Indexology^® Blog

Solvency II is the new region-wide supervisory framework for insurance and reinsurance companies operating in the European Union.  The new regime includes three pillars, calculation of capital reserves, management of risk and governance, and reporting to the national supervisory authority.  Moving to a risk-based approach in calculating solvency capital requirements (SCR) will require reassessment of investment choice.  Risky assets that will require a higher charge may become less appealing vis-à-vis a low risk asset, despite the expectation of better performance.

It falls on insurers to classify assets; certain types are well defined while some types need to be assessed against an extensive list of criteria, including qualitative factors.  In calculating SCR, insurers may follow the standard formula, develop an internal model subject to supervisory approval, or use a combination of the two.  Focusing on the standard formula approach, insurers will determine the level of instantaneous shocks prescribed for each asset to aggregate into a total capital requirement.

Cash-flow risk, issuer/credit risk, and duration risk are among the key factors in determining the prescribed shock schedule.  For example, a government bond issued by an EU member state in an EU member currency has a risk weight of 0%, while a B+ rated, 25-year duration corporate bond will have a risk weight of 66%.  In particular, exposure to member state central government debt, certain multilateral development banks, and certain international organizations, as well as debt guaranteed by member states’ central government, are assigned a risk weight of 0% (article 180, paragraph 2 of Regulation (EU) No 2015/35).

Looking at the types of securities that can potentially qualify for lower capital charges, green bonds stand out as one possible candidate for those requiring 0% capital charge.  Multilateral development banks and international organizations are among the active issuers in the green bond market.  Additionally, sovereign issuers such as Poland and France have initiated issuance in the green bond market.  Hence, an index of qualifying green bond securities could serve the industry as a 0% capital charge benchmark for European insurers and reinsurers.

We can highlight a hypothetical basket of qualifying securities by screening for these specific issuers within the S&P Green Bond Select Index, excluding U.S. municipals.  The screen produces a hypothetical portfolio of 42 green bonds, representing 31.9% of the S&P Green Bond Select Index market value (Exhibit 1).

This morning’s Wall Street Journal informs us that the growth of exchange-traded funds has “propelled” this year’s surge in equity prices.  “Booming demand for passive investments is making exchange-traded funds an increasingly crucial driver of share prices….Surging demand for ETFs this year has to an unprecedented extent helped fuel the latest leg higher for the eight-year stock-market rally.”

Or has it?  Suppose I edit the sentence quoted immediately above to read “Surging demand for equities this year has to an unprecedented extent helped fuel the latest leg higher for the eight-year stock-market rally.”  I’ve changed only one word, and yet the entire connotation of the sentence is different.  “Surging demand for equities” means only that investors, as a group, want to increase their exposure to the stock market.  In hindsight their decision may or may not prove wise, but it’s hard to make such a choice sound sinister.

ETFs are not a unique asset class.  They are a means by which investors can invest in the assets which have long formed the core of their portfolios.  There are, of course, a number of advantages to the ETF structure – transparency, ease of implementation, access to institutional strategies for the small investor, low cost, tax benefits – and these advantages may go a long way to explaining why an investor might prefer ETFs to traditional mutual funds.  But an ETF, mutual fund, or separate account are simply different ways to hold a given portfolio of assets; as such they are less important to an investor’s ultimate success than the choice of which portfolio to hold.

And for that choice, investors have increasingly realized that their interests are best served by placing passive index vehicles at the core of their portfolios.  Active managers, as a group, have consistently underperformed passive benchmarks, and above-average active performance, when it occurs, tends not to persist.  As the Journal recognizes, these facts have resulted in a continuing migration of assets from active managers to index-linked portfolios.  ETFs are not the cause of this shift, but rather one of the vehicles by which it is taking place.

The Financial Stability Board’s Task Force on Climate-related Financial Disclosures published its final report on June 29, 2017, leaving many companies and market participants considering how best to implement its important recommendations.

The recommendations are groundbreaking because they recognize climate change as a systemic risk to the financial stability of the global economy and present actions that all participants in the investment value chain should take—from asset owners to companies—to mitigate the risks and capitalize on the opportunities.

One of its key recommendations is that organizations should consider the scenario analysis of potential business, the strategic and financial implications of climate change and disclose them in their annual financial filings.  Organizations should assess a range of scenarios that cover reasonable future outcomes, favorable and unfavorable, including the transitional risks associated with commitments made by nearly 200 countries under the Paris Agreement to limit the increase in the global average temperature to 2°C.

One of the main transitional risks is increasing carbon regulation through carbon taxes, emissions trading schemes, or fossil fuel taxes.  Carbon prices have already been implemented in 40 countries and 20 cities and regions.  These regulations could drive up the cost of fossil-fuel-based energy and carbon-intensive raw materials, increasing operating costs and reducing profit margins.  Revenue growth may be constrained for companies that sell energy-intensive products when competitors have low-energy alternatives.  Asset owners and banks are exposed to these risks through their investments and loans to companies in carbon-intensive sectors.

