Speaker 0:
hello and welcome to this institutional round table where we will be discussing yield curve strategies. Today, I'm joined by Mara Dee, unlisted investment manager at the Government Employees Pension Fund. So Harris, head of fixed income at Sense Capital, as well as Trevor Abramovitz, head of liability driven investments at the Old Mutual Investment Group,

Speaker 0:
Welcome to you all. Thank you, thank you. So yield curve strategy is quite a technical topic within fixed income. Trevor. Why are long dated fixed income instruments appropriate for institutional investors such as pension funds, banks and insurers?

Speaker 1:
So if we look at the different types of institutional investors, they all have different forms of liabilities. Banks, for example, will have the liabilities that they have to their depositors.

Speaker 1:
Insurance companies will have liabilities in the form of making sure that they're able to pay claims related to disability benefits or to life claim benefits. And they can have very long data liabilities in respect of their annuity funds. Uh, DB pension funds, for example, very defined liabilities

Speaker 1:
respect to their pensioners, which may stretch many years into the future. Fund contribution funds also in fact, have liabilities. These liabilities are slightly more nebulous. They're represented by the retirement income requirements of an individual, and these also stretch many years into the future.

Speaker 1:
Even a high net worth individual, for example, could have, um, their income requirement to live comfortably thought of as as a liability. They may have, um, their bequest motive, how much they want to leave to their their heirs as a certain rand amount, which can be thought of as as a liability. And each of these type of investors, uh, and their respective cash flows

Speaker 1:
have a cash flow structure that resembles very closely the cash flow structure of a bond so liability can actually be thought of as a tailored bond. And if you are valuing these liabilities using the yield curve, then a bond or long dated, short dated fixed income instruments are a very good match for these type of liabilities.

Speaker 0:
So marilla you at the Government Employees Pension Fund, one of the few remaining defined benefit pension funds are left in the country. How would you employ the use of some of these fixed income instruments to manage manage the liability payments that you have due to your pensioners? So in a sense, as Trevor did touch on, uh, with DB funds effectively, you need to guarantee a pension, at least for the pensioner.

Speaker 0:
That's being through monthly payments, at least that a fixed amount. Correct. Now, in order to achieve that, you actually need to take on assets that have a similar duration at least at least the same duration to match that. But also just considering. Then, you know you need to account and manage, um, interest rate risk one and then inflation risk for the actual pensioner as they go into retirement or pension, because that is a big thing. And in doing so, you would need to actually take on a level of assets where you match it, almost 1 to 1 with the liabilities that you have on the book,

Speaker 0:
such that you know, you minimise at least any extreme fluctuations towards the end. The pension at least walks away with a full package of that, and you know, that's that's how you utilise that particular those yield curve strategies. So I mean, there are a number of strategies you can use to actually get to that point, but the one that comes to mind is a laded sort of strategy where you take on assets that match certain cash flows at certain points in time.

Speaker 0:
And I think that's that's how you sort of employ those kinds of strategies. I think before we get on to the barbell, um, bullets and lad strategies. I just want to lay a foundation of the relationship between assets liabilities as well as how they move. Um, with regards to

Speaker 0:
changes in interest rates. Yes, sure. So, I mean, as as we all know, uh, as as interest rates move higher, the asset values drop, and and, uh, and the same goes to, uh for for the liability structure. So, uh, what we've seen over the last year central banks hiking interest rates quite a bit now. You know, uh, the feds hiked by something like 475 basis points. Interest rates have moved up by quite a bit, and that would have decreased asset values.

Speaker 0:
So, um, if your fund wasn't, uh, hedged, uh, as as my previous colleague had had had said, uh, the asset duration would have been less than like liability duration, so you would actually gain there because the liability values would have dropped more than the asset values there. So if you were an active fund manager and you took that view of rising interest rates and wanted to be underway duration

Speaker 0:
you, you would have gained a little bit of surplus there. And also vice versa. If you expect interest rates to fall, uh, the asset values, uh, would rise the same with liability value. So it also depends on your active interest rate view where you see interest rates headed. And that's how you'd go about structuring how matched you want to be, uh, of of your assets

Speaker 0:
versus the liability structure. Thank you, Sand. So, Trevor, what is the importance then of defining these liabilities and understanding an institutional investors liability profile? So, for example, with the bank and a defined benefit pension fund, those two liability profiles are vastly different. Absolutely.

