527859-hsbc-june-2015

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June 2015 An Institutional Investor Sponsored eBook

CAN YIELD REALLY BE ENHANCED?

Can Yield Really Be Enhanced?

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June 2015 Institutional Investor eBook Sponsored by HSBC 3

Introduction: No End in Sight to the Low Yield Environment ......................................4

Chapter I: Exploring Opportunities for Enhanced Yields in Fixed Income Markets ....8

Chapter II: Harnessing the Potential of Loans and Infrastructure .............................12

Chapter III: Is There Still Value in Equities? ...............................................................16

Conclusions.................................................................................................................20

About HSBC Global Markets .......................................................................................21

Disclaimer ...................................................................................................................22

Can Yield Really Be Enhanced?

IntroductIon

No End in Sight to the Low Yield Environment

IntroductIon

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When the Spanish government sold 725 million of six-month paper at an average yield of -0.002 percent in April 2015, it was not the first time a European sovereign borrower was able to charge investors for the privilege of holding their debt. Germany, Ireland and Switzer-

land have all auctioned longer-dated bonds offering investors negative returns. It was, however, the first time that one of Europes so-called peripheral countries had auctioned government debt at a negative yield, making it perhaps the most striking demonstration to date of how far yields have fallen in Europe. To put the Spanish auction into perspective, when Madrid auctioned 3.26 billion of short-dated debt in November 2010, the yields on the three- and six-month notes were 1.74 percent and 2.11 percent respectively.

Its not just an increasing volume of peripheral as well as core European government bonds that have been trading at negative levels. By early Febru-ary, euro-denominated bonds of several blue-chip companies, including Nestl, Electricit de France (EdF) and Shell, had slipped into negative terri-tory in the secondary market.

Is QE to blame for low yields?Its easy to see why yields in Europe are being driven to ever-lower levels. Under

the unprecedented 1.1 trillion asset purchase program announced in January in response to economic stagnation, the European Central Bank is commit-ted to buying some 60 billion of government bonds and selected asset-backed instruments each month between March 2015 and September 2016. But with this quantitative easing (QE) program taking place against a backdrop of fis-cal consolidation in the Eurozone, there are growing concerns that there will be

6 Institutional Investor eBook Sponsored by HSBC June 2015

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insufficient supply of eligible government bonds to meet the ECBs demand. It is this disequilibrium that is driving government bond yields into negative territory, with some 2 trillion of Eurozone public sector debt trading at negative levels by mid-April.

Given that QE in the Eurozone still has well over a year to run, the chances are that yields will re-test the lows we saw in mid-late April. I think it will become more difficult for the ECB to fulfill monthly purchase requirements, which will mean yields are driven back, and possibly deeper, into negative territory further down the yield curve, says Simon Hotchin, Head of the EMEA Client Solutions Group at HSBC in London. The theoretical floor for these yields is the ECBs deposit rate of minus 20 basis points, which is currently the lowest level at which bonds can be bought under the asset purchase program. But as Hotchin says, this minimum is not cast in stone, which together with repo market spreads trad-ing tighter than -20bps, explains why some shorted-dated German government bonds (Schatze) have already traded at yields below minus 20bp.

Some have speculated that a shortage of government bonds may even push the ECB into adding corporate bonds to its asset purchase program. This would support the ECBs objective of spurring economic growth by further reducing corporate financing costs. But for institutions in Europe, it would make the task of generating positive returns on their investments even more challenging. Europe-an chief investment officers (CIOs) have a very difficult job today, says Hotchin.

Challenges for the insurance industryFor many Continental European insurance companies, the relentless decline in

yields is creating other formidable challenges beyond meeting investment targets. In many cases, Hotchin explains, unrealized gains on their bond portfolios, gener-ated by low rates and narrowing spreads, is impeding the way insurance compa-nies manage their investments. This is because if they were to realize these gains, they would be contractually obliged to share a high proportion of those gains with policyholders, rather than hold them back to set against their long duration

IntroductIon

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liabilities. In todays punitive low-yield environment, this also compounds the challenges of finding assets in which to reinvest.

In addition, the last thing banks want to do is sell their bonds, realize their gains and put them on deposit at the ECB, paying 20bp for the privilege of do-ing so, says Hotchin.

