Captive Insight Vol I | Page 46

CAPTIVEINSIGHT

to manage an asset portfolio of fixed income securities (or
Bond Funds, Bond ETFs, etc) to mitigate the effects of
rising interest rates.
For many captive owners, a natural and commonsense
strategy for controlling for volatility of returns is to invest
in, or remain in, ultra-short duration fixed income products,
particularly when markets anticipate higher forward interest
rates. But is that the right thing to do? While it may well
be if one’s strategy is to produce only a positive absolute
return and avoid any one-year period of negative returns,
it generally also leads to lower income over the long-term,
which matters more to most investors. The nature of bond
investments, as income generating assets and the shape of
the current and forward yield curve play important roles in
total return over a longer time frame.
We will use an example that fits well for a captive insurance
company. If Captive XYZ owns a two to three year average
life investment or bond fund, under a scenario where the
Fed becomes aggressive and raises rates eight times (once
per Fed meeting for one year) to 2%, he will indeed incur
a negative total return in year one due to a decline in Bond
prices (yields rise/price falls). However, if one looks at a
longer time frame, the two to three year investment will
have experienced maturities and been reinvested at a higher
yield along the way and over a four to five year spectrum,
or full interest rate cycle, one would have positive total
returns. Indeed, the original investment will always be
positive if held to maturity and will not have experienced

any permanent loss of principal! The obvious conclusion to this
is that for fixed income investors, it is always interest income
that matters most over the long-term, not short-term fluctuations
in the level of interest rates.
Conversely, what happens if the economy continues to show
unimpressive growth and the unemployment rate remains far
too high? Should the Fed take much longer to raise interest rates
over time because of a continued sluggish recovery, investors
will have paid a steep price for remaining far too conservative by
severely limiting the duration of their bond portfolios. They will
have pinned themselves at low rates (or zero in a money market
fund) for a very long time and not taken advantage of the higher
interest rates offered for longer-term bond investments.
So are we saying close your eyes and buy bonds and just hope
that rates don’t rise? We are not, but a well-diversified bond fund
or bond portfolio (and investment policy) that is careful not to
take excessive interest rate risk is an investment program that
can generate higher income over time. Higher income over a
longer time frame protects a captive from the one thing that CAN
actually erode principal in purchasing power terms, inflation.
The answer, therefore, is generally not to place too great an
emphasis on the future of interest rates and place greater
emphasis on the captive’s ability to generate income from its
investment portfolio. There is one time-tested and conservative
way this is possible without taking a large amount of interest rate
risk at what may appear to be the “wrong” time.
The fixed income investment universe is vast, with investment

“

The answer, therefore, is
generally not to place too
great an emphasis on the
future of interest rates and
place greater emphasis
on the captive’s ability to
generate income from its
investment portfolio.

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