Speaker 1:
Look, we believe that liabilities are everything. They are the premise of your whole investment strategy. And if I take it, you know, very simply to, um, say a commitment that

Speaker 1:
I may have to you, for example, of, um, I, I say 100 and 10 rand in in a year's time. Uh, let's imagine that rates are are 10% now, Um, and I've got 100 rand. So I know that if I take my 100 rand and I invest it at the 10% I'll be able to pay you back 100 and 10 rand in a year's time. But

Speaker 1:
let's say for some reason I deliberate on the the strategy, and I don't invest in that one year, 10 year, 10 10% rate. And I leave my money under my bed, for example. And then, well, there's a change in interest rates overnight. And let's say there's an extreme change in rates dropped to 9%. Then I wake up in the morning and I decide, OK, so let me take that 100 rand and put it on the one year rate. But now the one year rate is only 9%. So in a year's time, then if I have invested in that

Speaker 1:
in that one year rate at 9% I'll only have 100 and nine rand. I'll be one rand short. And so when we think about

Speaker 1:
immunisation duration matching all of these, these technical concepts we think about what is my obligation? What is my my my promise. What is my commitment and what is my risk of falling short of that ultimate commitment and all these types of investors? Institutional investors? Individual investors need to think about their obligations, their commitments and their liabilities when formulating their investment strategy and build the investment strategy around it. Thank you very much, Trevor.

Speaker 0:
So I think it's quite important. I think there's been a few unique terms that have been thrown thrown around today, immunisation being one of them when it comes to hedging this interest rate risk when interest rates rise, assets and liability values fall when interest rates fall, um, assets and liabilities move in the opposite direction. So take us through what immunisation actually is. Immunisation is effectively mitigating the risk of, you know, significant movements, at least in the book that you hold, be it assets or liabilities in that regard.

Speaker 0:
Now, if you look at it in that aspect, you have to look at how then you'd you'd approach that with the A l M model. At least, uh, when it comes down to L. D. I two, you'd be looking at interest rate risk that you need to manage for right, as well as in the case of a DB fund. As I did mention earlier on inflation inflation, which would affect in the long term the pensioner. So in that regard, you know, you can go through one method which is duration, uh, matching, which was mentioned early on, where you effectively take

Speaker 0:
or take on assets that have similar interest rate, uh, sensitivities to the liabilities.

Speaker 0:
In effect, you know, as via did point out in that case, you minimise. You know the fluctuations, at least in the assets that you hold, or and then you can cover the liabilities in that regard with the cash flow matching, which is which is the second one, at least for second form of, uh, hedging in that regard is that you take on securities or assets with similar cash flows or the same cash flows as the liabilities,

Speaker 0:
meaning that from three years from now, if your liability requires you to pay 100 you have an asset that also pays 100. And that in itself covers off the inflation risk. And that's you know, you don't see a lot of exposure in that regard. Each has its own you know, merits and de merits, but I think at a at a high level, that's that's what I can touch on.

Speaker 0:
So then Sana immunisation from my understanding then, is a perfect hedge, right? For for interest rates, hedging interest rates and inflation risk. Is there an opportunity cost to immunising? Yes, like, uh, like I had answered earlier on. So if you go uh,

Speaker 0:
uh, if you're going to immunise, you basically hedging out interest rate risk. And by doing so, you're giving away your upside. Uh so, like, like I said earlier, if interest rates rise And if you you go and immunise uh, you would have lost a relative if if you took the view to be underweight duration or, uh, duration match re, uh, relative to your

Speaker 0:
to your liability stream there, Um, so that's that's the cost that you you go and give, uh, give up there. But the positive is, uh, obviously that you know that you hedged against extreme interest rate movements because, for instance, if you weren't hitched and, uh, interest rate fall by 11 or 2% and you are underway duration you, you would actually incur quite a bit shortfall that maybe the plan sponsor the con contributors would would

Speaker 0:
have to pay for. So there is a little bit of give and take And, uh, by going, going and hedging out interest rate risk and other risks, you go and, uh, give away the upside returns. But you are limited in terms

Speaker 1:
of downside. So So if I can just jump in there, um, if you follow an immunisation strategy, you don't necessarily lose out on the upside because you can still hold the requisite bonds that have got the the right duration and the and the and the right convexity.

