countries of the world, only partially hedged against these changes.”
He calculated the funding ratios for different countries, being the percentage of the defined-benefit liabilities covered by available funds. In the US, examples of low funding ratios were found in the Illinois Teachers’ Retirement Fund (25 per cent), Central States, a scheme for unionised lorry drivers (22 per cent) and the Chicago police scheme (12 per cent). In the UK, the Universities Superannuation Scheme was at 56 per cent, while the Greater Manchester local-authority scheme recorded 70 per cent.
It was a very different story in the Netherlands, said Professor Raugh, because over a lengthy period the Dutch have been replacing traditional index-linked schemes “with pension rights that are…conditional on the performance of the assets and the funds”.
He added: “So the Netherlands, not surprisingly, has very high funding ratios…I would say, in the purest sense, that the Dutch plans have been fully funded for a while in the sense that the pension rights that were attached to the liabilities have always been rather weak.”
The spotlight switched from the Netherlands to Canada with the next speaker, Keith Ambachtsheer, Director Emeritus of the International Centre for Pension Management at the Rotman School of Management in Toronto. In the words of the World Bank: “Canada is home to some of the world’s most admired and successful public pension organisations.”
But, as Mr Ambachtsheer told the summit, it was not always so. Problems in Ontario schemes in the Eighties led to the creation of a task force of which he was a member. The result of its report was, in effect, to tear up the rules that had governed pension schemes hitherto, and, as he put it, to radicalise the management of pension systems.
Inspired, he said, by the writings of both John Maynard Keynes and the business guru Peter Drucker, he helped the group to craft an entirely new pension regime. The time-honoured rule of “60-40”, under which 60 per cent of a fund was invested in equities and 40 per cent in bonds, in search of a four per cent real return, was abandoned.
Instead, fund managers were unconstrained as to the assets they purchased, but the funds were subjected to strong, independent governance.
“The new focus became acquiring sustainable cash flows and nurturing those sustainable cash flows over time,” he said.
“The fact that the market would value those cash flows differently at different points in time was not all that relevant, as long as you had a pension model that could work its way through those ups and downs.”
Mr Ambachtsheer added: “The bottom line is, I think, it is still possible today going forward to generate that sort of ‘magic four per cent real’, which has been the basis on which to create sustainable pensions, adequate pensions at reasonable contribution rates.”
He concluded: “The old 60-40 is not going to do it anymore. A significant rethinking is required.”
Mohamed El-Erian, President of Queens’ College, Cambridge, treated the summit to a wide-ranging tour d’horizon of the current financial and economic scene before returning to the central theme, the challenges and problems of an ultra-low return environment.
On the worldwide level, he said: “We have a macro issue, a global economy issue, which is that it’s not clear who is our ‘locomotive’. Right now, China and Asia certainly are locomotives of growth, they are going to show some positive numbers.
“But you have to ask the question – do they have enough, based just on domestic demand, because it will take a lot longer for Europe to recover. Also, it will take a lot longer for us to recover.”
China, said Mr El-Erian, had made it clear that the old world economic model, with the United States at the centre and China on the periphery, is changing. “What’s changing is that China is looking to create more and more links that go around advanced economies, and to be that link with the periphery. I see this not only in how they conduct trade, I see this not only in the payment systems…but also in this incredible agility to take advantage of opportunities.”
On the central issue of financial turmoil and the associated low returns, he asked “what does a pandemic do?”, answering: “It alters perception of human counterparty risk. That's what it does. You, and I can no longer trust each other.
“And just as happens when financial counterparty risk goes up, the worst reaction to that is to step back. In stepping back, you turn short-term problems into long-term problems. You definitely decimate the service industry, for example, the restaurant shuts down.
“The other thing that happened during pandemics is because they are tail events, they increase household economic insecurity. So when you look at these two factors, they actually depress interest rates for a while. “
Looking at the official response to this, he said: “For me, the central bank has become an insurance company. But without genuine growth, this whole insurance model becomes problematic in a few years.”
Mr El-Erian added: “What worries me a lot is that the natural consequences is more and more and more risk taking on the assumption that the that the insurance company will provide more and more insurance, but you cannot insure people against default…So that's why we really need the real economy to come back. If the real economy comes back, central banks will look really smart.”