However, organizations face uncertainty over the pace at which carbon regulation will be implemented in different regions—particularly those with global operations.  The solution is to conduct scenario analysis using a range of potential carbon prices.  Exhibit 1 illustrates this at a global level, with forecasts from a threefold increase in regulated carbon prices based on full implementation of the existing Paris Agreement commitments (light blue line) to a sevenfold increase, assuming policies needed to achieve the 2°C goal are implemented (navy line).  A range of other possibilities exists between these extremes, as represented by the yellow lines.

Tools exist to help organizations calculate carbon prices, such as Trucost’s Eboard carbon price calculator, which market participants can use to calculate the at-risk revenue of companies in their investment portfolios and create investment strategies to minimize their exposure to that risk.  Trucost also works with companies to calculate internal carbon prices to quantify the financial implications of carbon regulation on cash flow, operating margins, and profits in different regions, highlighting those most at risk.

The Financial Stability Board says that all organizations should strive to conduct scenario analysis that is robust, comparable, consistent, and transparent.  Carbon pricing helps organizations meet these objectives by providing a powerful diagnostic tool to understand climate-related risks and opportunities in financial terms and explain to market participants how they are preparing for business in a low-carbon world.

On June 22, 2017, Mexico’s Central Bank (Banxico) made another hike in its policy rate, saying that it was consistent with the efficient convergence process of the 3% inflation objective.  For Banxico, this is the fourth adjustment of the year, and the 19^th since Banxico started a rising rates cycle in late 2015.  With all the global economic uncertainty, are we seeing the same trends in other countries of the region?  Let’s take a deeper look into what the central banks of Brazil, Chile, Colombia, and Peru have done in the past couple of years and how inflation is one of the main objectives for the changes in policy rates.

First, Exhibit 1 presents the historical policy rates since 2005 of these countries, and Exhibit 2 shows the actual policy rates of the central banks with their target inflations, actual inflations, and adjustments in the policy rates since 2016.  We can see how Peru hasn’t made many adjustments since 2016, with a total of only two in February 2016 and May 2017, leaving the policy rate at 4%—where it was at the beginning of 2016.  Meanwhile, Colombia and Mexico have changed their overnight rates 10 and 9 times, respectively.  Colombia had a cycle of increases in 2016 but decreased rates in 2017, closing May 2017 50 bps above since the start of 2016 (the Central Bank of Colombia has a meeting on June 30, 2017).  On the other hand, Mexico has increased rates by 400 bps after they were steady at 3%, a historical low, for more than 1.5 years.  Also, note that the last adjustment for all central banks has been on the downhill with the exception of Mexico.

One of the key components influencing policy rate decisions is inflation.  For Mexico, it is the main point Banxico has mentioned in their past announcements.  Taking into account market movements and inflation, Exhibits 3 and 4 show the performance and annual returns of the S&P DJI’s inflation-linked bond indices for these countries.

Source: S&P Dow Jones Indices LLC.  Data as of June 23, 2017.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes. For more information, please see: S&P/BM&F Brazil Sovereign Inflation-Linked Series B Bond Index, S&P Chile Sovereign Inflation-Linked Bond Index, S&P Colombia Sovereign Inflation-Linked Bond Index, S&P/BMV Government Inflation-Linked UDIBONOS 1+ Year Bond Index, S&P Peru Sovereign Inflation-Linked Bond Index.

It is interesting how inflation-linked bonds have performed in Peru in 2017, since its inflation is at -0.42% year-over-year as of June 23, 2017.  Also, as discussed in the paper “Liquid by Design-Building Inflation-Linked Bond Indices,” inflation in Brazil has been a concern, leading the inflation-linked bonds to outperform their peers for the past one, three, five, and seven years.

In our last piece, we discussed the Bank of Japan’s (BoJ) monetary policy and how the yields of Japanese sovereign bonds have responded since 2016. The latest BoJ minutes released on June 26, 2017, reiterated that it “should continue with the current monetary policy,” while it also stated that it is “necessary to reduce the pace of purchases… in order to secure the stability and sustainability of JGB purchases.”[1]

Now that we understanding that the BoJ currently controls the yield curve by keeping the short-term policy rate at -0.1% and targets the long-term rate at around 0.0%, let’s take a closer look at how it has affected sovereign bonds and the yield curve.

As of June 21, 2017, the S&P Japan Sovereign Bond Index tracks 302 bonds with a total market value of JPY 922 trillion, while the S&P Japan Government Bill Index measures the performance of 24 treasury bills with a market value of JPY 83 trillion. Among these bonds, JPY 607 trillion, or 60% of the overall exposure, have yield-to-maturity in the negative territory.  These sovereign bills and bonds have maturities ranging from 2017 to 2025, with one-half maturing in the next three years (see Exhibit 1).

The  yield curve is demonstrated in Exhibit 2. The 10-year period is the breakeven point where yield hovered around 0.06%, in-line with the BoJ’s target.  The 15-year period had active issuances and the yield was about 0.28%, compared with the 20-year period at approximately 0.50%.  The yield curve became flatter toward longer maturities, i.e. the 30- and 40-year period yields, which were around 0.80% and 1.0%, respectively.

Exhibit 1: Total Market Value in Negative Yields Versus Maturity Year

Exhibit 2: Yield-to-Maturity Versus Maturity

[1]   Source: Bank of Japan.  Data as of June 26, 2017.  https://www.boj.or.jp/en/mopo/mpmsche_minu/minu_2016/index.htm/