Ok, so I have a client, a P&C reinsurance company. They pledged their investment portfolio to serve as collateral for a LC facility. The investment portfolio is managed by a separate entity. They are requesting our consent to change their investment guideline (IPS) to increase the cap on weighted average duration in the investment guideline from 3 years to 4 years. This will enhance their flexibility to manage the duration of the overall portfolio. The reason: “As the yield curve has steepened, the company may potentially desire to lengthen the duration of its investment portfolio, while still maintaining prudent asset-liability mgmt.” My confusion: if the yield curve is steepening, then LT rate is rising, then shouldn’t they be shortening the duration instead of lengthening? Somebody please explain the rationale.
“has steepened” they may now wish to take advantage of higher rates now that the curve has steepend and in possible anticipation of the curve flattening or rates coming down.
Brain fart
So I guess my interpretation was wrong. They are actually anticipating the rates to come down?
I would hope that would be their reason, whether it’s legit is another matter. Many believe this current rally in longer term rates is overblown, I personally don’t subscribe. The Central Banks on both sides of the border are concerned with the rally from the standpoint that it may begin to choke off consumer lending as mortgage rates increase. Obviously higher inflation down the road due to the current monetary and fiscal policies are starting to creep into investors expectations, of which I am a big believer. I’ve read a couple of stories this week where members of the FED have expressed their opinions that those expectations probably aren’t realistic for the time being, but I have to question their objectivity at this point. The North American Central Banks have tried everything to open up lending, but it’s not working. What they continue to fail to see is the Financial Margin at Financial Institutions are being crushed in this low rate environment. Couple that with all the capital issues in the banking industry and the banks are handcuffed. Just a few months ago there was such a concern about liquidity, FI’s were vastly overpricing deposit gathering. At the same time mortgage rates were falling fast in line with the monetary policy actions. Deposit pricing has come down quite sharply, and with the recent bump in mortgage rates the spreads between deposit and mortgage pricing is opening up, which should encourage the banks to open the pipeline a bit. Rates are still extremely low relative to historical levels so those consumers that are able to borrow still could. Unemployment and job security concerns will cut back the number of those able or wanting to borrow at this time, but for them it doesn’t matter how low rates are, they wouldn’t be able to get a loan in this environment. I’d hope lessons have been learned and those days are gone. I’ve gone off on a bit of a tanget, but my point is the Central Banks have gone so far to try to open up lending, to no avail, and they’ve created this mass volume of excess liquididty now (because the banks are not lending at capacity levels) that when things do turn they will probably turn very quickly where we could see inflationary levels of the early 90’s. I think that’s what investors are starting to see right now which is driving longer term rates higher. The only way the Central Banks could curb it is to throw even more liquidity into the market which it surely doesn’t need at this time. I read a story yesterday where the FED had made a statement that they were going to relax on the quantitative easing for the time being and assess the situation. The brains at the FED are alot brighter than mine, but I have to question why it took so long for this to happen. I really do believe that the next big risk to the economy sits about two years out in wicked and crushing inflation levels. At that point those that were able to keep their mortgages coming out of the last fiasco will be forced into losing their houses due to unmanagable mortgage payments brought on by significantly higher mortgage rates and a new downturn will begin. But who knows, I picked the Red Wings and look where that got me.
Thanks guys. I need more help. Below is my boss’ interpretation. Do you guys think it makes sense? Though it is contradictory to your rationale above. His interpretation: “as the yield curve has steepened…” means the long term rate has increased. Therefore the company wants to take advantage of the higher rate in terms of current income, i.e., they can buy bonds at higher rate (coupon) with longer duration to lock in the stream of higher coupon incomes. My counter argument: yes it is true that they benefit from higher reinvestment rate, but their bond value will suffer because of the higher rate, therefore their portfolio value will decrease, which may lead to write-offs. I think protecting the portfolio value is far more important than getting higher reinvestment rates. His argument: because it is a P&C insurance company, their bond maturity is short any way, and they tend to hold the bond to maturity. Because bond prices converge to par at maturity, the bond value fluctuation in the interim is not a big concern for the company. What’s wrong with his argument. What do you guys think? The key sentence here is “as the yield curve has steepened, the company may potentially desire to lengthen the duration of the portfolio.” Seems like people interpret it in different ways. I really really appreciate any help. Thanks.
I don’t know but If the bonds held are classified as hold-to-maturity then it may not lead to write-offs. (not sure about this cause I forgot the stuff from level 2 and too lazy to grab the books) My guess is that if they choose to hold the bonds to maturity, they actually choose to hedge the market/ price risk and only want exposure to the reinvestment risk. If the write-offs are not their concerns and long-term rate is increasing, they would choose to increase the duration of the portfolio.