Wednesday 15 May 2013 by FIIG Research Legacy

What to do when the real cash rate falls to zero (real)?

Please note that the figure mentioned in this article is no longer available.

With the RBA’s surprise decision to cut the official cash rates this week the previously unthinkable now seems likely: within the year, investors may face a term deposit rate of just 2.5% or no more than the rate of inflation. Your spread above cash in term deposits will effectively become your real yield, and that will decline, over time.

For investors who are still scarred from the equity-market gyrations of the GFC this poses a dilemma of how to protect their real return against further rates cuts while maintaining a diversified portfolio that has a prudent fixed-income component. Three important developments now need to be considered when investing in a zero (real) investment environment:

  • First, one way to help solve this dilemma is to look more carefully at the liability driven investment (LDI) approach to investment. While we sketched the idea last week, this week we provide more detail by considering the typical objections against LDI, from investors
  • Second, recent policy developments will then be reviewed, and
  • Third, a consideration of what is ahead, in the zero (real) environment is then considered

LDI objections

Last week we briefly explained the Liability Driven Investment (LDI) approach that is very prominent in the UK, Europe, and the US. LDI is the procedure of purchasing a series of assets that matches your future stream of liabilities, where the selection of assets is always placed against the backdrop of the liability stream. Fundamentally, the assets that all SMSFs purchase would not exist if a liability, or stream of future pension expenses, did not exist. Therefore, LDI , features the underlying reason for superannuation investing, and then places all asset purchases in the context of meeting those liabilities. Some typical objections against LDI, are now addressed, in order to explain the LDI idea in more detail:

One: LDI is only appropriate for “de-cumulation” or pension phase:

LDI is a procedure of setting asset purchases in the context of meeting a future stream of liabilities and as such is relevant at all times in the life-cycle of the individual investor. While the capability to take risk varies with the life-cycle of the investor, where the young investor has the ability to take more risk, relative to the older investor, all investors have the same goal; to fund a stream of future liabilities. Hence, LDI is relevant in the “accumulation” phase, as well as the “de-cumulation” phase of investment, as it provides a sensible framework for selecting assets.

Two: Australia is “different” from the rest of the world:

Australia has a series of pension liabilities and assets, just like all other countries, and the problem of obtaining assets to satisfy these liabilities remains firmly in place. while Australia might have better growth prospects than the rest of the developed world, that is a completely different issue to the problem of selecting assets for a future liability stream; a problem common to all investors.

Three: LDI is appropriate only for defined benefit investment:

Defined benefit (DB) funds are where the fund provider assumes all the investment liability and guarantees a fixed benefit amount to the contributor, and the provider takes all investment decisions. DB funds make investment decisions because the fund keeps any surplus in the fund, in excess of liabilities, while funding any deficit. Alternatively, defined contribution (DC) is where the contributor takes on all the investment risk and makes the contributor, not the fund provider, responsible for all investment decisions. Here, the DC contributor is “free” to take on whatever risk he/she deems appropriate, and in Australia that has meant that equities are preferred as they provide excessive return. Yet, with freedom comes responsibility, and DC contributors have essentially the same problem as the DB provider, as a mistake on asset selection, possibly by “reaching for yield” as Bernanke recently put it, can lead to liabilities not being funded. So, if the DB provider fails to provide adequate assets, then there is a problem that everyone will know about, through disclosure to stock exchange, and equity price “adjustments”, all else being equal. However, the problem is much more complicated for the DC contributor; That is why the DB-DC distinction is irrelevant to the use of LDI; both DB and DC are doing the same thing, and the “freedom” of the DC contributor is not a licence to take unnecessary risk, as the DC contributor remains responsible.

Four: LDI is an asset allocation:

LDI is a procedure to place asset purchases within the context of future liabilities, and the participant can, within LDI, take risk. Some participants will want to “go for growth”, while others will be much more conservative. All these preferences for risk can be accommodated within LDI, yet the risks of underfunding liabilities will be quantified.

Five: LDI constrains exposure to growth:

LDI can allow adequate exposure to growth, depending on the risk preferences of the individual. Regardless of these preferences the LDI procedure places the exposure to growth, and the need for return, against the cold hard facts of life; funding the future stream of liabilities. With such a sobering backdrop, one would expect that “exposure to growth” is more constrained.

