Viewpoints

Switzerland: Investment Opportunities in a Negative Yield Environment

A well-diversified globally oriented portfolio may offer Swiss investors enhanced returns and structural benefits that may outweigh rising currency hedging costs.

There is little doubt that the Swiss National Bank’s (SNB) unexpected policy decision to abandon its Swiss franc/euro currency floor on 15 January 2015 came as a shock to the financial world. We believe the consequences will be lasting and far-reaching for investors, particularly Swiss investors, mainly through the impact of negative yields on Swiss government bonds and the rising currency hedging costs associated with the Swiss franc.

By abandoning the currency floor, interest rates have become the SNB's primary policy tool. The decision to pursue a negative interest rate policy has pushed yields of Swiss government bonds into negative territory for maturities up to 10 years, a situation which is unlikely to reverse anytime soon. However, the ramifications of this monetary policy shift are not limited just to government bonds (see Figure 1), as select short-term corporate bonds also have been trading at negative yields. This highlights the challenges for Swiss investors who are forced to invest in domestic assets. At the same time, leaving cash on bank accounts is no longer an attractive alternative, as many investors are now increasingly faced with negative interest rates on their cash holdings.

The abrupt change in the SNB's monetary policy caused severe stress in the Swiss franc currency market. In addition to a significant weakening of the euro and the U.S. dollar against the Swiss franc, there was a significant spike in currency hedging costs following the SNB's policy shift. While market dislocations have partially normalised, rising currency hedging costs have become an additional element in investors´ decisions on top of considerations pertaining to interest rate differentials (see Figure 2).

This is particularly true for Swiss institutional investors, such as pension funds, who are facing increasingly stringent regulations that further constrain their investment universe and their ability to achieve target returns on investments. For example, the more restrictive framework for the classification of receivables under the Swiss Ordinance on Occupational Retirement, Survivors’ and Disability Pension Plans (BVV2), either as traditional or alternative investment instruments, limits the range of potential investments for Swiss pension funds.

Is it time for investors to go global?

In our view, the heightened financial repression in Switzerland remains the key challenge for Swiss investors over the longer term.

At PIMCO, we believe they may want to reconsider their current asset allocation in the context of a globally oriented investment universe to potentially enhance expected returns. In the current low yield environment, however, going global has its challenges. Take global government bonds, for example: They appear to provide an obvious alternative to Swiss government bonds by offering a diversified, high quality issuer base. However, yields are low globally as major central banks across the developed world pursue ultra-low interest rate and quantitative easing policies. Add to that the elevated currency hedging costs, and we find that the yield on the Barclays Global Treasury Index, hedged to the Swiss franc, is also negative at the moment (Barclays, as of 31 March 2015). Among the developed market government yield curves, there are currently only a handful of markets where we see the potential for a positive, albeit meagre, return that can be earned on a currency hedged basis.

Simply going global by itself may not be sufficient. In our view, Swiss investors ought to consider moving selectively further out what PIMCO calls the “investment concentric circles” into investment grade credit, high yield, bank loans, emerging markets, distressed debt and real estate to complement the overall portfolio´s risk factor exposure and to enhance returns (see Figure 3), within the framework of their risk/return objectives.

Yields, however, are only a snapshot of current market pricing, and are not the same as prospective returns; returns are also determined by a number of additional factors, such as future changes in global yield curves, spreads and currency hedging costs. At PIMCO, we use 10-year expected returns that incorporate current yield levels, historical risk premia and our longer-term views on expected market movements, rather than yields, to evaluate strategic investment decisions.

To illustrate this point, let us take a look at the yields and expected returns for several model portfolios, as well as their estimated volatility (see Figure 4). The mid-point of the expected return range is positive, although modest, for Swiss government bonds, despite the current negative yields. This reflects our expectation for Swiss yields to rise over time, leading to a positive running yield and consequently to a modestly positive total return.

For example, a global investment grade credit strategy provides higher expected returns and a positive hedged yield against a volatility that is not much higher than that of Swiss government bonds, while a diversified global credit portfolio lifts the yield to over 2% and also increases the expected return for a 50% increase in volatility compared with that of Swiss government bonds.

When we plot the mid-point of the expected return for these four model portfolios against the estimated volatility, which is based on PIMCO’s proprietary risk factor model, we see that global treasuries have a lower volatility than Swiss government bonds due to the lower average duration and diversified issuer base (see Figure 5).

Should investors fully hedge their currency risk?

Swiss investors have historically been reluctant to accept currency risks within their fixed income allocation; however, our analysis suggests that some currency risks can exhibit diversifying characteristics in an overall portfolio context and increase expected returns over the long term. We believe that this is due to two reasons: hedging costs and currency valuation.

