CAN YIELD
REALLY BE
ENHANCED?
June 2015 • An Institutional Investor Sponsored eBook
Can Yield Really
Be Enhanced?
Sponsored eBook
Introduction: No End in Sight to the Low Yield Environment.......................................4
Chapter I: Exploring Opportunities for Enhanced Yields in Fixed Income Markets.....8
Chapter II: Harnessing the Potential of Loans and Infrastructure..............................12
Chapter III: Is There Still Value in Equities? ................................................................16
Conclusions.................................................................................................................20
About HSBC Global Markets........................................................................................21
Disclaimer....................................................................................................................22
June 2015 • Institutional Investor eBook Sponsored by HSBC • 3
Introduction
No End in
Sight to the
Low Yield
Environment
Sponsored eBook
W
hen the Spanish government sold €725 million of six-month paper
at an average yield of -0.002 percent in April 2015, it was not the first
time a European sovereign borrower was able to charge investors for
the privilege of holding their debt. Germany, Ireland and Switzerland have all auctioned longer-dated bonds offering investors negative returns.
It was, however, the first time that one of Europe’s so-called peripheral countries
had auctioned government debt at a negative yield, making it perhaps the most
striking demonstration to date of how far yields have fallen in Europe. To put the
Spanish auction into perspective, when Madrid auctioned €3.26 billion of shortdated debt in November 2010, the yields on the three- and six-month notes were
1.74 percent and 2.11 percent respectively.
It’s not just an increasing volume of peripheral as well as core European
government bonds that have been trading at negative levels. By early February, euro-denominated bonds of several blue-chip companies, including
Nestlé, Electricité de France (EdF) and Shell, had slipped into negative territory in the secondary market.
Is QE to blame for low yields?
It’s easy to see why yields in Europe are being driven to ever-lower levels. Under
the unprecedented €1.1 trillion asset purchase program announced in January
in response to economic stagnation, the European Central Bank is committed to buying some €60 billion of government bonds and selected asset-backed
instruments each month between March 2015 and September 2016. But with
this quantitative easing (QE) program taking place against a backdrop of fiscal consolidation in the Eurozone, there are growing concerns that there will be
June 2015 • Institutional Investor eBook Sponsored by HSBC • 5
Sponsored eBook
Introduction
insufficient supply of eligible government bonds to meet the ECB’s demand. It is
this disequilibrium that is driving government bond yields into negative territory,
with some €2 trillion of Eurozone public sector debt trading at negative levels by
mid-April.
Given that QE in the Eurozone still has well over a year to run, the chances are
that yields will re-test the lows we saw in mid-late April. “I think it will become
more difficult for the ECB to fulfill monthly purchase requirements, which will
mean yields are driven back, and possibly deeper, into negative territory further
down the yield curve,” says Simon Hotchin, Head of the EMEA Client Solutions
Group at HSBC in London. The theoretical floor for these yields is the ECB’s
deposit rate of minus 20 basis points, which is currently the lowest level at which
bonds can be bought under the asset purchase program. But as Hotchin says, this
minimum is not cast in stone, which together with repo market spreads trading tighter than -20bps, explains why some shorted-dated German government
bonds (Schatze) have already traded at yields below minus 20bp.
Some have speculated that a shortage of government bonds may even push
the ECB into adding corporate bonds to its asset purchase program. This would
support the ECB’s objective of spurring economic growth by further reducing
corporate financing costs. But for institutions in Europe, it would make the task of
generating positive returns on their investments even more challenging. “European chief investment officers (CIOs) have a very difficult job today,” says Hotchin.
Challenges for the insurance industry
For many Continental European insurance companies, the relentless decline in
yields is creating other formidable challenges beyond meeting investment targets.
In many cases, Hotchin explains, unrealized gains on their bond portfolios, generated by low rates and narrowing spreads, is impeding the way insurance companies manage their investments. This is because if they were to realize these gains,
they would be contractually obliged to share a high proportion of those gains
with policyholders, rather than hold them back to set against their long duration
6 • Institutional Investor eBook Sponsored by HSBC • June 2015
Sponsored eBook
liabilities. In today’s punitive low-yield environment, this also compounds the
challenges of finding assets in which to reinvest.
“In addition, the last thing banks want to do is sell their bonds, realize their
gains and put them on deposit at the ECB, paying 20bp for the privilege of doing so,” says Hotchin.
