Steady increases in interest rates will benefit alternative investment strategies that have investments in short-term, highly rated fixed income portfolios, as it will raise their expected returns and could result in them growing their share of the overall hedge fund industry, according to the founder of Agecroft Partners.
That bodes well for insurance-linked securities (ILS) and reinsurance as an asset class, with the fully-collateralized nature of catastrophe bonds, ILS and reinsurance linked instruments meaning that they are invested in cash equivalents, such as highly rated fixed income, treasuries and bonds, or similar.
Donald A. Steinbrugge, CFA, the CEO and Founder of consultancy and third-party alternative investment fund marketing specialists Agecroft Partners, explained in a recent interview that he feels the current trend towards higher interest rates will benefit asset classes such as reinsurance and ILS.
Speaking to publisher AlphaQ in this interview, Steinbrugge explained that while people often interpret rising interest rates to mean declining asset values, given the sensitivity bonds markets and certain equities have because of duration, those asset classes invested in short-term fixed income assets could benefit from them.
“Rising short term rates can have a positive impact for the many hedge fund strategies that hold large cash positions,” Steinbrugge said.
He cites CTA funds and market neutral long-short equity strategies as two examples of the types of alternative investments or hedge funds that could benefit from a rising interest rate trend, with a third being reinsurance.
“A third example of this can be seen in reinsurance. Reinsurance hedge funds are required to be fully capitalised for potential liabilities/claims that they may incur. These assets are also typically invested in cash or very short term, highly rated securities,” Steinbrugge explained.
On the current rate environment and the promise by U.S. Federal Reserve forecasters that rate rises would continue through the coming years, Steinbrugge predicts, “Rates rising from close to 0 per cent to over 3 per cent on short term securities will have a direct and meaningful impact on the expected returns these strategies should generate going forward.”
These higher expected returns could have meaningful impacts in the hedge fund world as a whole and how investors allocate their capital, he continued.
Steinbrugge forecasts that hedge funds which see their expected returns increase as a result of interest rate rises will benefit, taking market share away from other alternative investment strategies.
He explained, “Often there is only a 1-2 per cent difference of the expected return among potential hedge fund strategies on an investors’ shortlist. In a rising interest rate environment, the enhanced returns from strategies with large cash positions should make these strategies significantly more attractive.”
That bodes well for the ILS market and also serves to counteract the belief some have that some investors will exit the ILS market when interest rates rise.
The floating nature of ILS instruments including catastrophe bonds means that their returns will rise with interest rate increases, as the underlying collateral asset return increases.
A 2% to 3% interest rate could attract more investors to ILS, due to the increased expected returns available, Steinbrugge believes.
Although he does also warn that better expected returns in asset classes, such as ILS and reinsurance, could provide investors with more negotiating leverage on performance fees. So ILS fund managers, while perhaps receiving even more demand from investors, may also find they receive a little more pressure as well.
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