Speaker 1:
But you can also employ those in certain credit strategies both in the listed and unlisted space to give you additional yield over and above the government bond curve to capture some of that upside. So it really is a balancing act in terms of where you want to fit on the, uh, risk continuum in terms of trying to achieve your your goals and

Speaker 1:
immunisation is is something that can be thought of very much like the the global topic of immunisation. When you think about in the medical world, protecting yourself against viruses in the investment world. Immunisation is about protecting your portfolio against interest rate changes.

Speaker 1:
You can still achieve growth targets within a well constructed risk budget, knowing what risks you're hedging at and what risks you are capturing through very well studied and well researched risk Premier

Speaker 0:
So Trevor. To continue on your point,

Speaker 0:
you can either overhead or under hedge. Now, in my mind, hedging is to remove risk. But over hedging and under hedging sometimes exposes you to certain risks. What are the means then of over hedging or under hedging, without having to liquidate or purchase the underlying, um, fixed income security?

Speaker 1:
So one of the mechanisms to um

Speaker 1:
not have to purchase the underlying securities is through, uh, derivatives, whether it be futures, forwards, repo swaps and these transactions allow you to buy bonds. For example, in the the future at a price that you'll agree today and because you've contracted for that that future purchase, you've got economic exposure to the bond.

Speaker 1:
It does mean, however, that you're able to use the the capital to employ in alternative strategies to provide, for example, additional yield. Or as we saw in the UK, which probably leads to one of the big reasons that we saw the UK l d I crisis was using that additional funding to buy more government bonds.

Speaker 1:
Good strategy. If all goes well, their strategy if those government bonds are, are falling in value. So using a derivative strategy or Deri derivative overlay allows you to do portable alpha. It's not necessarily without its risks, but it does allow you to be able to hedge out or buy the necessary bonds to, as you say, get that perfect hedge in place.

Speaker 0:
Thank you so much for explaining that to us. So marilla once liabilities have been hedged Now either through,

Speaker 0:
uh, David says overlay or selecting the underlying, um, fixed income assets and through immunisation how would a defined benefit pension fund then earn Alpha? I know the GP. F is sitting at a funding ratio of you mentioned 100 and 10% that is our funding ratio and basically saying that you know, our assets are 100 and 100 and 10 times percent more than our actual liabilities, which in fact, is a good thing.

Speaker 0:
Um, now, to get Alpha, that really depends on how you then employ the investment strategy, right? And I think in this regard, you wouldn't want to invest in a fund that remains flat over the duration of its of its lifetime. Of course, you are affected by a number of factors, too. And in that regard, you know, you then take on what is seen as strategic asset allocation, which we employ in the portfolio. So you then invest in equities bonds offshore, onshore. You know, uh, property, property stocks, too.

Speaker 0:
Where that exposure, outside of least of bonds and matching the duration to gives you a bit of alpha too, you know, And I think that's that is the most important thing as the markets rise. You know, at least you capture that, too, as opposed to, you know, completely hedging yourself out.

Speaker 0:
So now, going on to the shapes of the yield curve and the strategies, um, for investing what typically drives the shape of the yield curve. I I know we've been seeing, uh, quite a significant change now, most recently in the shape of the curve. What drives that change? Sure. I mean, there are several factors, but I think the major ones have, uh, have to do with

Speaker 0:
economic growth, monetary and fiscal policy. And, uh, so far I mean, um, post covid, we've seen a lot of that, uh, go go wrong in terms of central banks. I mean, they've been getting that whole whole in inflation core wrong. I mean, the Fed was going about talking about transiting inflation for quite some time, and they got got that core right. I think it was mainly sparked because of the Russia Ukraine war supply chain issues. And that kind of led led to inflation increasing well, well above, uh, central bank targets now,

Speaker 0:
um, and that actually informed, uh, a much

Speaker 0:
more hawkish central bank tone. So they had to go about and hike interest rates aggressively, something that they haven't done for, like the last 30 40 years. And because of that, it's, um

Speaker 0:
it's affected the shape of yel curves. Generally, you would see an upward sloping yel curve, so you get short, medium and long data rates shaped that that way. But now, because, uh,

Speaker 0:
central banks have hiked interest rates high. What? What, uh, what you see is the short debt interest rates are actually higher than your medium and long debt. rate. So you actually have an inversion of of the yield curve. And unfortunately, in previous episodes, I think, uh, six out of the last recessions were

Speaker 0:
predicted by in

Speaker 0:
inverted yield curves. Now, and if you look at the shape of the US yield curve now, it's highly inverted. And unfortunately, now it's indicating that recession risks are quite high. And, uh, yeah, we we as a house have have have become a little bit more defensive in that in that way. But, um, yeah, going, going back to your question. It's mainly driven by monetary and fiscal policy as your big driving factor. And within that the economic risk and inflation.

