Pension and Endowment Portfolio Strategies: Spread, Rates, Volatility Suppression

Contributed by: Abhimanyu JL

Bengaluru chapter of the IAIP hosted Satish Swamy, CFA, a portfolio manager who oversees $9 billion in assets for the University of California’s (UC) pension, endowment and defined contribution plans, engaged the audience in a conversation about the system UC has built over the years and shared details about superior returns they have managed to generate over time. For example, Satish shared with us how for over 20 years there were no contributions from either the employer or the employee for the UC defined benefit or pension plan. He shared simple things that were changed in the organization which had positively impacted returns.

Satish also highlighted the various instruments/pools of funds managed in the organization that totalled about $90 billion. He reinforced the CFA curriculum and the need for diversification while managing assets critical to the functioning of the entire UC system. He shared several anecdotes of how the UC system evolved to its current state of affairs. Satish next moved onto sharing his thoughts on portfolio strategies to navigate the current unusual environment. He shared how he envisions things to play out while quantifying risks he is taking to get desirable returns. His talk revolved mostly around rates, spreads and volatility:

Rates: Satish opined that looking at both, the FED fund futures and Euro dollar futures contracts, the market is pricing an increase in US interest rates to commence in either late 2015 or early 2016. He predicted that rates would be low into the foreseeable future and that the FED was not overly concerned about inflation. Furthermore, he shared his thoughts on the yield curve, which is currently very steep. As is known, the steepness of the yield curve currently indicates slow economic growth. He also shared that the optimism of the economy recovering right away in the US had been cut back due to lackluster 1st quarter GDP and that the market viewed recovery to be pushed to the second half of 2014. Given this backdrop, Satish believed that short term rates were going to be low for a while and that one strategy he employs to generate returns is by rolling down the steep part of the yield curve and earning carry. That strategy has worked remarkably well the last few years especially with spreads contracting.

Spread: Commenting on Spreads, Satish noted that we were in very unusual times and showed spread charts for different sectors and highlighted that current Option Adjusted Spread to be under 1% for IG corporate bonds. On buying corporate bonds, he noted that spreads had compressed significantly, and when spreads eventually widen, bond prices would go down. On compression of spreads, Satish suggested there was not much upside, i.e., spreads can’t get to zero and what would drive spreads eventually was interest rate volatility.

Volatility: Satish shared Larry Summers’ thoughts on ‘Secular Stagnation’ and engaged the audience in listing the top things which could bring about a volatile environment. He brought the audience’s attention to economic growth, geo-political realities and global central bank behavior.

Commenting on volatility his thoughts revolved around where volatility currently was and what we could see in the near term. He shared how volatility could be used to generate returns. He talked about the concept of negative convexity which is akin to selling options and earning option premium. Callable bonds have negative convexity – that is, one is picking up yield while sacrificing convexity. When volatility is at an all time low, he noted that the payoff profile in shorting options was asymmetrical. This option premium is an added return in Fixed Income. When volatility is low, you get to keep the premium with passage of time. Satish also talked about the flip side of a low volatile environment and engaged in discussions of buying volatility or buying options. When volatility is low, option price is low. He commented on low volatility in the continued current scenario, what could drive volatility up and strategies to capitalize eventually when volatility heads higher. He spoke about strategies to create a positively convex portfolio and the risk profile of these strategies.

All thorough his talk, Satish shared relevant historical data and insights into geo-political, central bank, and other systematic concerns. He gave the audience food for thought by engaging them in a conversation, breaking down complex theoretical aspects to practical applications and helping analyze the times we live in. Satish concluded the evening with a very insightful discussion on the valuation of Uber, patiently answered questions and left the audience wanting more.