Bart Oldenkamp, Head of Integrated Client Solutions at NN Investment Partners
The uncertainty posed by rising interest rates when western central banks start normalising their monetary policies is likely to create substantial challenges for institutional investors seeking to match their portfolio of assets to their liabilities. Even though many investors anticipate rising interest rates, it is uncertain how the economy will unfold and how balance sheets will be affected. Investors may therefore consider ‘scenario analysis’ to assess the various potential economic outcomes and create better investments outcomes over the longer-term. We believe portfolios can also be made more robust by investing in less liquid investments such as alternative credit.
NN Investment Partners (NN IP) anticipates two likely scenarios along which rising rates may materialize. Scenario 1 entails global growth breaking through the 3.5% level that has acted like a ceiling over the last six years. Scenario 2 involves the continuation of a rangebound economy.
Even as most investors anticipate a rising rate scenario, a prudent and sensible approach that investors should take is to apply scenario analysis. This allows for testing strategies against opposing economic outcomes as well. Within this framework, investors who need to protect the value of their assets relative to their liabilities have several options to consider.
Under the base-case scenario of sustained economic growth, pension plan investment managers, amongst others, should consider increasing their focus on inflation rather than on nominal interest rates only. They have several options to manage inflation risks, including increasing their allocation to real assets and inflation-linked fixed income instruments. Investors who want to brace themselves against a moderate growth scenario – with interest rates moving within a range of 1 or 2% around current levels – could benefit from varying their hedge ratios.
For long term investors, investing in less liquid fixed income investments is a robust policy option enhancing portfolio efficiency under a wide range of economic outcomes. They offer an additional spread relative to their liquid counterparts, while the additional liquidity risks can be managed relative to the liabilities.
Bart Oldenkamp, Head of Integrated Client Solutions at NN Investment Partners, explains: “The low-rate environment has fuelled a search for yield that has prompted large insurers and other institutional investors to consider other assets classes within their matching portfolios, such as credits, mortgage loans and other types of alternative credit.”
“Alternative credit investments with a conservative risk profile such as infrastructure debt, corporate loans and export credit agency loans offer an attractive matching alternative to more liquid fixed income investments. The additional yield tends to outweigh the higher liquidity risk, which can often easily be absorbed while managing the overall balance sheet’s liquidity”, Oldenkamp adds.
Oldenkamp concludes: “Investing in alternative credit implies additional matching risk, measured in terms of short-term volatility relative to liabilities. In the longer run, however, the case for alternative credit becomes stronger as assets and liabilities tend to move more in parallel. When that happens, investors are likely to benefit from additional returns in their matching portfolios, leading to higher funding levels.”