  1. Hedging costs: Swiss interest rates are among the lowest of all the major currencies. This means that when hedging currency risk, investors continually pay away the difference between the foreign and Swiss interest rates. At the moment, the interest rate differentials are about 1% versus the U.S. dollar and 0.8% against the euro (Bloomberg, as of 31 March 2015). We expect this to increase going forward, especially versus the U.S. dollar as we expect the U.S. Federal Reserve to increase interest rates well ahead of the SNB.
  2. Currency valuation: The Swiss franc is now one of the most overvalued currencies based on fundamentals.

We therefore expect that hedging back to the Swiss franc will likely reduce portfolio returns since investors would end up paying away more than 1% per annum to buy an expensive currency.

However, leaving currency unhedged is not without risk. The estimated volatility of global treasuries nearly doubles when leaving the currency unhedged, while volatility for global investment grade credit is more than 50% higher. We believe a partial hedge that modestly reduces the hedge ratio from 100% to 80%–90% for government bonds and 70%–80% for global investment grade credit may increase expected portfolio return without meaningfully increasing risk (see Figure 6).

Our assumptions for the difference in hedged and unhedged returns are based on a combination of the expected interest rate differential and the expected spot price change. For example, for the U.S. dollar, we expect an interest rate differential of 1.4% per year and a Swiss franc depreciation of 1.1% per year, resulting in a 2.5% difference in the expected return on a hedged versus unhedged U.S. dollar-denominated investment.

And what about the spike in currency hedging costs on top of what interest rate differentials between currencies would suggest? We expect this to be a temporary dislocation that will eventually normalise – either the SNB will work to close the negative basis or value investors will arbitrage it away over time.

Conclusion

The SNB's monetary policy shift has created significant and lasting challenges for Swiss investors; however, the good news is that economic and monetary policy divergence may provide attractive opportunities for value investors with a broad investment horizon to enhance returns and reap the benefits of a globally diversified portfolio. Importantly, we believe that bonds continue to play an important role for investors as a diversifier as well as an income generator. Taking a global investment approach alongside an expanded investment universe provides structural benefits that may outweigh the costs incurred by currency hedging.

The Author

Jeroen van Bezooijen

Product Manager, EMEA Client Solutions and Analytics

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London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Milan
PIMCO Europe Ltd - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Munich
Pimco Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10


PIMCO Europe Ltd (Company No. 2604517) Ltd (Company No. 2604517) and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The Italy branch is additionally regulated by the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO Europe Ltd services are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | Pimco Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), Pimco Europe GmbH Italian Branch (Company No. 10005170963), and Pimco Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, and Spanish Branch are additionally supervised by the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act, and the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by Pimco Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services provided by PIMCO (Schweiz) GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser.

This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over a ten year period. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods.

A word about risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. All investments contain risk and may lose value.

Index descriptions: The Barclays Global Treasury Index tracks fixed-rate local currency sovereign debt of investment-grade countries. The index represents the Treasury sector of the Global Aggregate Index. The Barclays Global Aggregate Credit Index is the credit component of the Barclays Aggregate Index. The Barclays Aggregate Index is a subset of the Global Aggregate Index, and contains investment grade credit securities from the U.S. Aggregate, Pan-European Aggregate, Asian-Pacific Aggregate, Eurodollar, 144A and Euro-Yen indices. The Barclays Global Aggregate Index covers the most liquid portion of the global investment grade fixed-rate bond-market, including government, credit and collateralized securities. The liquidity constraint for all securities in the index is $300 million. The index is denominated in U.S. dollars. The Barclays Swiss Franc Aggregate Treasuries Index consists of Swiss Franc denominated bonds issued by the Swiss government. The BofA Merrill Lynch Global High Yield BB-B Rated 2% Constrained Index tracks the performance of below investment grade bonds of below investment grade bonds of corporate issuers domiciled in countries having an investment grade foreign currency long term debt rating (based on a composite of Moody’s, S&P, and Fitch). The index includes bonds denominated in U.S. dollars, Canadian dollars, sterling, euro (or euro legacy currency), but excludes all multicurrency denominated bonds. Bonds must be rated below investment grade but at least B3 based on a composite of Moody’s, S&P, and Fitch. Qualifying bonds are capitalization-weighted provided the total allocation to an individual issuer (defined by Bloomberg tickers) does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis. Similarly, the face value of bonds of all other issuers that fall below the 2% cap are increased on a pro-rata basis. The index is re-balanced on the last calendar day of the month. The inception date of the index is December 31, 1997. The JPMorgan Emerging Markets Bond Index Global is an unmanaged index which tracks the total return of U.S.-dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady Bonds, loans, Eurobonds, and local market instruments.

No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world.

PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd – Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. ©2015, PIMCO.

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