For insurance companies the implementation of Solvency II at the start of 2016 will force them to hold additional capital against portfolios of riskier as-sets, and to manage asset-liability mismatches within smaller tolerances, lead-ing some to extend duration further. This is likely to exert further downward pressure on fixed income markets at the longer end of the yield curve. l

Source: HSBC

countryno. of bonds with negative yields Amount (in Eurbn) total bonds o/s % of total o/s

Austria 10 99 192 52%

Belgium 11 130 300 43%

Germany 41 714 1,030 69%

Spain 7 132 663 20%

Finland 9 50 83 61%

France 23 591 1,229 48%

Ireland 4 31 98 32%

Italy 6 105 1,407 7%

Netherlands 14 196 321 61%

Portugal 2 8 102 8%

European Government Debt Trading at Negative Yield at End of April 2015

European Government Debt Trading at Negative Yield at Start of 2015

countryno. of bonds with negative yields Amount (in Eurbn) total bonds o/s % of total o/s

Austria 6 62 187 33%Belgium 9 89 298 30%Germany 33 563 1025 55%Finland 5 28 79 35%France 15 395 1194 33%Ireland 1 2 91 2%Netherlands 9 132 327 41%

As of April 28, 2015

As of January 2, 2015

cHAPtEr 1

Exploring Three Opportunities For Enhanced Yields in Fixed Income Markets

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While the challenges faced by CIOs today are profound and unprecedented, the good news is that for institutions prepared to adopt a more flexible approach to asset allocation and risk management, there is still a range of alternatives offering them

higher yields that will help to deliver positive returns to policyholders and investors.

Are sovereign bonds a low-risk solution?Some sovereign bonds, for example, continue to offer appealing

headline yields. But to access these returns, investors are finding that they either need to expand beyond their core Eurozone markets, or to look much further down the maturity curve. In some instances, they are doing both at the same time. In April, for example, Mexico issued the first 100-year government bond in the history of the euro-denominated market. This 1.5 billion transaction, co-led by HSBC, was offered at a coupon of 4.2 percent and generated total demand of more than 6 billion from more than 230 investors.

While initiatives such as the Mexico century issue will be welcome to yield-starved investors, supply of ultra-long-dated emerging market bonds will represent little more than a drop in the ocean for institutions needing to put billions of euros or dollars to work at positive yields.

A relatively low-risk option favoured by some European institutions has


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been to increase allocations to the worlds deepest and most liquid bond market. Nominal and inflation-linked US Treasurys have continued to offer a pick-up over Eurozone government bonds, with 10-year benchmark notes still yielding more than 2 percent as of late April. But as Hotchin says, this exposes European institutions to currency risk. From discussion with many issuers and pension funds, we know that the common practice for hedging FX risk is via rolling three or six months forward contracts, he says. Some are also looking at long-dated cross-currency swaps, but bank leverage ratio and collateral implications make these instruments more expensive and complicated than in the past.

Interest rates swaps and lightly structured productsA more sophisticated way of generating higher returns by expressing a view

on government bond markets, says Hotchin, is through yield-enhancement products on the interest rate side. These include looking at swap spread opportunities by buying dollar or yen products and cross-currency swapping them back into euros or sterling, he explains.

This can create a higher-yielding, synthetic euro or sterling asset where the underlying issue could be Japanese government bonds or US Treasuries or even a supranational issuer in a foreign currency.

Hotchin adds, Were also seeing demand for more lightly structured products such as constant maturity swaps (CMS)-referenced, where investors take a view on the evolution of rates or the yield curve through time.

These products are not suitable for all investors because they are less liquid compared to cash bondsand the costs of collateralizing cross-currency and interest rates swaps are rising due to tighter banking regulations. Another challenge associated with these strategies is the speed with which they need to be implemented. Windows of opportunity in these trades tend to be short, says Hotchin. This means institutions are being forced to become more nimble in responding to opportunities, which sometimes does not sit

cHAPtEr 1



well with their internal structures and governance procedures. So when we talk to clients, we dont just need to maintain a dialogue with the portfolio managers and trading desks responsible for implementing these trades. We also need to talk to the internal client or a third-party advisor to ensure that mandates can be changed or become more flexible.

