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Understanding Fixed Income Risk Metrics

In Australia the fixed income asset class receives comparatively less media attention than equities. For this reason, many investors find fixed income jargon, research and its related concepts confusing and hard to understand. However, in periods of extreme volatility relatively safe income securities can be the backstop to portfolio losses by offsetting the under-performance of other asset classes.

While equities are viewed as a growth asset, fixed income is classified as a defensive asset. As a result, capital protection, income generation and diversification are first priority when investing in fixed income securities to minimise volatility and reduce the probability of capital loss. This will ensure that a steady income will be paid over the life time of the security and more importantly, the principal will be paid back at maturity. As a result, risk management is a crucial step in the investment process. Given the asymmetric risk profile of fixed income securities, understanding and protecting portfolio downside is imperative to ensure steady returns. There are many metrics that can be utilised to measure this downside, sensitivities and ultimately the potential for capital loss.

Each measure provides a unique way to assess the different dimensions of risk on a security level and a portfolio level.

  • Standard Deviation measures the dispersion of data from the average value and hence, volatility.
  • VaR is a statistical measure used to identify the maximum potential loss for a specified degree of confidence over a given period. A common degree of confidence utilised in 95%.  For example, suppose a portfolio of investments has a one-year 95% VaR of -5%. This means there is a 5% chance of a portfolio/security experiencing more than a -5% loss over a one-year period.
  • (Interest Rate) Duration: This measures the weighted maturity of a fixed-income investment’s cash flows, taking into account all coupon interest payments and the maturity date. This is used in the estimation of the price sensitivity of fixed-income securities for a given change in interest rates (yields). Shorter duration bonds are less sensitive to market interest rate movements than long bonds.
  • Credit Duration: This is used to estimate of the price sensitivity of fixed-income securities for a given change in its trading margin and hence, the sensitivity of a security’s valuation in regards to the underlying issuer’s credit quality.
  • Breakeven Price: The breakeven price measures how far a security’s capital price would need to decline before capital losses exceed the carry income (measured by the current distribution) earned by holding the bond for a year. From here, we can calculate the increase in yield associate which such a price decrease.
  • Maximum Drawdown: A maximum drawdown is the maximum loss from the highest portfolio/security value (peak) to the portfolio/security value (trough) until a new peak is attained. The maximum drawdown is an indicator of historical downside risk and can be measured since inception or a specified time period.
  • Cash Flow Stress Testing: The underlying bonds’ future cashflows are mapped against the portfolio payouts to indicate the liquidity position of the investor and the ability of the portfolio to organically meet its target payments. These cashflows can then be stressed against different scenarios which is extremely useful for liability driven investing.

The objective of fixed income investment is to achieve a consistent and stable income rather than seeking growth prospects (as priortised in equity investment). It is therefore imperative that investors understand the concept and key drivers of risk before choosing to invest in this asset class.