For insurance companies the implementation of Solvency II at the start of
2016 will force them to hold additional capital against portfolios of riskier assets, and to manage asset-liability mismatches within smaller tolerances, leading some to extend duration further. This is likely to exert further downward
pressure on fixed income markets at the longer end of the yield curve. l
European Government Debt Trading at Negative Yield at End of April 2015
As of April 28, 2015
Country
Austria
Belgium
Germany
Spain
Finland
France
Ireland
Italy
Netherlands
Portugal
No. of bonds with
negative yields
10
11
41
7
9
23
4
6
14
2
Amount (in EURbn)
99
130
714
132
50
591
31
105
196
8
Total bonds o/s
192
300
1,030
663
83
1,229
98
1,407
321
102
% of total o/s
52%
43%
69%
20%
61%
48%
32%
7%
61%
8%
European Government Debt Trading at Negative Yield at Start of 2015
As of January 2, 2015
Country
Austria
Belgium
Germany
Finland
France
Ireland
Netherlands
No. of bonds with
negative yields
6
9
33
5
15
1
9
Amount (in EURbn)
62
89
563
28
395
2
132
Total bonds o/s
187
298
1025
79
1194
91
327
% of total o/s
33%
30%
55%
35%
33%
2%
41%
Source: HSBC
June 2015 • Institutional Investor eBook Sponsored by HSBC • 7
CHAPTER 1
Exploring
Three
Opportunities
For Enhanced
Yields in
Fixed Income
Markets
Sponsored eBook
W
hile the challenges faced by CIOs today are profound and
unprecedented, the good news is that for institutions prepared
to adopt a more flexible approach to asset allocation and risk
management, there is still a range of alternatives offering them
higher yields that will help to deliver positive returns to policyholders and
investors.
Are sovereign bonds a low-risk solution?
Some sovereign bonds, for example, continue to offer appealing
headline yields. But to access these returns, investors are finding that they
either need to expand beyond their core Eurozone markets, or to look
much further down the maturity curve. In some instances, they are doing
both at the same time. In April, for example, Mexico issued the first 100year government bond in the history of the euro-denominated market.
This €1.5 billion transaction, co-led by HSBC, was offered at a coupon
of 4.2 percent and generated total demand of more than €6 billion from
more than 230 investors.
While initiatives such as the Mexico century issue will be welcome to
yield-starved investors, supply of ultra-long-dated emerging market bonds
will represent little more than a drop in the ocean for institutions needing to
put billions of euros or dollars to work at positive yields.
A relatively low-risk option favoured by some European institutions has
June 2015 • Institutional Investor eBook Sponsored by HSBC • 9
Sponsored eBook
CHAPTER 1
been to increase allocations to the world’s deepest and most liquid bond
market. Nominal and inflation-linked US Treasurys have continued to offer
a pick-up over Eurozone government bonds, with 10-year benchmark notes
still yielding more than 2 percent as of late April. But as Hotchin says, this
exposes European institutions to currency risk. “From discussion with many
issuers and pension funds, we know that the common practice for hedging
FX risk is via rolling three or six months forward contracts,” he says. “Some
are also looking at long-dated cross-currency swaps, but bank leverage ratio
and collateral implications make these instruments more expensive and
complicated than in the past.”
Interest rates swaps and lightly structured products
A more sophisticated way of generating higher returns by expressing a view
on government bond markets, says Hotchin, is through yield-enhancement
products on the interest rate side. “These include looking at swap spread
opportunities by buying dollar or yen products and cross-currency swapping
them back into euros or sterling,” he explains.
“This can create a higher-yielding, synthetic euro or sterling asset where
the underlying issue could be Japanese government bonds or US Treasuries
or even a supranational issuer in a foreign currency.”
Hotchin adds, “We’re also seeing demand for more lightly structured
products such as constant maturity swaps (CMS)-referenced, where investors
take a view on the evolution of rates or the yield curve through time.”
These products are not suitable for all investors because they are less liquid
compared to cash bonds—and the costs of collateralizing cross-currency and
interest rates swaps are rising due to tighter banking regulations. Another
challenge associated with these strategies is the speed with which they need
to be implemented. “Windows of opportunity in these trades tend to be
short,” says Hotchin. “This means institutions are being forced to become
more nimble in responding to opportunities, which sometimes does not sit
10 • Institutional Investor eBook Sponsored by HSBC • June 2015
Sponsored eBook
well with their internal structures and governance procedures. So when we
talk to clients, we don’t just need to maintain a dialogue with the portfolio
managers and trading desks responsible for implementing these trades. We
also need to talk to the internal client or a third-party advisor to ensure that
mandates can be changed or become more flexible.”
