INVESTING in a low interest market

In the summer of 1981, Government of Canada bonds with a three-year term to maturity offered a yield above 18%. While the allure of this yield is lowered somewhat by the fact that inflation was running at nearly a 13% annual pace, it was nonetheless a golden age for “coupon clippers”. Furthermore, the Canadian bond market was about to embark on one of its greatest bull markets in history. In fact, over the last ten years alone, the Government of Canada component of the Scotia Capital Markets Short Term Index (average term of 2.7 years) had an average annual total return of 8.8%.

Eighteen years later, three year Canada bonds offer a decidedly less appetizing yield of about 5.5%. And for short Canada bonds to record a total return (interest plus market appreciation) in 1999 equal to the 8.8% ten-year average, interest rates would have to fall toward the 3% level by yearend — don’t hold your breath.

So, what can a property and casualty insurer do to mitigate this low interest rate challenge, and boost investment returns? There are alternatives, but as with all things relating to investments, the quest for higher returns necessitates the assumption of at least a moderate degree of additional risk. Further, each insurer will have to consider these alternatives in the context of their own constraints, particularly with regard to risk tolerance as well as tax and regulatory considerations. With those caveats in mind, here are some suggested ways to meet the low yield challenge:

Hold Longer Term Bonds. Traditionally, property and casualty insurance companies have tended to focus their bond holdings in terms to maturity of five years and less, with a typical average term to maturity of about three years. Such a positioning reflects the industry’s preference for a high degree of liquidity to deal with unforeseen claims. However, it has been our experience that companies frequently overestimate their liquidity requirements. As long as a reasonable weighting in cash equivalents is maintained, and the average maturity is appropriate to the nature of the associated liabilities, we recommend that companies consider holding some bonds of up to ten years in maturity within a well-diversified portfolio.

At the time of writing, the Canadian yield curve is very “flat”, meaning that a switch from a three year Canada bond to a ten year Canada issue only adds about 15 basis points in additional yield. However, there have been periods in recent years when this shift would add a very material 100 basis points in yield enhancement.

Add to Provincial and/or Corporate Bonds. In a bond bull market, a portfolio consisting only of Government of Canada bonds can generate very attractive returns, particularly if the bond manager has some success in forecasting periodic interest rate swings. However, in today’s low and relatively stable interest rate environment, many insurance companies are looking to hold provincial and corporate bonds in an effort to boost investment returns. This strategy can produce good results (see chart, next page), but it must be remembered that the decision to diversify away from strictly federal government bonds requires that the investor have a solid credit analysis capability. Such a capability can be developed “in house”, or acquired through the hiring of an experienced investment management firm. Credit research is essential even when investing in provincial bonds, where the risk of default is very low, since any change in a province’s creditworthiness can have a material impact on investment performance.

Adopt a More Active Trading Approach. “Buy and Hold” has been the credo of many of the world’s most successful investors, and has traditionally been the investment posture of Canada’s property and casualty insurance industry. However, buying a three-year Canada bond today and holding it to maturity guarantees a return of approximately 5.50% per annum. Many companies find such a return inadequate in today’s competitive marketplace, and are willing to consider more active investment management. The decision to adopt a more active trading approach carries with it a significant amount of additional risk, however, and should only be done when the following are in place: the portfolios must be managed by an experienced professional with an established track record. Active management cannot be prudently done on a “part-time” basis. Secondly, reporting systems and business results measures must be consistent with a “total return” investment approach, rather than simply an “investment income” basis. What is the point of generating trading gains if the results measure only track interest income? And, most importantly, specific parameters governing trading activity have to be established to prevent unanticipated tax consequences or significant potential capital deterioration.

Review the Asset Mix Strategy. Every investor, whether individual or institution, should review their mix of bonds, equities, and cash equivalents on a regular basis to ensure that such a combination is appropriate for their investment objectives and constraints. This review can also highlight opportunities to improve investment performance. For example, a property and casualty insurance company may discover that its balance sheet is sufficiently strong to allow for an increase in equity exposure. This shift may improve the potential for enhanced long term investment performance as equities have historically been the best performing asset class, although bonds have generated the best returns in Canada since the early 1980s. It is important to make sure that the asset mix review is done in the proper order: begin with an analysis of the investor’s objectives and constraints, and then proceed to construct an appropriate asset mix. Too often, investors look at the best performing asset over the last year or two, and then search for a justification to “squeeze” an additional exposure to this asset into their portfolio mix.

Ensure that Business Plans Reflect the Low Rate Environment. All of the suggestions outlined above offer the potential to add incremental investment yield to a property and casualty insurer’s portfolio. None of these alternatives, however, can magically transform today’s interest rate environment into the high rate world of 1981. It is therefore vital that insurance managers use realistic interest rate assumptions in their planning decisions and actuarial calculations. Any interest rate forecast that assumes a yield on high quality bonds higher than 5% to 7% should be viewed with skepticism. Double-digit interest rates will only return in association with an unlikely substantial resurgence in inflation. And that would create a whole new set of challenges.