Fixed Income Ain’t So ‘Fixed’
Summary Subclasses of Fixed Income has had highly unusual and varied performance over this market decline. Medium & Long Term Treasuries are two of the greatest sources of risk in the Fixed Income subclass. High Yield Corporate debt has not only had positive returns, but is reducing risk. We’ve convinced readers several times through our intuitive visualizations that the market decline currently underway can’t simply be explained by looking at historical norms. The current market dynamics are telling a unique story about the undercurrents of asset behavior. Take for instance, Fixed Income. It’s that canonical asset class that garners the second half of portfolio allocation parlance — 80/20, 70/30, 60/40… In all of these coptic number combinations, the second value indicates the amount an investor should allocate towards Fixed Income in an effort to reduce risk in the portfolio at large. And yet, as an asset class with such a refined mandate of risk reduction, investors have seen highly varied outcomes in the subclasses of Fixed Income over the past two weeks. Below, we use the following Fixed Income subclasses and related tickers for our analysis: Fixed Income Subclass Ticker Short Term Treasuries (1 – 3 Years) SHY Medium Term Treasuries (7 – 10 Years) IEF Long Term Treasuries (20+ Years) TLT US Inflation Protected Securities TIP Investment Grade Corporate Bonds LQD High Yield Corporate Bonds HYG USD Denominated Foreign Fixed Income EMB Local Currency Foreign Fixed Income BWX Cumulate Return Since the Decline Began The first market correction occurred on Friday, the 21st of August. Therefore, the chart below looks at cumulative return of the major sub-classes of Fixed Income from market close on the 20th of August to market close yesterday, the 1st of September. (click to enlarge) In fact, the return of Fixed Income subclasses has been anything but ” fixed” during this market decline. Usually, treasury bonds are the bastion of safety when it comes to market dislocations. For example the 10 year yield dropped to an all-time low of 1.695% during the 2011 September correction. Not this time. From the chart above, you can see the only subclass of treasuries that has not experienced decline is Short Term Treasuries (1 – 3 years). Medium Term Treasuries (7 – 10 years) and Long Term Treasuries (20+ years) have experienced declines of roughly 1/4 of one percent and nearly 3% respectively. For comparative purposes, the iShares Core Aggressive Allocation , ticker, AOA has dropped 4.5% since the correction began. In simpleton terms, the subclass of Long Term Treasuries has experienced a loss 65% as great as an aggressively allocated portfolio… take a minute, because that’s a big deal. Also surprisingly, low credit quality corporate bonds — also known as High Yield — have been one of the greatest sources of risk reduction in the current decline. The often-quoted dogma is that “high yield bonds act like stocks during market decline.” However, High Yield has not only accreted positive return over the past two weeks (albeit marginally), but also hedged risk most effectively (as can be seen in the final chart below). Risk Sources in Fixed Income Subclasses Our prior posts have demonstrated the value of intuitive visualization when considering sources of risk. Specifically, an investor shouldn’t just care about how risky an individual asset is, but should also analyze the risk of an asset using some measure of co-movement. Below we provide both of those measures — Expected Extreme Risk and Contribution to Portfolio Risk — for the Fixed Income subclasses. (click to enlarge) Expected Extreme Loss is calculated using today’s sample estimate of exponentially smoothed volatility to scale historical log returns. Those scaled historical returns are then used to create a non-parametric return distribution, for which we use the 99% CVaR as the Expected Extreme Loss. Note how the expected extreme loss of High Yield debt is only slightly higher than Medium Term Treasuries and Investment Grade Corporate debt. This chart is akin to showing, “if market dynamics were to change (i.e. the structure of covariation were to change), which subclasses might we expect to exhibit the most extreme risk given today’s volatility information.” In our upcoming post, we will go through a more comprehensive description of how we frame risk at Viziphi, and how our tools make those concepts easily accessible to users. However, it suffices to say that investors should not just be thinking about the information available in the market today, but what might happen should we see a shift in the co-movement structure. (click to enlarge) Contribution to Extreme Loss is used by simulating multivariate t-distributions whose volatility and covariance structure are determined using exponentially smoothed sample estimates of today’s information. The investor should take note that the two single greatest sources of risk in the Fixed Income subclass, given today’s market dynamics, are Long Term Treasuries and Medium Term Treasuries, and one of the greatest sources of diversification is High Yield Corporate Debt. If you’re still reading this post, you shouldn’t be… you should be checking your brokerage account to see how much exposure you’ve got to those two subclasses because this is a significant shift from the way that risk has been hedged using Fixed Income in past market environments. Summary Historical anecdote doesn’t suffice in understanding how investor’s portfolios are being impacted by the current market environment. Core tenets of asset allocation — like using Fixed Income to broadly reduce portfolio risk — can fail to provide the most effective guidance to hedging risk in different market environments. Measurements like Contribution to Extreme Loss and Expected Extreme Loss help investors quantify risk in ways to respectively understand how: The current market environment is driving asset subclass risk within the portfolio Aggregate risk could change given a shift in asset co-movement Both measures are vital in constructing a coherent picture of risk and should be leveraged when attempting to make prudent portfolio allocation decisions. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.