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The Problem with Interest Rate Predictors

October 6, 2022 By E.J. Smith - Your Survival Guy

By nullplus @ Shutterstock.com

The problem with interest rate predictors is they’re often wrong but never in doubt. Many companies have been surprised by higher rates, and are now facing the consequences of relying too heavily on cheap financing. Many pension funds are facing similar issues. Jon Hilsenrath, Sam Goldfarb, and Chelsey Dulaney report in The Wall Street Journal:

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The current tightening follows years of short-term rates near zero and sometimes below. Historically, low rates encourage risk-taking, complacency, and leverage—the use of borrowed money to amplify profits and losses. In recent years, central banks also purchased trillions of dollars of government debt to hold down long-term rates.

Low central bank rates were one reason that yields on corporate debt fell to less than 2% from about 6% between 2007 and 2021. During the same period, corporate debt ballooned to about half the size of the U.S. economy from 40% a decade ago. Yields shot higher this year, triggering unexpected losses.

In one case, investment banks including Bank of America Corp., Credit Suisse Group AG and Goldman Sachs Group Inc. are on track to collectively lose more than $500 million on debt backing the leveraged buyout of Citrix Systems Inc. after it was sold to investors at a steep discount. Shares of Credit Suisse, which is restructuring to exit risky businesses, fell 18% over the past month while the cost of insuring its debt against default, as measured by credit-default swaps, soared.

Meanwhile, the dollar has risen steeply against other currencies, threatening higher interest costs to emerging-market governments that borrowed heavily in recent years from foreign investors seeking higher returns. The foreign debt of low- and middle-income countries rose 6.9% last year to a record $9.3 trillion, according to World Bank estimates.

Emerging-market governments have to repay roughly $86 billion in U.S. dollar bonds by the end of next year, according to data from Dealogic. A United Nations agency urged the Fed and other central banks Monday to halt rate increases, warning that “alarm bells are ringing most for developing countries, many of which are edging closer to debt default.”

Pension pain

Financial upheaval often happens in unexpected places, where bankers and regulators are unprepared or where they think markets are well-insulated.

The turmoil in Britain involved pensions and government debts, long thought to be among the safest parts of the financial markets. The government on Sept. 23 announced a package of tax cuts that would have added significantly to deficits. In response, the pound sank to a record low against the dollar, and yields on British bonds, known as gilts, shot up.

The rise in yields was amplified by derivative instruments loaded with hidden debt, part of a strategy by U.K. pension funds called “liability-driven investments,” or LDIs.

Derivatives can be used to hedge risk or amplify returns. LDIs were designed to do both: protect pensions from low interest rates by constructing cheap hedges, while freeing up cash to invest in higher-yielding assets. British pension regulators encouraged plans to adopt LDI strategies despite signs that some had become dangerously exposed to interest-rate changes.

As interest rates rose, pension funds were exposed to losses and margin calls, demands for cash to cover the risk of more losses. To cover margin calls, managers sold assets, in many cases even more gilts. The selling pushed interest rates higher, in a liquidation spiral.

It had echoes of forced selling that figured in past crises, including the 1987 stock-market crash, the 1994 bond-market selloff that bankrupted Orange County, Calif., the 1998 Russia default and the 2007-09 global financial crisis.

The Bank of England last week stepped in with a plan to buy gilts to relieve the pressure on pension funds. On Monday, the government backtracked and said it was dropping one of its planned tax cuts.

Now, banks and governments around the world are grappling with how to interpret last week’s events. Some experts say the signs so far don’t point to disaster.

U.S. corporate pension plans managed by consulting firm and insurance brokerage Willis Towers Watson have posted tens of millions of dollars in collateral to address margin calls this year, said portfolio manager John Delaney of Willis Towers Watson. But the strategy and the resulting margin calls are on a far smaller scale than in the U.K., where derivatives are more prevalent and pension plans tend to be bigger relative to company size, he said.

Some U.S. public pension plans are vulnerable to margin calls. These plans used derivatives to substitute for bonds in their portfolio and increase the total amount they could invest to boost returns. The pensions adopted the strategy because low interest rates weren’t generating enough returns to pay promised benefits.

Action Line: One way to fight rising rates in your portfolio is by using a bond ladder. Now that rates are rising, treasuries can be an exciting part of that bond ladder. If you need help building a bond ladder for your portfolio, click here to get in touch with me. Until then, if you want to learn more, click here to subscribe to my free monthly Survive & Thrive letter.

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E.J. Smith - Your Survival Guy

E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. His focus at all times is on preparing clients and readers for “Times Like These.” E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zildjians. He grew-up worshiping Neil Peart (RIP) of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@yoursurvivalguy.com To sign up for my free monthly Survive & Thrive letter, click here.
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