"The Song Remains the Same" (The Peril of Ignoring Investment Risk)

For those of us of a certain age, the quote in the title of this article will obviously resonate. For others, the title comes from a concert film¹ featuring the band Led Zeppelin, shot during the band's 1973 3-night engagement at Madison Square Garden in New York and released in 1976.² I'm sure, though, that everyone reading this article is wondering where I'm going with this (you might be surprised to learn the subject is investment risk).

The genesis of this piece came from a recent Wall Street Journal (WSJ) article written by Akane Otani and Sebastian Pellejero and published June 2, 2020, titled "Collapse of Risky Securities Burns Individual Investors." After reading it, all I could think of was history repeating itself, but instead of using that as the lead for the story, I thought the film title was more apropos.

But what does the WSJ headline have to do with captive insurers? For me, it offers a cautionary tale about how quickly individuals and companies forget about investment risk or assume the risk probability of the event is too small to happen. It also illustrates the need for investors to always reach for yield, especially in low-interest-rate environments, even when they should beware.

The securities in question in the WSJ article are leveraged exchange-traded notes, or ETNs, for short. These products were offered by banks and brokerages to retail investors and I suspect may well have found themselves into some captive insurer portfolios. The following description of the product is from Fidelity Investments Learning Center and was adapted from a 2011 Wiley Global Finance article.

Exchange-traded notes (ETNs) are similar to exchange-traded funds in that they trade on a stock exchange and track a benchmark index. However, there are important differences:

• An ETN is a senior, unsecured debt security issued by a bank, unlike an ETF, which holds assets such as stocks, commodities, or currencies, which are the basis of the price of the ETF. The return of an ETN is linked to a market index or other benchmark.
• An ETN promises to pay at maturity, the full value of the index, minus the management fee. Like any other debt security, the investor is subject to the credit risk of the bank issuer.

… An ETN is essentially a bet on the index's direction guaranteed by an investment bank. As the index moves, so moves the ETN. The financial engineering underlying ETNs is similar to the financial engineering that investment banks have long used to create structured products for institutional clients. ETNs are different from ETFs because they don't own the underlying assets that their return tracks. ETNs are unsecured debt obligations.

Whether they understood it or not, what investors were purchasing in ETNs was a derivative. A derivative is a security that in and of itself is worthless. The name comes from the fact that the security in question derives its value from the underlying security it is linked to. These investments are considered to be highly sophisticated and require significant investment expertise to fully understand.

This complexity was further compounded by the fact that the ETNs were then leveraged to increase the possibility of higher returns. Instrument leverage in this case adds additional risk exposure to an already complex investment, by magnifying the change in value of the underlying security. It's been called "investing on steroids." As an example, if the value of an underlying asset, let's say a mutual fund, increases by 1 percent for the day and the corresponding ETN is leveraged at a three-to-one ratio, the ETN's value will increase by 3 percent. What many ordinary investors tend to overlook is that leverage cuts both ways. It will magnify losses when the underlying security declines and can quickly wipe out the value of the ETN.

So, to close this circle, how does the current ETN debacle relate to prior history? Let me offer the name "Orange County, California." Almost 26 years ago, in December 1994, Orange County was forced to file bankruptcy due to a failed bet on what was known as "inverse floating rate collateralized mortgage obligations (CMOs)." Inverse CMOs were history's ETNs. Like an ETN, an inverse floating CMO was a derivative. Its value was derived from an underlying pool of Government National Mortgage Association mortgage bonds. The fact that the underlying investment had an AAA bond rating meant that the CMOs could be peddled to investors with the same sterling credit rating. But credit risk was only one side of the coin, and buyers forgot about interest rate risk.

The financial wizards of the time took a fixed-rate mortgage and through their alchemy created variable-rate bonds that were packaged as collateralized mortgage obligations. In order to create a variable-rate bond, you also needed to create the inverse of that security, since the underlying mortgage paid a fixed amount of interest, hence inverse floating rate CMOs, essentially a bet that the interest rate would remain stable or fall.

For those not familiar with the years leading up to 1994, interest rates had been on a downward trajectory, thereby putting pressure on fixed-rate investment portfolios and leading investors to assume rates would continue in similar fashion. Many of today's captive insurance industry members will remember the "taper tantrum" event in 2013, when US Treasury yields surged on news that the Fed would be tapering its policy of quantitative easing. But you might not know this was preceded by the 1994 great bond market massacre,³ when government bond yields spiked by 200 basis points.

Those investors holding inverse floaters, such as Orange County, got slammed. Not only did prices fall dramatically for these bonds, but they also became zero-coupon bonds, meaning they would no longer pay any interest. Like today's ETNs, yesterday's CMOs enticed investors chasing yield.

In writing this article, my purpose is to remind all captive insurers of three simple axioms about investing and investment risk.

1. You can't have excess returns, above-normal interest rates, and low risk.
2. If an investment manager can't explain a proposed investment in simple terms, due to its complexity, pass.
3. And, finally, all captive insurers should rigorously follow "caveat emptor," or let the buyer beware.

With interest rates likely to stay low for a sustained period of time, possibly a decade or more, captives will need to learn to rely less on investment income or be willing to bear the consequences when they reach for yield.

1. The Song Remains the Same, Led Zeppelin tour documentary written by Peter Clifton, directed by Mr. Clifton and Joe Massot, and starring Led Zeppelin band members including Robert Plant, Jimmy Page, and John Paul Jones. Released October 20, 1976.
2. Wikipedia, The Free Encyclopedia, "The Song Remains the Same (film)."
3. "The Great Bond Massacre," by Al Ehrbar, February 3, 2013, Fortune.