Expanding into corporate bonds
The credit market also offers some refuge for yield-starved investors,
and a number of European institutions are known to be amending their
mandates to allow them to expand further into corporate bonds. As Fitch
noted in a recent survey of fixed income investors with €8.2 trillion of fixed
income assets, “Investors are piling into corporate bonds.” More specifically,
Fitch found that high yield was the most-favored marginal investment
choice for the respondents to the survey, with 25 percent of the votes,
compared with 21 percent for investment-grade corporates.
Fitch’s findings are corroborated by some of the industry’s heavyweights,
such as Zurich Insurance, which has investments of just over $200
billion. Cecilia Reyes, Zurich’s CIO, said in a recent interview that her
group is now planning to invest “a very small amount” of its credit
portfolio in high yield bonds.
In some instances, however, the term “high yield” is now becoming
a misnomer. For example, when the UK’s Merlin Entertainment sold
its debut €500 million seven-year bond in March, the coupon of 2.75
percent was one of the lowest ever for a European high yield bond debt
issue. HSBC was joint bookrunner on the Merlin transaction, alongside
Barclays and RBS.
While credit markets therefore offer some relief for yield-hungry
investors, compressed spreads, twinned with the higher capital levels that
many pension funds and insurers are required to set against them, will limit
the appeal of high yield bonds to European institutions. l
June 2015 • Institutional Investor eBook Sponsored by HSBC • 11
CHAPTER 2
Harnessing
the Potential
of Loans and
Infrastructure
Sponsored eBook
F
or institutions with flexible asset allocation mandates,
some pockets of the global loans market offer increasingly
attractive value relative to fixed income. “We’ve seen a huge
amount of interest and activity from insurance companies
and pension funds in loan assets,”says Hotchin. The most notable
examples, he says, are commercial real estate loans and facilities
issued by government-guaranteed export credit agencies such as
Hermes in Germany and Coface in France.
Institutional lenders are also playing a more prominent role in
shipping and aircraft loans. They are also more active in the market
for lending to small and medium sized enterprises (SMEs), where
insurance companies are increasingly making more productive use
of their liquidity by competing or co-operating with commercial
banks. Hotchin points to the example of France’s AXA, which has
teamed up with banks such as Société Générale and Commerzbank
to originate SME loans.
Infrastructure financing, a promising area
The area where the increased potential participation of
institutional lenders has perhaps attracted the most attention is
infrastructure finance, with very good reason. Standard & Poor’s
(S&P) has estimated that infrastructure financing needs worldwide
could reach $3.4 trillion annually through to 2030. While S&P
believes that governments and banks will remain the dominant
investors in infrastructure, it estimates that an additional $500
billion per year will be needed from alternative sources in order
to plug any shortfalls. S&P believes that insurance companies
could provide about $80 billion (or 3 percent of their assets under
management) of this shortfall. This is because infrastructure assets
are in many ways a perfect fit for insurance companies starved of
yield in traditional fixed income markets. Rated, long-dated project
June 2015 • Institutional Investor eBook Sponsored by HSBC • 13
Sponsored eBook
CHAPTER 2
finance bonds typically yield between 4 percent and 5 percent, their
recovery rates are generally high, their long tenors are suitable from an
asset-liability (ALM) perspective, and their correlation with other asset
classes is low.
Hotchin agrees that infrastructure is a promising area for institutional
investors, although he adds that their participation in the market to
date has not lived up to expectations. Some of the reasons for this are
clear enough. “Regulation, project complexity, illiquidity and a lack
of suitable projects may thwart insurers’ progress in making such
investments,” S&P cautions.
Infrastructure loans: better for banks?
There are other pitfalls associated with infrastructure loans, says
Hotchin, such as their floating rate, repayable structure without makewhole clauses. This makes them more appropriate for banks than for
institutional investors. Borrowers are keenly aware that it is in their
interest to address these shortcomings, says Hotchin, to diversify away
from the shorter-dated bank market and access longer term institutional
funding. “We are seeing borrowers becoming more receptive to
including fixed rate tranches with make-whole provisions in the event of
prepayment,” he says.
Lack of expertise is also a notable stumbling block to increased
institutional involvement in the infrastructure market. Hotchin says that
some institutions, like Allianz, have recruited specialist professionals to
develop their infrastructure franchises. Others, such as Swiss Re, have
chosen to invest in this asset class through externalmanagers with a
recognized track record in infrastructure such as Macquarie.
Going beyond core European economies
European institutional investors looking for exposure to the
infrastructure market for the first time have tended to prefer brownfield
to greenfield projects. They have also generally favored familiar
14 • Institutional Investor eBook Sponsored by HSBC • June 2015
Sponsored eBook
regulatory regimes and markets in which they can minimize currency
risk. This has meant that their overwhelming preference to date has
been for projects in core western European economies, although their
appetite for risk may now be changing. “A couple of years ago investors’
focus was strictly on core Europe,” says Hotchin. “That has changed,
and there is growing appetite for exposure to markets like Spain,
Ireland and Italy.”