Speaker 1:
And also just just to add to what is saying. Certainly that expectations theory where you ex expect long term rates Being an indicator where future short term rates should be is a big a big driver of what, uh, ultimately the shape and form of the of the yil curve, but also things like, uh, liquidity preference there.

Speaker 1:
So as an investor that is committing my capital for the long term, I need and demand a a reward for committing my capital for the long term as opposed to holding it for a shorter term, which means that there should be some steepness to the yil curve, which is reflected by the term structure or term term premium in the term structure.

Speaker 1:
You've also got, uh, theories called, uh, market segmentation theory, which says that different investors will invest in different segments of the curve and that will ultimately drive the movement and shape of activity in that curve. So, for example, DB pension funds very, uh, big holders of long term bonds and

Speaker 1:
and their supply and demand of long term bonds will drive the shape in the long end of the curve as opposed to, uh, shorter term investors that may be more active on the short side of the the yield curve. So it's all these factors that ultimately drive what we see in the movement of the yield curve on a a day to day basis. So,

Speaker 0:
Mara, there've been some rewarded risk factors that have been mentioned by Trevor. Are there any other risk factors that, uh,

Speaker 0:
feed into the return profile of a fixed income portfolio? I think as you you actually touched them a lot of them, but you know liquidity being the key being the key one, right? Uh, especially if you are looking at longer data government bonds. You need to make sure that well, the government, or at least Treasury needs to make sure that there's an auction to at least offload these securities onto the market of which they absorb them by fund managers such as

Speaker 0:
and, you know, just trading that continuously in the market. Of course, when the C eels rise and drop just for their own benefit and the benefit of their portfolios, Um, and I think that that for us is a very key risk to control and manage in that you want to make sure that you do have the necessary cash flows, or at least if you get dividends and interest something in the back pockets to cover your obligations

Speaker 0:
as they occur as and when they occur. OK, so now, looking at the shape of the yield curve, we've seen this inversion of flattening, should we say. But now what happens when you have an expectation that there's going to be no change in the yield curve? How would you earn, um, outperformed? Uh, performance returns, um, in A in an instance, when we see no change in the yield curve, Yeah, um,

Speaker 0:
it would be great if I would be able to forecast yield curve changes and know that that it's gonna remain the same going going forward. And if that was the case, then you'd obviously buy the highest yielding instrument there. And you just bank on the yield or carrier some some, some people know it. And if if the YEL curve stays the same, you also get this effect known as the roll down effect. So the bond becomes shorter, it rolls down the yield curve. So you actually

Speaker 0:
get a little bit of capital gain coming through as well. So you so you'd get your capital gain and then you'd get your annual yield pickup. So in terms of assuming the yield curve stays constant, you just go and you buy the highest yielding instrument roll down. Assuming that it's upward sloping, of course, Yes, that if we looking at a flat, flatter yield curve now, are we not getting much roll down return then? Trevor.

Speaker 1:
So So I mean, looking at the the current inflationary bond, uh, curve. It's pretty flat from the 10 year point out, uh, need to be therefore very careful around what bonds you you're selecting in the in the in the short term. Um, for us, it's all about, uh, what is the carry on the liabilities versus the the carrier

Speaker 1:
on the on the assets. Uh, and making sure that those are are in in line, um, and then understanding where you bought, uh, the bonds. So if, uh, you see that, uh, spreads have have tightened there is an opportunity for you to, uh, liquidate to be able to make a profit on that and then

Speaker 1:
be able to invest in more, more attractive assets. Conversely, if you see, uh, yields, uh, rising, then you may not necessarily sell out of the asset and, uh, ultimately hold the asset until until it's maturity and then ride out that that term pre to the full.

