About Fixed Income
Managing Interest Rate Exposure
Interest Rate exposure is a key consideration in the management of a diversified global portfolio. It should be quantified and managed in particular in today's artificially compressed yield environment which leaves little margin for error.
Interest rate exposure is less intuitive to assess than equity market or FX exposure as we cannot really stress test it with the 1% rule (to calculate the impact on the portfolio of a 1% adverse move on any of its holdings). Still, a portfolio's interest rate exposure can be significant. In the years to come, we should be mindful and vigilant about those risks that appear dormant after 30 years of a global bond bull market and ever declining bond price volatility.
There are two “primary” types of interest rate exposure:
Duration is the metric used to calculate the sensitivity of a bond or collection of bonds to a shock of 1% in yield. Without going into the nutty gritty of bond math, “duration” is derived from both the "time to maturity" of a bond and its coupon. The maturity factor by far outweighs the coupon factor. The longer the bond, the longer its duration and the higher the coupon, the smaller the duration (interest rater risk) for a given time to maturity.
As a rule of thumb, a portfolio with a 8 years duration, equivalent to that of a 10 year bond in normal times (and which is closer to 10 years in certain cases because interest rates are close to "0") will have an interest rate sensitivity of 8%, meaning that a move up in yield of 1% will transalte into an unrealized capital loss of 8%. For the time being, this risk may be dormant but it is very present and could erupt like a volcano, leading to significant capital losses for investors caught unaware. Generally, people have been dragged into longer dated securities because of the term premium which tend to make longer dated bonds carry a bigger yield than short dated securities. Catching that yield premium in today’s context is gratifying for now but could be compared in some cases to catching a few pennies in front of a roller steamer. Hence the need to monitor and manage that risk as well.
Investing in bond ETF’s is more convenient than investing in individual bonds but it is important to keep its duration in mind as well. You will find all this information in the “Investment Universe” daily report of our PCMI report.
Credit risk assesses the risk that a bond will lose value if the credit standing of its issuer deteriorates (which may follow or most often precede a credit rating agency downgrade). The duration of your bond will also determine how it will respond to a given rise in the credit risk premium with the caveat that sometimes when credit troubles hit, a short dated bond may lose as much as a long dated one if not more because it is the capital which is at risk and sometimes shorter dated bonds are restructured faster than long dated ones. This risk needs to be monitored as well by checking the credit rating of the issuer and the seniority of the debenture (which determines which bond is wiped out first in case of default by the issuer).
For a private investor, the most essential aspect of the management credit risk is diversification in particular in the High Yield segment. If one issuer defaults and you own one such bond, you might end up being down 80% to 100% on this investment. If you own a diversified fund that owns 1% of his AUM with that issuer, you will be down 1% on this investment, not considering the contagion effect.
Credit risk analysis is fairly similar to equity risk analysis and there are many opportunities undertaking credit risk. They need to be monitored and managed as well.