Katrina King
Fixed income investors should be factoring a rise in the term premium into their planning, according to QIC, one of Australia’s largest institutional investment managers. The QIC Global Liquid Strategies (GLS) team is conservatively anticipating normalisation of around 50 basis points.
The ‘term premium’ defines the compensation required by investors for holding long-term debt, as opposed to continually rolling over short term debt.
“For some years now, the term premium has all but evaporated or even been in the negative. In essence this means there’s been no excess compensation for investors holding long term debt,” explained Susan Buckley, MD of QIC’s GLS team. “But we have identified a range of global factors that signal a return to higher levels – and believe investors should be acting upon this return sooner rather than later.”
These factors include a “normalisation” of monetary policy following the US’s withdrawal of quantitative easing, investors’ demand for higher compensation to counter increased illiquidity caused by increased regulation in the finance sector and the general expectation of higher interest rates and inflation.
The nearing of peak foreign ownership of US Treasuries and sovereign investors’ consequent move to new asset classes is another driver. That includes increased interest in the Chinese renminbi as a currency, coinciding with the debate about its inclusion in the IMF’s standard drawing right basket and its new, more freely traded basis.
“Investors should understand that the return of the term premium does not signal a return to ‘normal’,” said Katrina King, GLS’ Director of Research and Strategy.
‘This time is different’ are said to be the four most dangerous words in economics and markets. Well, this era really is different. For a start, the term premium has spiked three times since the global financial crisis, showing that that term premium can move quickly and undercut unprepared portfolios. Then there is the emergence of a new risk, illiquidity, which investors are only now starting to give thought to. There is a rising tide of commentary on the new threat, but few ideas on how to counter it.”
Against this backdrop, QIC’s view is that fast, targeted responses to market adjustments will be critical for success. Inflation protection and inflation-related assets warrant renewed attention as will favouring short rates positions when valuations show mis-pricing.
“Rising inflation should not be a source of alarm – we are looking at moderate levels that we believe offer return opportunities for investors that look beyond the present and signal a welcome step-change in the post-GFC era,” explained Ms King.
“The upshot is that the extended holiday from risk premium is coming to an end – and that is a good thing. The return of the term premium represents a significant step up from the current broadly zero figure. For best results, investors must adjust to its return – but doing so may well test some nerves,” concluded Ms Buckley.
Read more in QIC’s latest Red Paper: The term premium is down but not out: prepare for its return.