Six: LDI is only appropriate for large companies, who report liability shortfalls:

Techniques used at the “top end of town” are very instructive for the small investor, as they show what larger investors do, when the stakes are magnified, in terms of the possibility of large asset selection mistakes. Yet, the smaller investor will feel the impact of poor asset selection very brutally; even more than the “professionals” running large funds, as the small investor is usually the beneficiary of the asset performance/underperformance. So, while the large manager may lose reputation from poor asset selection, the small investor faces the ugly possibility of literally “losing his/her shirt”. Lessons learnt the hard way, in large companies, therefore, need to be heeded very seriously by the smaller investor.

Objections to the LDI approach are all very interesting, yet one needs to tie in these objections into the important developments in the local fixed income market, as we indicate below.

Rates higher, post RBA Rate cut and the SOMP

The RBA surprised everyone with the rate cut last week, and RBA delivered the quarterly Statement on Monetary Policy (SOMP), yet longer rates rose. In order to explain this curious development, the following needs to be considered. First, in the SOMP, the following important issues were addressed by the RBA:

  • Global growth prospects remain mixed with adequate US growth being offset by an ongoing European recession and a struggling Japan,
  • Domestic growth is much the same as it was in February, which has sub-trend growth forecast until the end of 2013,
  • Domestic transition from mining, to non-mining led growth is proceeding, yet is slower than needed,
  • Commodity prices are expected to resume their steady downtrend,
  • While the domestic economy grew at trend in 2012, yet 2013 growth will be below trend
  • Housing sector appetite for loans is improving, yet more is needed to offset the decline in the mining sector, and
  • Inflation outlook is balanced, and the employment growth is expected to moderate (SOMP, May 2013).

Given this rather sombre outlook, one would have thought that the local market may have rallied, yet the global bond markets trended a little higher in yields, and that is the main reason for the higher yields in Australia, after the easing. Global bond markets are being weighed down by the relentless rally in equity markets, and the growth that such equity pricing implies. While Bernanke has observed that quantitative easing may be causing a “reach for yield”, he, and the Federal Reserve, remain very cautious about changing internal settings for the US too early. Hence, some external measures may be more appropriate, such as a general rise in the US dollar, which will reduce the growth prospects of the US economy, as a rising dollar will reduce the prospects of the export sector. In addition, the impact of fiscal drag on the US economy, from the sequester, remains largely unknown at this time.

All this tends to suggest that the time ahead will see slightly lower rates for longer, as the cash rate effectively settles at the medium term rate of inflation; cash rates will be zero (real) for some time.

What is ahead?

One option is to get in ahead of the expected yield-compression and buy Inflation-Linked Bonds (ILBs) which still offer returns of up to 4% above the inflation rate for the life of the bond. Most corporate bonds, and all corporate ILBs, are only offered in the over the counter (OTC) market. Corporate ILBs have already fallen dramatically in real yield, and there is much more to come, as investors scramble for yield when the cash rate settles around the medium term rate of inflation. Also, Qantas bonds at 5.50%, or Mackay Sugar at 6.50% are great alternatives.

In anticipating what will happen here, one needs to look at what is going on overseas. Here, quantitative easing in the US has, is, and will continue to, compress nominal rates to the rate of inflation.

While Australia faces a different situation to the US, where QE is not in effect, the impact on Australia cannot be ignored., The recent fall in the yield of corporate ILBs, and other corporate bonds, has been testament to the ongoing spread contraction in all markets; from the nominal to the ILB bond market.

Now, consider what will occur when the domestic cash rate approaches the medium term rate of inflation, of 2.50%. Here, we expect that a zero real short term rate will tend to drive all spreads tighter.


Compression of the cash rate to the rate of inflation is but the first step in the compression of other bond spreads, especially corporate ILBs, and other corporate bonds. These securities really help the application of the LDI approach to portfolios, and some of the typical objections to LDI were considered above, in the context of an RBA rate adjustment procedure that is ongoing; it has not finished yet. Slightly lower rates are now needed to gather momentum in the non-mining sector, so as to offset the anticipated decline of the mining sector.

Within this context of low rates, opportunities for protection against inflation come and go, and the recent opportunities in the Australian ILB, and corporate bond market are fast “going”. Low cash rates for longer will mean that the Australian market follows the global trend, towards lower yield, that is now entrenched in other developed markets. Apart from other things, this means that Australia will look more and more like other developed countries, not less, over the next few years. Compression of spreads to inflation is now the order of the day, and will remain the order of the day, as we have observed in other developed markets.

While investment grade, corporate ILBs at around 4% real, provide an investor with fairly cheap insurance against inflation, along with other corporate bonds, all that will change as the cash rate approaches the rate of inflation.

Specifically, we expect that corporate ILBs and other corporate bonds will not stay as cheap as they are at present