Speaker 0:
So the term carry has been mentioned. What exactly is the carry? Trade me. So there are two ways of looking at it, as as we pointed out, you know, the carry is what you effectively hold. And, uh, you may correct me if I'm wrong as well. I'm not as as experienced as you hear. But, you know, the carry is what you hold effectively from that bond without really trading it. So

Speaker 0:
to carry trade. And that's again. You hold it to a point where you you benefit from the yield over that period of time. You're not actively trading in and out, as you'd find, perhaps on the desk of a bank, right. So you would ideally look to, you know, um, I think, yeah, just you might be the expert. Yeah, no. So So so, yeah. I mean, just just to expand on. What

Speaker 0:
what Mala has been saying in terms of a carrier trades it. There's there's there's different ways that you can define it. Obviously, it's the yield pickup that you get holding the bond. The secondary is kind of known as a spread trade. So you take a view on one particular yield curve versus the other, and then you lock in the in the interest rate of different range of like like you mentioned. So, for instance, we we would buy a government bonds and then we'd sell, for instance,

Speaker 0:
Japanese 10 year bonds because the Japanese ten-year bond is extremely low. I think it's offering half a basis for half uh, half, half a percent yield versus our ten-year bond at 10. So you'd you'd want to lock in that that additional yield. OK, so we've spoken about carrier trades, spoken about immunisation duration, matching etcetera.

Speaker 0:
So now I'm looking at the shape of a specific yield curve. Now, when it comes to matching the duration of the assets and liabilities Trevor, take us through. What are the different strategies? Um, with the bar, bowel ladder and bullet strategy.

Speaker 1:
So with a bullet strategy, what you're gonna try and do is you're gonna try and get the assets in your portfolio to have the same duration as the liability duration. So if my liability duration is, say, 10, I'm gonna be holding bonds that have got a very similar, um, average duration as the liabilities of of 10 and, uh, a barbell strategy.

Speaker 1:
What I'll do is I will hold, um, certain bonds with a much shorter duration. So to keep things simple and an example maybe a duration of of five, and then I'll hold the the second grouping of bonds with perhaps much longer duration, maybe 15 20 for example, um, on average, then the duration will be around 10, depending on what proportion I hold those those two groups of acids in. But essentially, what I've done by creating this barbell strategy is I've created a strategy that's got higher convexity.

Speaker 1:
And this allows us if the, um there is volatility in the yield curve i e. If the yelk curve moves up in a parallel fashion or down in a parallel fashion allows us to to make profits from a bar strategy.

Speaker 1:
If, however, uh, we expect, like we were saying, perhaps the the yield curve not to change to to to to remain then actually, the the bullet strategy is going to give us a high expected return. Uh, and so if that was our view, we'd be holding the the bullet strategy instead of the the bar

Speaker 0:
strategy. OK, so, Trevor, you've mentioned our convexity another unique term, um unique to fixed income investing. So

Speaker 0:
has mentioned before that parallel shifts are a lot more common than non parallel shifts. When it comes to yield curve changes, why is a bar bell strategy when relating to Convexity preferential

Speaker 0:
when we experience a parallel shift in the yield curve.

Speaker 1:
So to understand that we have to understand Convexity. So when when we look at Convexity, we are trying to understand the curvature of the relationship between the bond price and the yield. And the more,

Speaker 1:
uh, parabolic that relationship is the better. So we actually want the

Speaker 1:
relationship between the the the bonds and the and the liabilities. Um, to be such that the the bonds have got, um, higher convexity than the liabilities. This means that if you've got a fall in your, uh, yield, then the bonds will rise by a higher amount than the liabilities and vice versa. If you've got the yields that are increasing, your bonds will fall by less than the liabilities. And that's what we have when we when we have got Convexity in our relationship between our assets and our liabilities.

Speaker 0:
OK, so then, in a DB plan scenario, you've got laded liability added liability profile. How does the convexity differ then, between a bar strategy and a added strategy. So, as as I said going back to the original phrase that I used earlier on the latter strategy in itself is where you effectively match cash flows at different time periods by taking on the ass that at least pays that out.

Speaker 0:
Now, in terms of Convexity, you would want to make sure that you are somewhat protected, at least from, you know, increases in the yield well in in interest rates. In that regard, such that you know, you minimise at least the downside but also try and maximise the upside in that regard. And

Speaker 0:
with the barbell strategy, it's It may not make a lot of sense, given the profile, at least of our members, too, right? You'd. Of course, you might assume that, you know, everybody leaves at one point in time, but that's not always the case. The member leaves, you know, on average, that's I'm not quoting the number directly from the from the report, but it's hypothetical. You know, you could have 100 members leaving per year, and you need to match that as you go. So, of course, where you have instances where the interest rate rises extremely, so

Speaker 0:
you know, you need to make sure that you cover yourself and the pensioners in that regard. So the bar strategy, in that sense would not actually make sense. So the ladder is the one that is preferred over time, favouring. You know, uh, Convexity towards the assets, at least such that you're not negatively affected by an inflation and the value of the bonds of the liabilities as well. Ok, thank you so much for a

Speaker 0:
so Sana. We've mentioned that parallel shifts are more common than nonparallel shifts. What we've been seeing now is an uncommon nonparallel shift in the yield curve. What strategy would be most favourable considering the yield curve that we're facing locally and perhaps in the US as well?

