Relative to some other institutions, healthcare organizations hold substantially large allocations of fixed-income assets. That reliance necessitates a well-articulated fixed-income strategy and a good understanding of the potential risks.
Fixed-income securities have enjoyed a secular bull market since interest rates began to drop from their early 1980s peaks. But the sharpest fall in yields—to historically low levels—was traceable to November 2008 when the Federal Reserve introduced its quantitative easing (QE) monetary policy. The Fed has since initiated three QEs, in which it purchased trillions of dollars in U.S. Treasury and mortgage-backed securities, injecting liquidity into an economy battered by the credit crisis and Great Recession of 2007 to 2009. As the economy gradually started to recover, Fed chairman Ben Bernanke announced in early 2013 a policy of “tapering” the QE policy contingent on continued positive economic data. The news sparked a major sell off in the bond market during the second quarter of 2013—the sharpest quarterly decline in three years–and a simultaneous backup in interest rates.
This phenomenon raised two questions for investors, including many healthcare organizations: What will happen if interest rates continue to rise in the coming months and years? And how can we shelter our investable asset portfolios from bond losses stemming from rising rates? The questions are particularly relevant to healthcare institutions due to their large fixed-income allocations–commonly as much as 35 to 40 percent of their investable asset portfolios. By contrast, not-for-profit educational endowments and foundations typically have fixed-income allocations ranging from 10 to 15 percent.
Of course, rising interest rates carry the investor benefit of higher—and much-needed—income. But because bond prices move inversely to their yields, investors face the challenge of making the transition to the higher rate environment without suffering major capital losses in the portfolio. For example, U.S. Treasury yields hit a low of 1.4 percent in July 2012. On June 30, 2013, they closed the first half of the year yielding close to 2.5 percent–a nearly 110-basis-point yield surge. The result was that holders of 10-year Treasury notes realized a loss of 4.9 percent on a total return basis in the first half of 2013, while investors in 30-year Treasury bonds suffered a loss of 9.1 percent over the same period. If rates continue to rise, the losses would mount.
Beyond the immediate risk of rising interest rates, healthcare organizations with large fixed-income holdings face a more strategic, long-term cost. Data from independent nationwide surveys of not-for-profit healthcare organizations indicate that their portfolio returns are lower than those of educational endowments and foundations. To make matters worse, healthcare organizations’ high fixed-income allocations offered little protection in the recent financial crisis, during which healthcare organizations reported portfolio losses nearly equal to other types of not-for-profit organizations.
Optimizing Fixed-Income Allocations
Previously, this column has discussed the merits of the “endowment model,” an investing approach many endowed not-for-profit institutions use for their perpetual asset pools. Its practitioners seek higher long-term total returns through a high degree of diversification biased toward equity investments and combined with a higher allocation to less-liquid investments, such as hedge funds, real estate, and private capital. Healthcare organizations find the model attractive, but feel obligated to maintain their current fixed-income allocations due to the greater liquid asset requirements of bond rating agencies. Bond issuance is a primary financing tool for healthcare facility construction and renovation, and bonds are likely to maintain that role in the future.
These constraints leave three basic options for healthcare organizations looking to optimize their fixed-income allocations:
- Pursue higher yields by investing in longer-dated instruments, while accepting a higher risk of capital loss
- Mitigate the risk of capital loss by investing in shorter-term instruments, but accept the low–or negative–real yields that come with short-term investments in the current environment
- Stay the course with a mixed-maturity portfolio, while seeking a midlevel return with a middling–but not inconsiderable–level of risk
The first option implies investing in a portfolio of mixed 10-year Treasury notes and 30-year Treasury bonds or–with higher levels of yield and credit risk–corporate bonds, high-yield bonds, distressed debt, and emerging market debt. This strategy carries interest-rate risk, with prices of long-dated bonds more sensitive to changes in interest rates. Other risks for non-Treasury instruments include credit, duration, and liquidity risks.
The second option provides greater principal protection and higher liquidity for the portfolio through the use of Treasury notes maturing in two, three, or five years and Treasury bills maturing in one year or less. Maturities of about five years begin to add the same interest rate risk present in longer-dated instruments. Shorter-term instruments, although less vulnerable to interest rate risk than the long-dated bonds used in the first option, currently offer low yields. In fact, the midyear yield on Treasury notes was well below the inflation rate, which means that their real yield after inflation was negative.
Option three—the medium-risk and medium-maturity option—requires that the institution be satisfied with its current risk profile, despite the threat that increased interest rates could produce significant capital losses. Such risks mean that staying the course also is a decision–one that will be open to criticism if substantial interest rate movement occurs.
Implications for Investors
Investors have acknowledged the rising interest rates and increasing credit and liquidity risks present in the bond market. These risks are connected to equity prices because any downturn in stocks could weaken credit-based bonds. So what do those conditions mean for healthcare investors with large fixed-income allocations? They need to weigh the tension between the demand for yield and the risk taken to achieve it in order to identify an approach that fits them best.
Many institutional investors have adopted the endowment model, which spreads their risk across different investment strategies–domestic and international equities, hedge funds, and private capital. This approach carries a relativelylow fixed-income allocation. For healthcare organizations that choose a higher allocation,
the choices are relatively few and involve specific trade-offs. The uncertain market environment, which is expected to prevail for some time, has led healthcare organizations seeking to grow their investable asset pools to increasingly examine more diversified portfolios as an alternative to traditional large fixed-income allocations.
William F. Jarvis is managing director, Commonfund Institute, Wilton, Conn.
Publication Date: Sunday, September 01, 2013