Guest article written for AllAboutAlpha.com – the official publication of the Chartered Alternative Investment Analyst (CAIA) Association
Originally posted at: http://allaboutalpha.com/blog/2012/12/20/managing-risk-in-fixed-income-markets/
At any given time, almost US$100 trillion is outstanding on the global bond market. This is roughly twice the size of the world’s equity markets combined, amounting to almost 150% of global GDP. Bonds and other fixed-income instruments are the foundation of how much of the world’s economy is funded.
From central banks to financial institutions, insurers and more- everyone has their eyes firmly glued to even the most minute movements in these markets. James Carville (former political advisor to President Clinton) once said: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody…”
The very word “bond” conjures up an idea of how these instruments were perceived in the market. Bonds were typically seen as being the ultimate safe-haven instruments for a portfolio, but following the near-existential events of 2007 have showed investors otherwise. Research shows that, “…Collateralized debt obligations (CDOs), once a money making machine on Wall Street, have been responsible for $542 billion of the nearly trillion dollars in losses suffered by financial institutions since 2007…” By magnitude, this would be similar to losing the entire Deutsche Börse.
To learn more about managing risk in fixed income portfolios, I spoke to Dr. Kevin Anderson, Global CIO (Fixed Income and Currency) at SSgA (State Street Global Advisors) – a firm with US$23.4 trillion in assets under custody and administration, and US$2.1 trillion under management.
Kevin is a Senior Managing Director of SSgA and Global CIO of Fixed Income and Currency. He is responsible for all fixed income and currency strategies and products. Kevin holds a PhD in Theoretical Physics from the University of Southampton and he graduated with a BSc Honours degree in Mathematical Physics from the University of Edinburgh in 1994.
Q: What are the key risks and mitigation strategies in government and other sovereign debt?
[Dr. Kevin Anderson] Before we make an investment and look at risks, we have to look at what our clients want in terms of investment outcomes and their own risk profiles. Linking that to government bonds and the treasury curve for example, we see that pension fund clients will have long-dated liabilities and potentially will need to match longer-duration. They have a different risk-profile to short-dated insurance or other participants. It’s important to look at the risk of the instrument and investment in context of client’s needs and strategies. Before you think about the alpha, you have to think about the client’s beta.
We hold government debt for principally for those classes of client- defined benefit pension funds, institutions such as central banks, insurance firms and so on. Assessing the interest rate risk is still the key when looking at the full or partial duration of those instruments.
If we look at sovereign paper, recent experiences in Europe have illustrated the creation of the ‘sovereign risk premium‘. Investors who previously thought that sovereigns were a quasi-risk-free asset have been challenged in that respect. Domestic local-currency sovereign debt is certainly not risk-free. It very much depends on the willingness and ability of the sovereign to pay-back its debt! Sovereign debt is reasonably unique in that there are no underlying assets one can claim unlike corporate bonds. Assessing that idiosyncratic risk premium is very important. For example, in our more alpha-focussed mandates, research has been directed at assessing risk between the fundamentals between euro zone states.
Q: What are the key risks and mitigation strategies in corporate debt?
[Dr. Kevin Anderson] Corporate bonds have additional risk factors. You have the underlying rate-profile and the position of that issue from a particular issuer on the yield curve, and how that impacts the interest-rate profile. However, there are a number of other factors one should consider.
We are certainly taking a view on a sector basis, with utilities, industrials and financials at the top-most level. Looking down beneath that, we will see banks, brokerage, insurance, different types of utility companies, autos and so forth. Those sector-based calls are important from a macro and cyclical sense. Understanding your relative exposure to those macro factors is important.
Another important element is the idiosyncratic risk profile of the issuer. A corporate bond is ultimate a long-term loan structured in the form of a bond. Corporate entities are not default-remote and are not guaranteed to pay-back their debts. You have to look at the balance sheets of the corporates in your portfolio, and understand how that balance sheet looks from a bond-holder perspective rather than a shareholder perspective. This can introduce in macro considerations such as concentration, sectoral risk.
Liquidity in corporate bond markets has been challenging this year. Many large trading bank models are trading, and flow-trading has been transformed. Ongoing regulatory changes aiming to increase transparency will also create changes in this market.
Q: What are your views on the risks presented by CD instruments?
[Dr. Kevin Anderson] Key is to recognise who the issuer of the deposit is. At SSGA we manage traditional bond portfolios (typically over 1 year to maturity) and also have significant cash business. Here, we manage portfolios that look to provide market value cash or liquidity. It’s incredibly important to understand the credit-worthiness of the investments, the issuer’s own status and so on.
Q: What are your views on the risks presented by MBS, CDO and other fixed-income derivatives?
