New Techniques to Manage Sovereign Credit Risk

Guest article written for – the official publication of the  Chartered Alternative Investment Analyst (CAIA) Association

originally posted at:

In a recent paper entitled Managing Sovereign Credit Risk in Bond Portfolios (Bruder, Hereil & Roncalli October 2011) the writers assert that, “…with the recent development of the European debt crisis, traditional index bond management has severely called into question….”.

Traditionally, sovereign bond indices use the level of outstanding debt each country has to determine proportional index weighting.  The writers note an intuitive flaw insofar as this, “…gives higher index weightings to the most indebted countries, regardless of their capacity to service their debt.  A country facing financial hardship and trapped in a debt spiral to remain solvent would see its index weight increase until the whole mechanism collapses and an exclusion from the index occurs…” (Greece clearly is a clear example of this happening in recent times).

The writers also cite a number of fund managers such as Blackrock who, with their Blackrock Sovereign Risk Index, utilise a wider range of factors quantitative (GDP, Debt structure and terms, revenue, and so on) and qualitative (willingness to pay, political factors, etc) to construct more advanced models for sovereign risk.

The New Normal

The sovereign credit of developed economies had (until recently) typically been considered ‘risk free’ by market participants.  This feeling was part psychological, “People underestimate their personal probability of encountering negative events” Wrote Frank McKenna in the British Journal of Psychology (1993, Volume 84), “…it is not so much that individuals believe that negative events will not happen, but rather that these events are relatively unlikely to happen to them.” and part functional (insofar as for the ‘maths-of-the-market’ to work, the market needed a risk-free asset, and developed country sovereign credit ‘kinda-fit-the-bill’).

It would be extremely hard for any rational individual to now argue that sovereign credit is ‘risk free’ and given the diversification of sovereign portfolios and the unique operational nature of these markets, it’s necessary for a new range of tools to model risk.

 A New Model for Managing Sovereign Risk

The writers propose to define, “…the credit risk of a bond portfolio as the volatility of the CDS basket which would perfectly hedge the sovereign risk of the portfolio…” (logical as CDS instruments provide indication of perceived risk in the underlying sovereign credit in both a timely and measurable fashion).  The writers also then cite the greatest benefit of this logic, meaning they can decompose the index to show the sovereign risk contribution of each country across time (something which is very hard in current models which can, for want of a better analogy, see the nodes without the links).

The next (critical) step is to develop on this by indexing based on ‘risk budgeting’ techniques.  This process involves taking the decomposed portfolio where the constituents are visible (above) and setting risk-limits to each underlying based (in their model) on GDP.   This then allows the manager to monitor the portfolio over time and correctly assess developing risks (allocating assets based on their own trade restrictions) and trade opportunities.  These tools can also be extended to factor in foreign exchange weightings and any number of other quantitative factors.

As a side-note, for portfolio managers, understanding the VaR (value at risk) in any portfolio is becoming increasingly crucial.  Historic methods of determining VaR in sovereign credit portfolios- while not without basis- certainly did not present an accurate representation of the individual risks of the underlying instruments and their relative risks to each other.  Tools such as those applied (above) in the writer’s risk-budgeting methodology will certainly move towards providing more accurate measures of VaR in sovereign portfolios (very necessary when- for example- one considers the many constituents within the Euro Zone, and the integrated risks that presents).

 For Investors and Risk Managers

If we (with some difficulty) put the current sovereign crisis to one side, there is no doubt that sovereign credit still exists as an important investment and risk management asset.  Much jitteriness in this recent-crisis has come down to ‘flying blind’ – where investors and risk managers have been caught somewhat unaware, and do not have the visibility to make decisions with support.

The 2007-08 financial crisis led to huge growth in academic interest and research into understanding financial market volatility, risk, contagion and more- with some of this research now being adopted by financial market participants.  Sovereign credit will, no doubt, follow a similar route- and by following and understanding the latest thinking in managing sovereign credit risk- portfolio and risk managers will not only be able to extract greater returns from their existing investments, but deliver greater protection for clients.

Thought Economics

About the Author

Vikas Shah MBE DL is an entrepreneur, investor & philanthropist. He is CEO of Swiscot Group alongside being a venture-investor in a number of businesses internationally. He is a Non-Executive Board Member of the UK Government’s Department for Business, Energy & Industrial Strategy and a Non-Executive Director of the Solicitors Regulation Authority. Vikas was awarded an MBE for Services to Business and the Economy in Her Majesty the Queen’s 2018 New Year’s Honours List and in 2021 became a Deputy Lieutenant of the Greater Manchester Lieutenancy. He is an Honorary Professor of Business at The Alliance Business School, University of Manchester and Visiting Professors at the MIT Sloan Lisbon MBA.