Speaker 0:
Yeah. So I mean, um, generally, according to the research that that that we do with sent you and something that I've done in my PhD as well is that, uh, you see

Speaker 0:
parallel shifting occurring a lot more during normal times. But then during your high macro risks environments like we've seen over the last, like, uh, uh, one or two decades like your, uh, two thousands dot uh uh dot com bubble. Uh, G f C uh covid Russia Ukraine crisis. You see a lot more of these nonparallel shifts occurring, right? So that's where your short medium elongated, uh, yields move by

Speaker 0:
differing amounts. And, uh, if that happens, um, you have to be very specific about where where you want to be on the curve. And with the the US curve, for instance, we've seen a lot of flattening. So your short term yields have increased a hell of a lot more versus your medium and your longer dated yields hence that in

Speaker 0:
inverted yield curve there. So if you were sort of positioned for a barbell strategy there, so you generally

Speaker 0:
it's a term that fix fixed income managers use is where they're holding the wings. So the short and the longer dated bonds you would have actually underperformed, uh, relative to if you had a, uh, bullet strategy there because on average, your or the average yield between your short and long,

Speaker 0:
uh, Deb bonds have actually increased more than your medium dated bonds, and then you would have underperformed. So in terms of a flattening scenario that we've seen currently, you actually would have been better positioned for, um, a

Speaker 0:
bullet strategy. Um, sorry. Let me go back. Um, so, in terms of a rising flattening, So there's a term also that's called be flattening, where yields rise and Then the yield curve flattens. You would have been better positioned for a bar bell was the bullet strategy.

Speaker 0:
Um, but if if we see interest rates for so, for instance, central banks decide to cut interest rates now, your short debt yields will rally a lot more, and you would get some benefits in your medium and longer debt bond yield. So on average, your short and long debt bond yields would rally or drop more than your medium Deb bond yields. And in that case, barbell,

Speaker 0:
uh, a bubble strategy would be suited over a bullet strategy. So you have to take into account the macro views in terms of monetary policy and interest rate changes now. And as I mentioned, you have to take into account whether you're in a normal risk environment or a macro, uh, risk environment because of the shape of the Yoko. With with whether you're gonna see a

Speaker 0:
a lot more parallel shifting or whether you're going to see a lot more non parallel

Speaker 1:
shifting of the and obviously that can change in the blink of an eye, it can change from normal to highly volatile, and what you'll see then, if that changes very quickly is you'll see a whiplash effect. You'll see the curve spike. And so being in, say, a barbell strategy there, having exposure to elongated instruments can really hurt your your portfolio, particularly if you've got defined commitments over the regular term, where you have to make sure you're able to liquidate it at the app rate

Speaker 1:
and therefore having a close matching. Talking about that latter strategy, for example, could ultimately play dividends. If that is, um, your mandate, as as an investor to make sure that you need and can meet your commitments to your your pensioners or to or to your new.

Speaker 0:
So I just want to understand. Then so

Speaker 0:
say, for example, a. A laded liability profile is what the um GP f has. How would you match your

Speaker 0:
assets and portfolio duration with your liability portfolio duration when they're all of differing durations.

Speaker 1:
So without trying to, um, speak for the GP f I, I don't know their their strategy in in in a particular detail, but I think that the overriding concept will be to say that with any defined pension defined benefit pension fund, you've got a stream of of cash flows. There are not enough bonds in the market place to be able to buy a bond that matures at every single point when there's a cash flow. So you have to do, uh, some element of duration hedging, making sure that the duration of your asset portfolio is appropriate for your liability.

Speaker 1:
There's a whole other range of of techniques that you can use. You can use PV 01 or rand per point hedging. Ultimately, you're trying to make sure that whatever my interest rates do to my liabilities, my asset portfolio is going to move in the same way. And one of the key things to factor in is what is my liquidity like? So if I have to make regular commitments to my pensioners to my investors, I need to make sure that in my asset portfolio, it's also sufficiently liquid.