Expanding into corporate bondsThe credit market also offers some refuge for yield-starved investors,

and a number of European institutions are known to be amending their mandates to allow them to expand further into corporate bonds. As Fitch noted in a recent survey of fixed income investors with 8.2 trillion of fixed income assets, Investors are piling into corporate bonds. More specifically, Fitch found that high yield was the most-favored marginal investment choice for the respondents to the survey, with 25 percent of the votes, compared with 21 percent for investment-grade corporates.

Fitchs findings are corroborated by some of the industrys heavyweights, such as Zurich Insurance, which has investments of just over $200 billion. Cecilia Reyes, Zurichs CIO, said in a recent interview that her group is now planning to invest a very small amount of its credit portfolio in high yield bonds.

In some instances, however, the term high yield is now becoming a misnomer. For example, when the UKs Merlin Entertainment sold its debut 500 million seven-year bond in March, the coupon of 2.75 percent was one of the lowest ever for a European high yield bond debt issue. HSBC was joint bookrunner on the Merlin transaction, alongside Barclays and RBS.

While credit markets therefore offer some relief for yield-hungry investors, compressed spreads, twinned with the higher capital levels that many pension funds and insurers are required to set against them, will limit the appeal of high yield bonds to European institutions. l

cHAPtEr 2

Harnessing the Potential of Loans and Infrastructure

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For institutions with flexible asset allocation mandates, some pockets of the global loans market offer increasingly attractive value relative to fixed income. Weve seen a huge amount of interest and activity from insurance companies

and pension funds in loan assets,says Hotchin. The most notable examples, he says, are commercial real estate loans and facilities issued by government-guaranteed export credit agencies such as Hermes in Germany and Coface in France.

Institutional lenders are also playing a more prominent role in shipping and aircraft loans. They are also more active in the market for lending to small and medium sized enterprises (SMEs), where insurance companies are increasingly making more productive use of their liquidity by competing or co-operating with commercial banks. Hotchin points to the example of Frances AXA, which has teamed up with banks such as Socit Gnrale and Commerzbank to originate SME loans.

Infrastructure financing, a promising areaThe area where the increased potential participation of

institutional lenders has perhaps attracted the most attention is infrastructure finance, with very good reason. Standard & Poors (S&P) has estimated that infrastructure financing needs worldwide could reach $3.4 trillion annually through to 2030. While S&P believes that governments and banks will remain the dominant investors in infrastructure, it estimates that an additional $500 billion per year will be needed from alternative sources in order to plug any shortfalls. S&P believes that insurance companies could provide about $80 billion (or 3 percent of their assets under management) of this shortfall. This is because infrastructure assets are in many ways a perfect fit for insurance companies starved of yield in traditional fixed income markets. Rated, long-dated project


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finance bonds typically yield between 4 percent and 5 percent, their recovery rates are generally high, their long tenors are suitable from an asset-liability (ALM) perspective, and their correlation with other asset classes is low.

Hotchin agrees that infrastructure is a promising area for institutional investors, although he adds that their participation in the market to date has not lived up to expectations. Some of the reasons for this are clear enough. Regulation, project complexity, illiquidity and a lack of suitable projects may thwart insurers progress in making such investments, S&P cautions.

Infrastructure loans: better for banks?There are other pitfalls associated with infrastructure loans, says

Hotchin, such as their floating rate, repayable structure without make-whole clauses. This makes them more appropriate for banks than for institutional investors. Borrowers are keenly aware that it is in their interest to address these shortcomings, says Hotchin, to diversify away from the shorter-dated bank market and access longer term institutional funding. We are seeing borrowers becoming more receptive to including fixed rate tranches with make-whole provisions in the event of prepayment, he says.

Lack of expertise is also a notable stumbling block to increased institutional involvement in the infrastructure market. Hotchin says that some institutions, like Allianz, have recruited specialist professionals to develop their infrastructure franchises. Others, such as Swiss Re, have chosen to invest in this asset class through externalmanagers with a recognized track record in infrastructure such as Macquarie.

