Fixed Income Risk Management - The Most Important Lesson

Kamyar Hazaveh's picture

Fixed income risk management – the most important lesson

As we wind down our active positions in 2015, it is important to reflect upon our performance, revisit our principles, plan for 2016 and position the portfolios accordingly for the coming year.

The year 2015 was a difficult one for fixed income active management as gyrations in commodities led to interest rate gyrations in Canada and globally. These fluctuations whipsawed many investors and especially macro positions within the portfolios. Moreover, the weakness of credit spread products meant that (unlike the last few years) one of the important levers in fixed income did not contribute to additional income for most real money fixed income managers.

The U.S. economy slowed down from Q4-2014 onwards with slowing real and nominal GDP. Global growth disappointed yet another year and developed market interest rates hit yet another new low. The European Central Bank (ECB) eventually embarked on Quantitative Easing (QE) by purchasing sovereign bonds after months of speculation. The strength of the U.S. dollar and the U.S. Federal Reserve's premature hawkish rhetoric and communication disarray led to volatility and substantial damage to the emerging market assets, commodities, corporate credit and global trade in general.

In the face of this difficult environment, we are closing the year with respectable absolute return and value-add (alpha) relative to portfolio benchmarks in our fixed income mandates for our retail and institutional clients.

Table 1: Signature’s Select Fixed Income Mandate Gross Performance

* Canadian bonds benchmarked against FTSE/TMX Canadian Bond Universe and Global bonds benchmarked against J.P. Morgan Global Bond Index - Currency Unhedged
** Launched January 20, 2015

The key for us is to continue this performance and improve upon them in 2016. We see risk management as a critical ingredient in achieving this goal. In the last few years, we have built in-house analytical systems that enable us to properly manage the various risks embedded in our portfolios. That brings me to the next section on why risk management is key in building a repeatable investment process, i.e. the holy grail of investment management.

Risk management – the most important lesson

A portfolio manager's fundamental beliefs are the best determinant of the nature of her portfolio's risk and return. Since past performance is no guarantee of future returns, the best way to understand the behaviour of a portfolio is to understand the portfolio manager's principles and philosophy.

There are lessons that one learns by wearing active fixed income positions in real time that are different from the lessons from back-testing and retrospective analysis.

Here are some of our guiding principles in fixed income core interest rate management:

  1. It is difficult to separate investment skill from luck when looking at a portfolio manager's performance, especially in the short-term.
  2. The market for interest rates is, by and large, efficient. While equity and credit markets offer opportunities at a sector level (e.g. 2000 technology bust) or security level (e.g. Nortel and Valeant), interest rate markets do not offer those opportunities as frequently (putting cases like Greek bonds aside). As a result, although our portfolios take modest duration risk, the contribution to portfolio tracking error as a result of outright duration positioning needs to be closely monitored and controlled to make sure it does not overwhelm the other alpha drivers (curve, credit, inflation, volatility, etc.) in the portfolio.
  3. The value-add opportunities in fixed income are better exploited by interest rate curve positioning (e.g. Canada 10-year bonds vs. 30-year bonds), cross-market (e.g. German bunds vs. U.S. treasuries) and cross-asset positioning (e.g. credit vs. U.S. treasuries or TIPS vs. treasuries) among others than outright duration positioning.
  4. As the bedrock of all financial assets, understanding the message from the fixed income market contributes substantially to the management of multi-asset portfolios. In that sense, the view on global interest rates is a substantial contributor to our clients’ multi-asset portfolios.
  5. There is no progress without measuring one's investment decisions. It is human nature to focus on our winning trades. It is only with measurement and reflecting on our losing investment decisions that we learn and grow.
  6. Knowing our strengths and weaknesses as a result of continuous measurement of investment decisions is a portfolio manager's most valuable attribute and asset. We can focus our risk (tracking error) budget on our strengths and define our weaknesses as areas for learning and growth.
  7. Generating true alpha returns with no directional market bias is hard. Global bond markets allocate to best risk-adjusted return opportunities continuously eliminating the opportunity for value-add relatively quickly. Every excess return comes with implicit or explicit risks. This is even true for the beta-neutral, long-short, hedge-fund or alternative strategies. If the risk is not obvious, it is probably not measured correctly or not communicated properly.
  8. The importance of alpha in achieving client goals (individuals, pension plans, insurance companies, etc.) is often over-emphasized in our industry. Most clients can also use consultation with regards to constructing portfolios that have the best chance of achieving their objectives over the long run.
  9. There is no substitute for hard work and building our own analytics, systems and data to explore investment ideas. Relying on the research of others (e.g. pundits, sell-side economist and strategists) for the positioning of our portfolio is a losing proposition.
  10. Constructing genuine independent global macro views is difficult and reserved for the skilled few. More importantly, structuring trades to actually generate profits with good risk-adjusted returns based on those views is a rare skill.
  11. Liquidity risk is what in the end ruins a fixed income portfolio manager. Interest rate and default risks are easier to measure and hence manage. Liquidity risk is the blind spot of fixed income portfolios.
  12. Investment talent is rare. Investment talent is not only about understanding the macro or having analytical aptitude or paying attention to the technicals and flows, etc. It is that rare combination of skills that can be genuinely described as investment talent. Organizations should constantly search for and internally foster investment talent.
  13. Leadership talent has no correlation to investment talent. In our industry, leadership talent is even more rare than investment talent.
  14. "Who are we if not risk managers?"

This quote from one of my early mentors brings me to the most important lesson: the importance of risk management. By risk management, I do not mean the regulatory risk calculations and reporting that is the middle-office function of large banks. I do not mean the Value at Risk (VaR) number that gets reported in various buy-side and sell-side organizations. By risk management, I mean the real time downside risk management of the portfolio in the face of a changing market environment which changes the downside risk of the portfolio in real time.

The reason that proper risk management is the most important aspect of fixed income portfolio management is this: investments of all sorts are different forms of risk transformation. When a client invests cash in our portfolios, it is transformed to investments that have longer maturity, more default risk and less liquidity than cash. For those reasons our portfolios offer higher returns than cash. In fixed income, we have a decent chance of realizing those higher returns, if we can mature our bonds.

The problems that can occur happen from the point of investing to maturity. From here to maturity, our investments are subject to various risks: market volatility, fluctuating investor sentiment, changing liquidity environment, economic shocks, etc. Risk management ensures that we can withstand market fluctuations from here to the maturity of our investments. This entails managing the interest rate exposure, credit exposure, currency exposure and most important of all the liquidity exposure of our portfolios. It boils down to superior portfolio construction where different portfolio levers provide maximum diversification and downside protection.

To summarize, since we are wearing various (thoughtful) risks in our portfolios, we will most likely be rewarded with higher returns in the end. Risk management ensures we can actually get there safely. In the end, successful portfolio management is really about successful risk management, in real time.

Appendix: Annualized Returns

* Canadian bonds benchmarked against FTSE/TMX Canadian Bond Universe and Global bonds benchmarked against J.P. Morgan Global Bond Index - Currency Unhedged
** Launched January 20, 2015

This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This report may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Unless otherwise indicated and except for returns for periods less than one year, the indicated rates of return are the historical annual compounded total returns including changes in security value. All performance data assume reinvestment of all distributions or dividends and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. ®CI Investments and the CI Investments design and logo are registered trademarks of CI Investments Inc. ™ Signature Global Asset Management and ™ Signature Funds are trademarks of CI Investments Inc.

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