While investors’ focus on Europe is clearly an effective way of
minimizing risk, it also restricts the volume of projects they can
access, given that the bulk of infrastructural projects are being
undertaken in emerging markets. “Investors will move into emerging
markets when they are more comfortable with how project loans are
configured,” says Hotchin. l
About Simon Hotchin
Simon is Head of the EMEA Strategic Solutions Group.
Prior to this role, he headed up the Insurance Solutions
team for Europe and was co-head of the insurance client
joint venture between Sales and Debt Capital Markets.
Simon joined HSBC six years ago from Morgan Stanley,
where he spent nearly 10 years running the European
ALM team and latterly Benelux Insurance coverage. The
ALM team advised insurers, pension funds, corporates,
Sovereigns and banks across Europe, Africa and Asia and
worked closely with coverage teams to structure strategic
solutions. He worked in similar teams at Société Générale,
Simon Hotchin, Head of the
EMEA Client Solutions Group
Tokai Bank Europe, Bankers Trust and CSFB, after starting
his career in Corporate Planning at BP. Simon holds an
MA, BA in Economics from Cambridge University.
June 2015 • Institutional Investor eBook Sponsored by HSBC • 15
CHAPTER 3
Is There
Still Value
In Equities?
Sponsored eBook
B
eyond the fixed income market, equities are another yieldenhancing option for multi-asset investors or for those with
flexible mandates. In the market for financial institutions’
bonds, added flexibility of mandates has been forced on
some parts of the investor community by the growing importance
of instruments such as additional tier 1 (AT1) securities. These subinvestment grade instruments offer alluring yields, typically of between 5
percent and 8 percent. But many are convertible into equity if the issuer’s
core capital falls below a predetermined minimum. This means that
investors with inflexible fixed income mandates are either excluded from
the market altogether, or are forced sellers in the event of the conversion
clause being triggered.
More broadly, however, some institutional investors in Europe have
been withdrawing from equities. “Over the last few years we’ve seen
a lot of de-risking, including a retreat from public equity markets by
insurance companies in Europe, although less so by pension funds,”
says Hotchin. An exception to this rule, he adds, is the UK market
where with-profits policies are sold on the understanding that they will
deliver equity-driven returns. “This has constrained the capacity of
UK insurance companies to de-risk in the cash equity space, although
it doesn’t prevent hedging of shareholder risk within the Estate,” says
Hotchin. “In Europe, where equities are held within general accounts,
there is less of an explicit promise to provide equity-like returns, which
has given European insurers more flexibility to de-risk.”
Why increasing equity allocation is not straightforward
Today, insurance companies remain hesitant about equities for two
main reasons. First, after a powerful run in recent years , valuations
are looking stretched: a quarter of respondents to the Bank of America
Merrill Lynch (BAML) global fund managers’ survey in April indicated
that they believe equities to be overvalued. This is the highest level since
June 2015 • Institutional Investor eBook Sponsored by HSBC • 17
Sponsored eBook
CHAPTER 3
2000, which saw a sharp correction in equity markets worldwide.
Second, Solvency II is continuing to encourage a drift away from
equities. Under the standard model, insurers are required to set 39 percent
capital against the market value of public equity holdings, and 49 percent
against private equity investments. Most insurance companies’ internal
models demand even higher levels, requiring that as much as 50 percent
is set against equities. “So although there is some sign of re-risking on
the equity side from an asset allocation viewpoint, capital requirements
remain onerous,” says Hotchin.
However, an innovative and unconstrained approach is also a way
Equity Yield Enhancement
Short Positions in VIX® Futures Can Generate Attractive Yields
160
30%
140
20%
120
0%
80
-10%
60
40
20
-20%
VIX Futures Exposure (RHS)
-30%
HSBC Volatility Alpha Index 10% RC Index (HSIEVA1E)
HSBC Volatility Premium Index 10% RC Index (HSIEVP1E)
0
May-11
-40%
Nov-11
May-12
Nov-12
May-13
Nov-13
May-14
Nov-14
Source: S&P Dow Jones Indices / Bloomberg. Past performance is not a reliable indicator of future performance.