[Dr. Kevin Anderson] Securities like MBS have a prepayment risk in their profile. There is always the ability for mortgage owners- who are ultimately behind the instrument- to refinance and prepay their mortgages. This gives mortgages a convexity risk feature which is different to most securities in issue. This has to be assessed against interest rate volatility as it can affect not just risk, but also alpha.
When one talks about MBS, CDO, ABS- all of those are part of a rich and expansive set of securities. MBS includes the Ginnie Mae issues in the US, agency mortgage-backs (which are exclusive guaranteed by the US Government) and Fannie Mae & Freddie Mac which are implicitly guaranteed. In totality, those mortgage-backed pools of issuance account for approximately one fifth or so of the whole US investment grade bond market. They are a significant part of many US Dollar investor exposures, especially if they are buying in aggregate.
When one looks at ABS, there is more of an issuer-profile to take into account as well as an interest-rate differentiation profile given the type of cash-flow the instrument may generate over its term. You also have to look at the underlying pools of assets and collateral backing the issue. These risks must be compensated for in the price.
Transparency is paramount. We have to make sure that we have sufficient transparency in the investments we are making, to be able to manage risk for our clients. CDOs and tranches thereof are certainly not part of mainstream institutional investor portfolios- mainly because of the risk-preferences of clients, and our own specialisations. These are specialised and complex instruments. We have seen a continued push for drive from our investors, especially since central-bank interventions in markets have pushed yields lower. We still have short-term memory of the financial crisis and are nowhere near the stage where investors would look for yield ‘at any cost‘. Investors have therefore moved away from instruments with a lack of transparency.
Q: What are your views on the risks presented by high-yield and non-investment grade instruments?
[Dr. Kevin Anderson] We invest in high-yield both in the European and US markets. One of our very large Exchange Traded Funds is a US High Yield product, we’re there buying the market!
When one buys an ETF in fixed-income, one cannot replicate every issue in the market and so one must look carefully at the risks involved. The assessment of risk in terms of high-yield has additional dimensions. You have sectoral risk, the nature of the issuer, idiosyncratic risks due to the companies themselves and more.
The other risks are due to covenants. For example, there are a fair percentage of these instruments which are callable bonds. These present the risk where an investor could call the bonds back with a value of 100 if they reach a price over-par. Given the current rally in high-yield, there is a significantly greater call-risk in the market. Bonds are behaving with a slightly different convexity- giving a negative convexity rather than others in the market.
Q: What are your views on the environment for price discovery and rating for fixed-income instruments and portfolios?
[Dr. Kevin Anderson] Price discovery is a function of the execution venues that one has, and which determine the price at which the market is willing to buy and sell. In equities this is somewhat straightforward, given that they are traded on exchanges- and those exchanges are an important source of price-discovery and liquidity. The fixed-income market (with the exception of fixed-income futures and derivatives) are primarily traded OTC or between counterparts- the main players being large regional and global banks. The price discovery process in an OTC market is somewhat more challenging than equity markets. There may not be the same availability of pricing at any given time. There have been developments, principally around electronic trading networks. These have significantly improved price-visibility. We do a substantial volume of our trading across these networks and find they allow for substantially better discovery of pricing. Our aim being to get best-execution for our clients.
Looking at ratings… Although we have our own team of research analysts to do fundamental analysis of credits and corporates, they also determine- with our portfolio managers- the relative value between issuers. Rating agencies are a very prevalent part of the landscape, and pay an important role. They provide an additional source of analysis. These agencies should make sure they are operating with transparent business models, and with mechanisms to ensure their research is objective and can be independently assessed. In the mid-80’s there were a greater number of smaller ratings agencies. Significant consolidation followed, and now we have a small number of dominant agencies. Post-crisis a number of new agencies have emerged. I think this greater-number will help increase transparency- as long as quality is maintained. There are also regulatory changes coming on board in respect of ratings. It’s important these changes continue to allow a common platform to be understood, and still allow for a high quality of analysis and research to be conducted.
One of the important aspects of rating agencies that we shouldn’t ignore is that many indexes and benchmarks have rules determined by ratings. You may have an investment grade benchmark, which may mean you are not allowed to own high-yield. This determination of an investment grade benchmark is not made by our own research analysts, but an independent rating agencies or a group of them together. Rating agency output is still very prevalent in many types of financial contracts.
What does this mean for investors and risk managers?
Investors in equities and other asset classes are frequently kept on their toes with major events ranging from frauds such as Madoff (with an impact potentially over $50 billion) to collapses such as Lehman (who collapsed with assets of US$691 billion), WaMu (who collapsed with assets of US$327 billion) and Worldcom (who collapsed with assets of just over US$100 billion). Even investors in commodities have to face real-time geopolitical and climate uncertainty.
The bond market has long been the elephant in the room, and events in the financial markets since 2007 (including the European sovereign debt crisis, QE and recent LIBOR scandal) have shown that investors and risk managers need to carefully understand the risks these instruments carry.