Speaker 1:
And by doing that, by managing the interest rate, risk the inflation risk by investing in the appropriate inflation bonds and by managing the liquidity risk, you're able to achieve many of the objectives of a defined benefit fund. Like I imagine that GP f would be aiming to do

Speaker 0:
correct, and I think an alternate sort of solution, at least to add on to what you have there, uh, is that you can also employ the use of derivatives, right?

Speaker 0:
Specifically swaps where in, you know, you basically sell your cash flow and buy another cash flow, which in effect, can extend the duration of the asset that you have in your book, or at least bond in that case, to match that of liability. Um, you know, this this again depends on the fund that you're looking at their rules. You know how, what they tolerate in terms of derivative used to. But that's that's an alternate there. And yeah, I think,

Speaker 1:
just to add to that point, it also depends how you're valuing the liabilities. Because if your liabilities are being valued using the government bond yield curve, then investing in swaps could create basis risk because the the swap curve and the bond curve may not necessarily move in the same way, which can be perfectly allowable in terms of your investment strategy.

Speaker 1:
But the client needs to understand that there could be volatility there, recognise that it's a source of risk, and make sure that wherever the the cash funding is related to that. That swap, or that derivative is appropriately used to achieve the appropriate risk premium, and also to make sure that you've got sufficient cash to meet your liquidity requirements. So,

Speaker 0:
Mala, um, Trevor touched on some of the additional risks that the use of derivatives, uh, might introduce into a fixed income portfolio.

Speaker 0:
Are there any further risks that, um, you would take into consideration or try and mitigate? I think, uh so predominantly what I've spoken about, you know, you're trying to mitigate some of those major risks in that regard managing duration, managing cash flows, you know, And look, there are instances in which you can't hedge everything. I think that that needs to be said

Speaker 0:
in a perfect world, you probably could. But, uh, in reality, that's not always the case.

Speaker 0:
And I think perhaps this might go back to a point that, uh, Trevor had raised here. But, you know, in terms of matching assets and liabilities,

Speaker 0:
it's not always needed to exactly match you can allow. I think pension funds usually don't match exactly. You know, it's, uh, d BS, especially whereas D CS tend to be closer to to that matching effectively. And in that regard, you know you allow for some room for some risk, but to make sure you avoid that kind of scenario, you set yourself minimum funding level just to make sure that you are at the end of the day, uh, safe. And at least you can deliver on the obligations at the end of the day. Like I said,

Speaker 0:
with the GPS sitting at 100 and 10% with the minimum for the fund being 90% as stated in the annual report, you know other funds may approach it differently, targeting 100% to make sure that everything is covered.

Speaker 1:
May maybe just to add in terms of, um, taking on additional risk in a in a calculated fashion. Uh, we've spoken a lot about the government bond yil curve, uh, ways to essentially, uh, beat. The government bond yield curve is to invest in credit

Speaker 1:
because then you are earning a spread over and above that government bond yield. You are deliberately taking on risk by investing in that that credit opportunity. So you need to understand what is my probability of default. What is my loss given default associated with that particular type of investment. Make sure that you understand that in terms of your risk budget, If you are a type of investor like an insurer, make sure that it impacts your solvency capital in the appropriate fashion. Make sure that your return on that capital is appropriate for your investment objectives,

Speaker 1:
but it is very easy to dimension in terms of a calculated risk. It will help me achieve my long term investment goals that will add Alpha to a basic government bond strategy.

Speaker 0:
Absolutely. Thank you, Trevor. Um, and I think credit opens a whole new chapter of discussions with regards to the strategies around how you in in investment grade.

Speaker 0:
But I'm there now to, um, slowly but surely close off the session. How do the interest rate movements in the US influence the shape of the yield curve? Um, locally and in other emerging markets or developed markets? Yeah, so I mean, the way that we view the US, we see it as a global risk free rate. So the yields that they that that you get on US bonds, we view it as a global benchmark or standard, and then on top of that. You go and you add your risk premiums. Uh, namely being

Speaker 0:
the currency risk, premium and country risk premium. So then, uh, and and And that changes, uh, where you are in the world. So I think here in, uh, s a, uh So the current US 10 year bond yield is about, uh, 3.5% and our, uh, currency and country risk rates around around about 3.5 44% each, leading to a yield curve. Uh um, leading to a ten-year bond, uh, yields around about 10.5 or 11% there.

