August 2019

What are the alternatives to negative interest rates in CHF?

Gianluca Tarolli

Gianluca Tarolli

Market economist, Bordier & Cie

10 years after Lehman Brothers went bankrupt, the extremely accommodating monetary policies put in place by the major central banks are still effective. The Swiss Confederation has since then been financing itself at negative rates up to maturities of over 25 years (!), not without putting a crimp in the investment environment. Paying for lending is the new paradigm in which we operate. What effects does it have on our investment policy for portfolios in CHF?

More than 90% of sovereign bonds in Switzerland have a yield of less than zero. For an investor, this means paying to lend money… This anomaly is still far from being dealt with: both the Fed and the ECB have recently confirmed their intention to continue their very accommodating policy, dragging the SNB in their wake.

What then is the use of holding such assets?

Historically, sovereign bonds were yielding altogether safe, guaranteed and risk-free returns through a coupon. At the same time, they were also protecting a multi-asset portfolio. In addition to the coupon, they were actually offering a capital gain when interest rates were slipping down amidst fears of economic growth and that the prices of risky assets were falling
(Graph 1: 2008, 2011 and 2018). Today, as long as the maturity is long, the potential capital gain still exists if there is a recession. But a cost is henceforth attached to this assurance, which is precisely negative return. It is therefore quite possible to earn money on negative- rate bonds, as long as they will not be held until maturity (Graph 1: 2015, 2018, 2019). The «buy and hold» era is behind us, and a more dynamic management approach is required. Indeed, the absence of coupons opens the door to greater potential capital losses in the event of recovery of interest rates (Graph 1: 2013 and 2017). In the long run, the usefulness of such bonds will therefore lie in their role as a performance stabilizer if activities were to dwindle drastically. In a worst case scenario, their carrying cost can be assimilated to insurance coverage taken against the risk of deposit in case of bank failure.

In this environment, holding cash costs 0.75% per annum. It must be seen as a pool of ammunition that can be mobilised very quickly to take advantage of asset-price dislocations, which will certainly occur in the future. Despite the risk of additional credit (quality corporate bonds that will reach maturity in less than one year), money market funds unfortunately do not succeed in sufficiently increasing the already negative return. Unlike cash, they can still serve as bank deposit insurance.

The first alternative to negative sovereign returns is to move the cursor to higher loan risk, and then to corporate bonds. But since the returns offered by the better quality credit are close to zero, the best opportunities are in the «BBB» category, which is the low end of the quality credit (Graph 2). More complex hybrid bonds («coco’s», «covered bonds») also hold value. In all these cases, a thorough credit analysis is indispensable to limit volatility and ensure satisfactory quality selection. This is the reason why Bordier & Cie acquired research skills (credit) and bond strategy («Bordier Enhanced Yield» management mandate) in early 2015.

Sovereign bonds issued by emerging countries in USD (or EUR) represent a risk-adjusted source of return that we consider attractive. Less risky than high-yield corporate bonds, they offer coupons large enough to cover the monetary risk involved and retain attraction (return of 6% in USD, so around 3% in hedged CHF).

Graph 1:
Swiss assets - Annual performance in CHF

Against the backdrop of low interest rates, the dividend paid to shareholders becomes a useful source of return, while the valuation of the asset class remains historically affordable in relative terms (Graph 2). If we take some key values of the SMI index, such as Nestlé, Roche or Novartis, we note that they finance themselves at 10 years at -0.15% and zero respectively… while paying shareholders a dividend of 2.7%, 3.2% and 3.4%! From a long-term holding perspective, the expected performance gap in favour of equities quickly becomes important. Even volatility, detrimental for being higher in the short term, is more acceptable in case of long-term holdings! In more general terms, and beyond the simple accumulation of shares paying high dividends, selected companies on the basis of fundamental criteria of durability of the business model, experiencing economic cycles with cash flows that are consistently positive, showing high profitability and reasonable leverage, are especially beneficial to the low interest rate environment and modest overall growth. Bordier core-holding, the preferred investment style in equities is perfectly in line with this approach and makes it possible to better control the volatility associated with the selected shares through a true fundamental analysis.

