Interest rates in Europe fell dramatically until the middle of April 2015 driven, in part, by the European Central Bank’s (ECB) EUR 60 billion a month government securities asset purchasing programme, which is set to run until at least September 2016. Even after the sell-off that began in mid-April 2015 the French government is borrowing at negative rates on yields below three years and at less than 1.30% on 10-year yields, while Germany is borrowing at less than 1 % on 10-year yields. Such volatility in bond markets, coupled with uncertainties over global growth, tends to bring back volatility to equity markets.
Exhibit 1: Evolution of volatility over 1 year (VIX index)
Exhibit 2: The change in the yield curve for French government bonds
Exhibit 3: Recent movements in French and German 10-year government bond yields
In this uncertain climate, private investors understandably seek security for their investments including, if possible, the sacrosanct 100% capital guarantee. In the current environment does this type of solution make sense for investors?
To answer this question, we need to remind ourselves of the basic mechanism of a target-dated fund with a 100% capital guarantee at maturity:
– Part of the capital is invested in low-risk bond assets (generally zero coupon-type government bonds*) that at maturity will return 100% of the amount invested (excluding default risk). The size of this allocation is inversely proportional to the level of interest rates (it will have to be bigger when interest rates are low and vice-versa)
– The remaining portion of the capital is invested in risky assets with the objective of achieving capital growth through this allocation.
The question we must ask ourselves is this: at current interest rate levels, how much is an investor required to allocate to low-risk bonds in order to provide a guarantee of the capital invested at maturity and how much is left over for the allocation to performance generating assets?
The table below simulates the capital necessary to secure a capital guarantee under various interest-rate regimes of which the current period is on the last line.
How much to invest to guarantee a 100% capital return at maturity: Simulation of zero coupons depending on interest-rate levels
So we can see that for a 10-year investment, one currently has to invest 93% of one’s initial capital to achieve no capital loss at term. This leaves only 7% (assuming no leverage is used) to invest in risky, performance-generating assets. A doubling of the risk assets over the period was not sufficient to generate an attractive return (14% over a 10-year period is a little over 1% in annualised yield).
On the other hand, in periods of higher interest rates, the problem is reversed: for example, with interest rates at 5% one has to invest 61% of one’s initial capital to guarantee 100% of the capital invested at a 10-year horizon. This leaves 39% of the initial capital to invest in risky assets, which may seem a lot. An investor could, for example, legitimately choose to secure 120% of his capital at maturity by allocating approximately 73% to 10-year zero coupon bonds and only some 27% to risky assets.
Finally, seeking a capital guarantee in a low interest-rate environment is costly in terms of likely performance. The 100% guarantee works best when rates are high but the risk taken can be too high whereas the capital protection level could have been more ambitious and exceeded 100%.
An alternative is to seek more flexible solutions where the level of capital protection at maturity depends on the level of interest rates, which leaves room for a significant allocation to risky assets that will permit an attractive level of capital growth by maturity.
BNP Paribas Asset Management’ research teams have worked on finding a solution to this issue. Today we can offer state-of-the-art solutions in the field of capital protection target-dated funds.