Going beyond core European economiesEuropean institutional investors looking for exposure to the

infrastructure market for the first time have tended to prefer brownfield to greenfield projects. They have also generally favored familiar

cHAPtEr 2



regulatory regimes and markets in which they can minimize currency risk. This has meant that their overwhelming preference to date has been for projects in core western European economies, although their appetite for risk may now be changing. A couple of years ago investors focus was strictly on core Europe, says Hotchin. That has changed, and there is growing appetite for exposure to markets like Spain, Ireland and Italy.

While investors focus on Europe is clearly an effective way of minimizing risk, it also restricts the volume of projects they can access, given that the bulk of infrastructural projects are being undertaken in emerging markets. Investors will move into emerging markets when they are more comfortable with how project loans are configured, says Hotchin. l

Simon is Head of the EMEA Strategic Solutions Group.

Prior to this role, he headed up the Insurance Solutions

team for Europe and was co-head of the insurance client

joint venture between Sales and Debt Capital Markets.

Simon joined HSBC six years ago from Morgan Stanley,

where he spent nearly 10 years running the European

ALM team and latterly Benelux Insurance coverage. The

ALM team advised insurers, pension funds, corporates,

Sovereigns and banks across Europe, Africa and Asia and

worked closely with coverage teams to structure strategic

solutions. He worked in similar teams at Socit Gnrale,

Tokai Bank Europe, Bankers Trust and CSFB, after starting

his career in Corporate Planning at BP. Simon holds an

MA, BA in Economics from Cambridge University.

About Simon Hotchin

Simon Hotchin, Head of the EMEA client Solutions Group

cHAPtEr 3

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Is There Still Value In Equities?

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Beyond the fixed income market, equities are another yield-enhancing option for multi-asset investors or for those with flexible mandates. In the market for financial institutions bonds, added flexibility of mandates has been forced on some parts of the investor community by the growing importance of instruments such as additional tier 1 (AT1) securities. These sub-investment grade instruments offer alluring yields, typically of between 5 percent and 8 percent. But many are convertible into equity if the issuers core capital falls below a predetermined minimum. This means that investors with inflexible fixed income mandates are either excluded from the market altogether, or are forced sellers in the event of the conversion clause being triggered.

More broadly, however, some institutional investors in Europe have been withdrawing from equities. Over the last few years weve seen a lot of de-risking, including a retreat from public equity markets by insurance companies in Europe, although less so by pension funds, says Hotchin. An exception to this rule, he adds, is the UK market where with-profits policies are sold on the understanding that they will deliver equity-driven returns. This has constrained the capacity of UK insurance companies to de-risk in the cash equity space, although it doesnt prevent hedging of shareholder risk within the Estate, says Hotchin. In Europe, where equities are held within general accounts, there is less of an explicit promise to provide equity-like returns, which has given European insurers more flexibility to de-risk.

Why increasing equity allocation is not straightforwardToday, insurance companies remain hesitant about equities for two

main reasons. First, after a powerful run in recent years , valuations are looking stretched: a quarter of respondents to the Bank of America Merrill Lynch (BAML) global fund managers survey in April indicated that they believe equities to be overvalued. This is the highest level since


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2000, which saw a sharp correction in equity markets worldwide.Second, Solvency II is continuing to encourage a drift away from

equities. Under the standard model, insurers are required to set 39 percent capital against the market value of public equity holdings, and 49 percent against private equity investments. Most insurance companies internal models demand even higher levels, requiring that as much as 50 percent is set against equities. So although there is some sign of re-risking on the equity side from an asset allocation viewpoint, capital requirements remain onerous, says Hotchin.

However, an innovative and unconstrained approach is also a way

CHAPTER 3

Source: S&P Dow Jones Indices / Bloomberg. Past performance is not a reliable indicator of future performance.