18 • Institutional Investor eBook Sponsored by HSBC • June 2015
May-15
VIX Futures Exposure
10%
100
of generating an efficient risk-reward dynamic within an equity
portfolio. “What we’re seeing on the equity side is a strong demand
for re-shaping equity returns to make them efficient within a
Solvency II framework,” Hotchin explains. “This means either
developing solutions to hedge downside risk efficiently, or volatilitycontrol strategies based on dynamic asset allocation between
cash and equities. Or it means using structured products using a
combination of equities and rates within the same product. So the
way investors are taking equity exposure in the context of Solvency II
is becoming more sophisticated.” l
June 2015 • Institutional Investor eBook Sponsored by HSBC • 19
Sponsored eBook
Conclusions:
Unprecedented But Not
Insurmountable Challenges
T
he message for investors is clear. Although the challenges created by a low
or negative interest rate environment are unprecedented, there is no need
for investors to respond passively by tolerating much lower long-term
yields. Institutions will still be able to generate reasonable returns, but
only by adopting a more flexible approach to asset allocation. The key takeaways
for yield-starved investors today are:
• In credit markets, investors may need to broaden their mandates to
accommodate increased allocation to high yield bonds, and to allow them to
harness the potential of emerging markets and structured notes.
• Institutional investors can step into the breach created by reduced bank lending
in longer maturities by playing a more active role in financing infrastructure
and SMEs.
• Equity markets may still provide pockets of value for investors able to
implement more dynamic asset allocation strategies and structure protection
against heightened volatility.
20 • Institutional Investor eBook Sponsored by HSBC • June 2015
Sponsored eBook
About HSBC Global Markets
H
SBC Global Markets offer sophisticated 24-hour coverage across our
main trading and sales platforms in London, New York and Hong Kong.
Our global teams deliver a wide range of solution-driven products for
our Corporate and Institutional clients. We provide our clients access
to Equities, Fixed Income including Credit and Rates, Foreign Exchange,
Commodities and Prime Services, in addition to Research, across both developed
and emerging markets.
As a global investor, you’ll benefit from HSBC’s local knowledge in over 70
countries, balanced by our understanding of global economics. Use HSBC Global
Markets’ expertise to invest in:
• Rates - Gain access to global liquidity and streamline transactions. To help you
access global liquidity and transact seamlessly, the HSBC Global Rates group
provides debt issuance, financing, innovative risk management and investment
solutions through a broad selection of vanilla and structured products.
• Credit - Maximise opportunities with the HSBC Global Credit group to unlock
liquidity globally. Leverage our significant global emerging markets presence and
our extensive suite of credit services, which include traditional and secondary
trading products such as bonds, loans, securitised products, credit derivatives and
credit financing solutions.
• Foreign Exchange – Benefit from the expertise of a leading global market maker.
Our host of solutions provides liquidity from the purely transactional to the
highly customised. The HSBC Global FX group provides risk management and
tailored solutions such as Transactional FX, Algorithmic Execution, FX indices,
FX Overlay and FX Prime Services that allow clients to select and create individual
propositions to suit their needs.
• Equities - Take advantage of HSBC’s global connections and rigorous research. Our
far-reaching network gives you access to over 600 sales, trading and research specialists
worldwide. The HSBC Global Equity group brings together cash and derivatives
trading, sales and distribution, structured equity and equities finance expertise.
June 2015 • Institutional Investor eBook Sponsored by HSBC • 21
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Disclaimer
This article should not be regarded as investment research for the purposes
of the rules of the Financial Conduct Authority (“FCA”) or any other relevant
regulatory body. Any charts and graphs included are from publicly available
sources or proprietary data. Figures included in this article may relate to past
performance or simulated past performance (together “past performance”).
Past performance is not a reliable indicator of future performance.
Reproduction of this article, in whole or in part, or disclosure of any of
its contents, without prior consent of HSBC, is prohibited. This document
is not intended for distribution to, or use by, retail clients as defined in
the FCA rules, or any person or entity in any jurisdiction or country
where such distribution would be contrary to law or regulation. You are
solely responsible for making your own independent appraisal of and
investigation into the products, investments and transactions referred to in
this article and you should not regard any information in this document as
constituting investment advice. HSBC is not responsible for providing you
with legal, tax or other specialist advice. Except in the case of fraudulent
misrepresentation, neither HSBC nor any of its officers, directors, employees
or agents accepts any liability for any loss or damage arising out of the use of
all or part of this material.
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Counterparties only by HSBC Bank plc. Authorised by the Prudential
Regulation Authority and regulated by the Financial Conduct Authority and
the Prudential Regulation Authority
Registered in England No. 14259
Registered Office: 8 Canada Square, London, E14 5HQ, United Kingdom
22 • Institutional Investor eBook Sponsored by HSBC • June 2015
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