How is AG adapting its investment strategy in this low interest rate environment?

Wim Vermeir explains how AG is diversifying its investment portfolio.

Published on 23/06/2021

Intro text
As countries around the world press ahead with COVID-19 vaccine rollouts, investors stymied by persistently low interest rates see a glimmer of hope. Against this backdrop, AG is constantly looking to diversify its investment portfolio on its quest to earn higher returns. We caught up with Wim Vermeir, AG’s Chief Investment Officer (CIO), to find out more about the company’s new diversification strategies.

How would you describe the current economic environment, in broad terms?

The COVID-19 pandemic has sparked a major global crisis, introducing a great deal of uncertainty into the economy and financial markets. Central banks have slashed interest rates to historic lows in an effort to prop up the economy and stimulate growth, while governments have been forced to step in to support businesses and their employees. But things are starting to improve for most people – and for the economy as a whole. Activity is running at 95% of pre-pandemic levels, not least because most large corporations have all but switched to full-time work from home, although sectors like tourism, hospitality and the arts are still in deep trouble. Looking at the overall picture, however, the economy is up and running again. And that’s causing interest rates to edge upwards.

Why are rates starting to move again?

With a game-changing vaccine in play, the recovery is set to pick up pace. So this is very much a temporary crisis. We’re not out of the woods yet, but the economy is still in one piece and things seem to be under control. That’s what really matters. Burgeoning optimism about the outlook for the financial markets is pushing rates slightly higher. Some observers are even talking about inflation returning, citing three reasons. First, commodity prices are ticking upwards now that the shock to the economy has passed and negative sentiment is fading away. Second, some logistics systems are unable to keep up with the faster-than-expected pace of the recovery. And third, restaurants have raised prices in the aftermath of the crisis ahead of an anticipated consumer spending boom. These three factors, taken together, are pushing up prices and creating inflationary pressures which, in turn, are causing rates to rise.

Do you foresee interest rates rising in the long term?

No. I don’t think this slight uplift is a structural phenomenon. Our view is that it’s a temporary trend. Wages are still flat, and wages are what really drive inflation. We’re not seeing any increase on that front yet – at least not in Europe. A small amount of inflation should come as no surprise, given the exceptionally low starting point where deflation was a very real risk. But the long-term outlook remains unchanged.

What are your predictions for the future?

I expect the economy to bounce back strongly before growth stabilises at a lower level. The inflation we’re seeing now won’t last, and it won’t be structural, even though governments are currently spending more than they did under austerity. My view is that interest rates will remain low for a long time to come, only marginally higher than the historic lows we saw at the height of the crisis last year.

But if wages start climbing too, then we could see structural inflation setting in, and this would impact our predictions. So we’ll be keeping a close eye on these developments..

"Overall, economic activity is running at 95% of pre-pandemic levels, not least because most large corporations have all but switched to full-time work form home."

How is AG adapting to this low interest rate environment?

A low interest rate environment makes our job more challenging than ever. But we have two aces up our sleeve: our liabilities are long-term commitments and they are predictable. This means that we can invest based on the same long-term horizon - cashflow matching - as well as invest in alternative, less liquid assets, i.e. investments that we can’t sell off before their expected maturity date.

What exactly do you mean by “alternative, less liquid assets”?

At AG, we seek out additional alternatives on top of government bonds, which central banks currently buy as a means to inject money into the economy – a process known as quantitative easing. For our customers, we’re always looking for attractive investment options in addition to these bonds. This helps us diversify our portfolio in order to earn higher returns.

It goes without saying that these alternatives are in keeping with our defensive investment strategy, with a similar risk profile to government bonds.

To what extent does this investment strategy increase risk in AG’s investment portfolio?

Investing in less liquid assets doesn’t carry any particular risk. For AG, the illiquidity risk posed by this asset class is vanishingly small because we use cashflow matching as a matter of policy. In other words, we buy assets that match our liabilities. So as long as our assets are consistent with our liabilities, and as long as our liabilities are as liquid - or as illiquid - as our assets, there’s no issue.

And since our liabilities are incredibly stable, we can safely invest in high quality assets that are less liquid than other classes. In fact, this type of asset makes up roughly 25% of our portfolio. In general, we’re aiming for a stable, sustainable, long-term investment strategy that delivers attractive returns.

Can you give us some examples of these illiquid assets?

We invest in three types of less liquid asset classes. Sometimes we invest directly, but in a less liquid way, in projects run by Belgian regions and communities. This approach is about playing our part in shaping the future of our society. And it chimes with our “supporter of your life” brand promise. For instance, we finance low income housing projects guaranteed by regional authorities, which have the same risk profile as less liquid government assets.

Another example is high quality Belgian and Dutch mortgage loans. They yield much higher returns than government bonds. And although they also carry a higher risk, losses on this asset class have historically been very low. The higher returns more than offset the downside risk. We also have a €2.5 billion infrastructure portfolio, where we step in as an alternative provider of financing for government-sponsored projects. Our investments here are incredibly diverse, ranging from schools, courthouses and prisons, to sports facilities. Beyond that, our portfolio includes solar and wind farms, as well as transport infrastructure such as motorways, conventional and high speed rail networks, and the tram system in Liège. AG is also investing in high speed fibre broadband networks to improve connectivity, mainly in France and Spain.

"Our liabilities are incredibly stable. This predictability allows us to safely invest in high quality assets that are less liquid than other classes. In fact, this type of asset makes up 25% of our portfolio.”

So sustainable investing is still central to AG’s strategy...

Absolutely. We’re constantly exploring ways to make our investments more sustainable. Europe has come to recognise the power of sustainable investing to make a positive impact on the planet. That’s the thinking behind the EU’s Green Deal, which focuses on renewables, and the Digital Deal, which is about bringing high quality connectivity to all. By backing these two initiatives, AG intends to do its bit for society – and really deliver on its commitment to being a “supporter of your life”. That’s why we’re investing in low income housing, to take just one example.

AG’s Branch 21 products are backed by a cautious investment approach. Are there other financing alternatives for group insurance plans?

It’s important to stress that we invest optimally in Branch 21 products and that our offering is attractive. But we’re always on the lookout for alternatives to zero return bonds, even if we already have good results.

With rates at historically low levels, now is the time for investors to try “hybrid” solutions, such as by investing in Branch 21 and in Branch 23. The risk may be higher, but the potential long-term return is much higher too. The idea is here is to strike the right balance between Branch 21 investments, which shield an investor’s portfolio from risk, and a Branch 23 product that delivers higher potential returns. I think this combined approach is a wise alternative given the current economic climate.