Vineer Bhansali Slides

The Return on your money:

Investing When Bond Yields Are Negative

Vineer Bhansali
Managing Director, Portfolio Manager
Q-Group Presentation
October 2015


This material is for presentation to Q-Group. It is for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. The references to “insurance” contained herein do not refer to traditional insurance related products , but rather portfolio management techniques employed for insurance like characteristics. PIMCO does not offer insurance guaranteed products or products that offer investments containing both securities and insurance features. PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and
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No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical and forecasted performance results have several inherent limitations. Unlike an actual performance record, these results do not do not reflect actual trading, liquidity constraints, fees, and/or other costs. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated or forecasted results and all of which can adversely affect actual results. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve

Negative Yields:A time to rethink history,Asset Pricing and portfolio construction

“A basic principle of Austrian economics is that the original rate of interest (the rate of discount of future
goods compared to the present, otherwise identical, goods) can never be negative. The reason for this arises
not because capital is productive, nor out of man’s psychology. Rather, it is embedded in the very concept
of human action.” Walter Block [1978].

“it may be time […] to go negative”, If lowering interest rates stimulates the economy and policy rates are
already very low or even zero, then why not keep cutting rates and have negative interest rates? The idea
of negative rates, that is, lending 100 and getting back say 95, may seem absurd “but remember this: Early
mathematicians thought the idea of a negative number was absurd [too]”. Benoit Coeure quoting Greg Mankiw [2014].

Fraction of the bond index universe at negative yield


Broad outline of talk

Explanations for negative bond yields

Negative yields as insurance

–The insured discount factor
–Impact of Risk aversion vs. subjective probabilities

Implications for Asset pricing, Risk Premia, and Diversification with negative yields

A simplified framework

Main Explanations for Negative bond yield

Technical reason 1: Supply
-demand imbalance
–Sovereigns buying up all the float of existing bonds

Technical reason 2: Indexation of bonds markets
–Preferred habitats of investors

Economic reason 1: Demographics of aging populations and changing preferences. Different consumption basket in older age that requires deferred consumption

Economic reason 2: Rare disaster and/or protracted deflation premium

Supply-demand imbalance :Central banks have left investors with fewer bonds to buy


The Premium price zero coupon bond as an insurance asset

Consider a zero coupon bond
-P = e-yT
  -Then if y<0,for anyT,P>1.

-The Premium p – 1 can be thought of as an insurance premium

-As time pass,the premium decays not unlike that of an option

-So basic building block, the discount factor,has an insurance interpretation to it

-You can also see what happens to a perpetuity

Negative Rates and the Reverse Peso Problem(Kugler and Weder 2002)

Peso problem:Mexican peso traded at long term discount for 20 years before the devaluation happened

Reverse Peso problem Swiss Franc trades at premium (and negative rates) structurally it’s a reverse peso problem or insurance against global financial catastrophe

A choice:negative yields or random confiscation?

“Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return from holding currency would become negative 10 percent. That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10 percent.”–Mankiw, quoting an unnamed graduate student in the NY Times, April 18, 2009

CHF sovereign zero coupon curve negative out to 12 years!


CHF swaps curve negative out to 7 years


But deposit rates are peggeed at -0.75%


So other then the very short end, there is still positive carry despite negative yields


Swiss franc cross currency basis swap vs. Euro


Eurchf 1y basis swap 5y deposit rates


FX basis swaps in most markets show insurance characteristics


Yield in Barro’s Rarre Disaster Model

(Rare Disasters and asset Markets in the Twentieth Century, QJE, 2006.)


As disaster probabilities increase, nominal yields can go negative. Bond defaults in Barro’s model shift bond yields up


Equities:The Gordon model

D/P = r – g
-If r is negative , then g has to be negative for D/P to be postive.
-Sign of future defaults?
-In the rare disaster model, falling t-bill yields are accompanied by rising equity risk premia.

Rare disaster premium in index option prices

Recent research (Welch 2015) suggests that index option prices can be used to explain about 2% of the 7% equity risk premium as disaster compensation

Fitting a behavioral model (Bhansali 2015) suggests that the crisis of 2008 was different in attributing a much higher subjective probability to fat tails. Compare this to 1987 where index option skew emerged mostly from
increased risk aversion

Risk-premium = insurance premiums for factors (see Cochrane 2002)


Expected returns arise from risk premium harvesting


Risk premiums can classically be understood as compensation for the covariance term or sale of an implicit option

Credit: Default risk premium

Equity: Growth risk premium

Duration: Cash rebalancing premium

FX Carry: Growth, inflation differential, volatility premium

Commodity: Hedging pressures premium


Falling term premiums:Is there duration risk premium when yields are negative?


Is an upward sloping yield curve a source of premium or something else?

Black’s original argument:
-Observed Rate = Shadow Rate + Max[0,-Shadow Rate]
-Nominal rates = Call options on shadow rates
-Return to money market investor = Shadow Rate Return + Return on Floor

So yields = compounded(expectations + risk premia +shadow call)

So easy to mistake an upward sloping yield curve as source of risk premia rather than premium for shadow rate call

Disappearing default premiums:Is there default premium when floater coupons are negative


Correlations and diversification when yields are negative

If yields are floored close to zero, the diversification properties of duration are less potent

When yields are very high, any further rise in yields usually means slowdown in economic activity and downward bias to equities, all else being equal. So this implies positive correlation to stocks and bonds returns

When yields are very low for the same reason (i.e. higher yields would mean lower growth), the same logic applies, and we may also expect correlations becoming more positive

Proposqal 1:A modified classification for assets

Are assets ex-ante insurance assets or investment assets?

–For insurance assets, depending on the moneyness of the insurance, risk premium is paid, not earned.
–For investment assets, risk premium is earned as compensation for providing insurance.

Choosing individual stocks assets without any idea of what you are looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.Paraphrasing Joel Greenblatt, author of The
Little Book that (still) beats the market

Proposqal 2:A modified of the portfolio construction approach

Investors need to evaluate the mix of insurance assets and investment assets in their portfolio according to their own exposure and tolerance to disasters.

The control of disaster risk allocation will then determine the expected return.

Application:A two factor stylized model

Carry: Selling “insurance” against rare disasters

Trend: Purchasing insurance against rare disasters

Optimal mix of long and short implicit and explicit insurance based on relative valuation

Carry + trend payoff is a mix of long and short options


Example: Ten year futures


How much time did we spend in each quadrant


Trend and carry across time for asset classes


Average carry and trend indicator across all markets, A factor timing model of factors


Indicator statistics{1960-2014)


Returns over 54 years(work with Rennison, Davis, Dorsten, JPM 2015


Return over rising rates 1960-1982


Risk parity and be characterized as a package of carry and trend on real rates

Chart shows cumulative excess returns of hypothetical monthly sales of 1M 40

-delta “real
-yield payer swaptions”, versus risk parity excess returns.

Similar return profile, 69% monthly returns correlation.

Helps characterize the risk for which this strategy earns a premium.


Negative nominal (and real) yields are a reality and might reflect changes in the economics of asset markets

They highlight the dual nature of assets: as insurance assets (return of your money), or investment assets (return on your money), under rare disasters

Portfolio construction is less about maximizing expected return per unit of risk, and more about the appropriate mix of sales and purchases of rare disaster insurance