Equity Yield EnhancementShort Positions in VIX Futures Can Generate Attractive Yields

-40%

-30%

-20%

-10%

0%

10%

20%

30%

0

20

40

60

80

100

120

140

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May-11 Nov-11 May-12 Nov-12 May-13 Nov-13 May-14 Nov-14 May-15

VIX Futures Exposure (RHS) HSBC Volatility Alpha Index 10% RC Index (HSIEVA1E) HSBC Volatility Premium Index 10% RC Index (HSIEVP1E)

VIX

Futures E

xpo

sure

of generating an efficient risk-reward dynamic within an equity portfolio. What were seeing on the equity side is a strong demand for re-shaping equity returns to make them efficient within a Solvency II framework, Hotchin explains. This means either developing solutions to hedge downside risk efficiently, or volatility-control strategies based on dynamic asset allocation between cash and equities. Or it means using structured products using a combination of equities and rates within the same product. So the way investors are taking equity exposure in the context of Solvency II is becoming more sophisticated. l



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The message for investors is clear. Although the challenges created by a low or negative interest rate environment are unprecedented, there is no need for investors to respond passively by tolerating much lower long-term yields. Institutions will still be able to generate reasonable returns, but only by adopting a more flexible approach to asset allocation. The key takeaways for yield-starved investors today are:

In credit markets, investors may need to broaden their mandates to accommodate increased allocation to high yield bonds, and to allow them to harness the potential of emerging markets and structured notes.

Institutional investors can step into the breach created by reduced bank lending in longer maturities by playing a more active role in financing infrastructure and SMEs.

Equity markets may still provide pockets of value for investors able to implement more dynamic asset allocation strategies and structure protection against heightened volatility.

Conclusions:Unprecedented But Not Insurmountable Challenges

About HSBC Global Markets

HSBC Global Markets offer sophisticated 24-hour coverage across our main trading and sales platforms in London, New York and Hong Kong. Our global teams deliver a wide range of solution-driven products for our Corporate and Institutional clients. We provide our clients access to Equities, Fixed Income including Credit and Rates, Foreign Exchange, Commodities and Prime Services, in addition to Research, across both developed and emerging markets. As a global investor, youll benefit from HSBCs local knowledge in over 70 countries, balanced by our understanding of global economics. Use HSBC Global Markets expertise to invest in:

Rates - Gain access to global liquidity and streamline transactions. To help you access global liquidity and transact seamlessly, the HSBC Global Rates group provides debt issuance, financing, innovative risk management and investment solutions through a broad selection of vanilla and structured products.

Credit - Maximise opportunities with the HSBC Global Credit group to unlock liquidity globally. Leverage our significant global emerging markets presence and our extensive suite of credit services, which include traditional and secondary trading products such as bonds, loans, securitised products, credit derivatives and credit financing solutions.

Foreign Exchange Benefit from the expertise of a leading global market maker. Our host of solutions provides liquidity from the purely transactional to the highly customised. The HSBC Global FX group provides risk management and tailored solutions such as Transactional FX, Algorithmic Execution, FX indices, FX Overlay and FX Prime Services that allow clients to select and create individual propositions to suit their needs.

Equities - Take advantage of HSBCs global connections and rigorous research. Our far-reaching network gives you access to over 600 sales, trading and research specialists worldwide. The HSBC Global Equity group brings together cash and derivatives trading, sales and distribution, structured equity and equities finance expertise.

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This article should not be regarded as investment research for the purposes of the rules of the Financial Conduct Authority (FCA) or any other relevant regulatory body. Any charts and graphs included are from publicly available sources or proprietary data. Figures included in this article may relate to past performance or simulated past performance (together past performance). Past performance is not a reliable indicator of future performance.

Reproduction of this article, in whole or in part, or disclosure of any of its contents, without prior consent of HSBC, is prohibited. This document is not intended for distribution to, or use by, retail clients as defined in the FCA rules, or any person or entity in any jurisdiction or country where such distribution would be contrary to law or regulation. You are solely responsible for making your own independent appraisal of and investigation into the products, investments and transactions referred to in this article and you should not regard any information in this document as constituting investment advice. HSBC is not responsible for providing you with legal, tax or other specialist advice. Except in the case of fraudulent misrepresentation, neither HSBC nor any of its officers, directors, employees or agents accepts any liability for any loss or damage arising out of the use of all or part of this material.

Issued and approved for publication to Professional Clients and Eligible Counterparties only by HSBC Bank plc. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority

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TOCIntroduction: No End in Sight to the Low Yield EnvironmentChapter I: Exploring Opportunities for Enhanced Yields in Fixed Income MarketsChapter II: Harnessing the Potential of Loans and InfrastructureChapter III: Is There Still Value in Equities?ConclusionsAbout HSBC Global MarketsDisclaimer

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