Finally, assets that are less traditional than bonds or equities, which we call «exoplanets», are also investments to integrate better into our allocations.

The family of structured products offers a panoply of almost infinite investment solutions, both in terms of the nature of the underlying assets (bonds, equities, raw materials and currencies), as well as on the direction (upwards, downwards, even stability or dispersion) or the lever or commitment period (from a few months to several years). More specifically, the reverse convertible segment transforms a traditional asset into a source of return. It is indeed possible to subscribe for a fixed term to a «reverse» on a basket of shares or indices and receive in return a guaranteed coupon and known in advance. This provided that the price of any underlying assets should not at maturity be lower than a threshold, which is also defined in the initial contract. Otherwise, the investor will receive at maturity the underlying asset that has lost the most and will therefore incur a capital loss. The size of the coupon will depend on several parameters (loss threshold, duration of the product) including volatility: the higher the latter is at the time of issue, the more the coupon will be bounteous. The ideal timing to access this type of investment is therefore when markets go through periods of turbulence accompanied by peak volatility. Finally, the choice of a financially-sound issuer will be part of the prerequisites required for this type of investment.

If the cash needs are modest and that an investment can be kept in the long term (7-8 years), the so called «private»  investments offer particularly attractive yield prospects. They exist on the debt (loan, project financing, infrastructure, etc.), with the advantage of being older than traditional corporate bonds. In addition, they record a default rate comparable to quality credit but with a better return (2-3%). Private equity (unlisted shares) has long been reserved for very large investors (entry ticket above CHF 5 million), mainly institutional investors. The asset class has since then been democratised and it is now possible to access it for smaller amounts (CHF 150,000) with Hermance Capital Partners, the fruit of the strategic partnership between Bordier & Cie, Banque Pâris Bertrand and Banque Reyl in this sector. The investor undertakes to finance concrete and well-defined projects (business development, real estate or other projects) and to liquidate the investment once the asset has been executed (through an IPO, by its transfer to an industrial stakeholder or another Private Equity player). To ensure a satisfactory degree of diversification, we recommend investing in these assets exclusively through investment funds (no more than 5/10% of the total portfolio). For this type of investment, the traditional notion of volatility loses its relevance because it fades away over time. For the same reason, the timing will be less decisive for the final performance, but this does not mean that the financial commitment is risk-free!

The low liquidity available in hedge funds is no longer their main shortcoming. Significant efforts have been made by the industry, which now makes available funds that can be released not only on an annual or quarterly basis, but also weekly or even daily. This being the case, the decision to enter this asset class must be made in the long term so as to benefit fully from the most successful strategies that fit in the long term. For the sake of portfolio diversification, we will favour the decorrelated strategies of the markets management office («market neutral» for example).

Finally, listed real estate seems the most logical alternative for investors whose investment horizon is particularly long. Hence the interest, even the euphoria, it exercises with Swiss pension funds (some hold about 30% of their allocations) with the 2-3% yield it releases. In Switzerland, direct investment funds enjoy a tax advantage, which has to be considered. Even if the fund is listed on the stock market, the underlying asset remains illiquid and the time horizon must be in line with it (spanning several years). This being the case, the potential seems to have reached its limit, especially as the Swiss National Bank is worried about household mortgage debt and, without wishing to reduce property prices, it wants to limit their increase in numbers.

Graph 2:
Swiss assets - Return by asset class

(dividend return for shares)

Although atypical, the negative interest rate environment promises to be sustainable. Yet, there is no equivalent to the risk-free asset. As a result, sacrifices on the credit quality, volatility, cash and/or investment duration must now be integrated into the portfolio construction process. This financial repression orchestrated by central banks pushes investors out of their comfort zone if they want to maintain a satisfactory return. Be careful not to pile up the risks and the correlated assets! To be considered balanced, a portfolio will therefore still need sovereign bonds, even at negative rates.