Clients that have reduced, or deferred, planned increases in their interest rate hedges have been motivated by short-term tactical and opportunistic considerations. When taking such active views in their fixed income hedging portfolios, we educate our clients on sizing the risk of the active view—e.g., consider sizing the deviation in duration exposure to be in line with the duration deviation limit that would ordinarily be given to a third-party active manager having an equivalent-sized portfolio. The intention is to seek a balance of active risk-taking in the portfolio, so that no one active view is dominating the investment outcome. The hedging portfolio is often so large, and sometimes augmented with leverage, that what seems like a modest shift in positioning can still be a very large active risk in comparison with other active managers in the portfolio.
It’s also important to note that while the level of interest rates is low, interest rate volatility has not declined by a proportionate amount. For example, in the mid-1990s, US 10-year Treasury yields were around 6% and today they are well inside of 1%. Yield volatility was 90 to 100 basis points (annualized) in the mid-1990s, and is around 70 basis points (annualized) today. A ten-fold reduction in yield levels was accompanied by a reduction in yield volatility of only around one-quarter. Also, while US rates have declined to unprecedented levels, rate regimes in non-US markets are lower still, with 10 year UK gilt yields approaching 25 basis points and 10 year German bund yields near negative 50 basis points.
We do not expect longer maturity US Treasury yields to fall to negative territory, but should this occur the trade-off in such an environment between reducing rate-related risk and the cost to do so may lead to changes in our views on corporate credit allocations. In a negative rate regime, US pension plans may wish to consider transitioning from a strong focus on interest rate risk management to one increasingly focused on credit spread risk management.