Speaker 0:
So when your base rate moves your US bonds, if that moves higher, obviously yields around the world will move higher. And vice vice versa. If the US yield drops, Uh,

Speaker 0:
but once once once again, there's a little bit of Catch 22 there. Uh, if you have, you have to understand why US US yields are drifting lower if it's drifting low because we're in a normal risk, uh, risk environment. Sure, yields throughout the world will drop. But if it's moving lower because we're moving into a high risk environment, meaning like recessionary risk. And that's seen as a flight to safety. Um,

Speaker 0:
currency risk premium credit. Uh, spreads around the world will start to widen. So despite your base yield moving, lower risk premiums are moving higher. So on a net effect your yield, especially in your high

Speaker 0:
or high beta regions, uh, will start to widen. All right, So you have to be, uh, wary of the risk environment you you are in, uh, but generally, assuming everything is normal, it moves. Vice vice versa. 11 for one. So if US yields up

Speaker 0:
across the globe are up and if they're down yields across the glo down. I think you explained that quite nicely. There. Thanks. Thanks, Cynthia. So, Trevor, recently, we've seen the fallout of Silicon Valley Bank, and there was an obvious mismatch in their assets and liabilities. How did they get the shape of the old?

Speaker 1:
In the case of Silicon Valley Bank, they they were a bank. That is, uh, relatively Well, uh, funded solvency was good. Um, the issue was a mismatch in the liquidity between the the assets and the liabilities they had locked away. Um, their their funding in, uh, 15 10 year, uh, paper, Um, and the depositors, their liabilities, uh, were very short. Um,

Speaker 1:
and once there was news around, um, the potential mismatches within the, uh, the bank, um, depositors wanted access to their funding in the world that we we live in now. Access to your funding should be at the click of a button. And essentially, rather than having a run on the bank with, uh, people standing outside the door trying to get their cash people on their their laptops on their cell phones, uh, calling their deposits in and because, uh, S V B had locked away their their funding for

Speaker 1:
15 10 year, uh, periods. Uh, because of the low interest rates in in in the US, they weren't necessarily able to provide depositors with access to to that funding. So really, it was an issue of liquidity biting and literally biting overnight because people have got access to their technology at the click of their their fingertips. And so

Speaker 1:
that is really a great example of how, uh, in today's day and age, um, you need to make sure that with news travelling so fast and access tech to technology at the at your fingertips. You need to make sure that your assets are property matched to your liabilities. Importantly, not only from an interest rate perspective, but also from a liquidity perspective.

Speaker 0:
So sorry. Just just just to expand on what, uh, Trevor was saying,

Speaker 0:
um I think as well the whole regime that we've found ourselves in post g f C where we had a low low interest rate and inflation regime forced Silicon Valley Bank and a lot of other banks. Like like, for instance, Credit Suisse. They actually seek higher yielding investments. And the way you go about that is, uh, taking on a lot more risk in terms of credit duration liquidity. And that's why, uh, they went out further into the curve, locked in their their assets and and

Speaker 0:
unfortunately, post covid interest rates and inflation started to rise, and it actually reversed for them. So they actually encountered a lot of losses in terms of their assets, and they weren't able to liquidate because they were such long, long term assets. And that kind of kind of compounded the the the issue with them. Any comments on the Silicon Valley Bank? So I mean or perhaps just the way that you manage, Um,

Speaker 0:
matching your assets and liabilities. I think, uh, I've I've gone into detail around that specifically, but with the S V b case, You know, uh, as as you would see, liquidity was an issue. And typically, I think with the bank, especially of that size with that client base, too, which are startups that require that kind of funding. It's always important. And I think we tie this back to the first question to consider the liability of the profile of your liabilities.

Speaker 0:
Where in in that case and I This is my take on it. But in that instance, they were being a bit speculative in that regard to which you can't do with depositors money. So you need to make sure that at least you can see what 6 to 12 months out just to see exactly what's what is coming through and to lock it in the 3 to 5 year sort of periods. That does not make sense at all, especially for that kind of bank.

Speaker 0:
Well, on that note, um, liquidity profiling and planning is particularly important when managing a fixed income portfolio, and yeah, Thanks for taking us through, Uh, your strategies and how to manage them for For your portfolios. Thank you very much. Thank you. Thank you.