Suyash Choudhary

Introduction

 

Investment decisions are mostly made on the basis of expected returns. However, the delivery of these returns is based on taking and managing certain risks. These are, then, two sides of the same proverbial coin. However, in the ‘bull’ phase of an asset market, focus is mostly on the expected return from the asset class. Whereas when the phase turns the focus turns as well to the potential risks and how they can be managed. Now it is readily apparent that for the long term portfolio investor this alternate realignment of focus on reward then risk and then back again is sub-optimal and may entail significant impact costs. Two such types of impact costs come readily to mind: One, there is a leakage in realized returns when switching from ‘chasing’ expected return to ‘chasing’ risk aversion. Two, there may be a taxation impact as well as for instance in the case of what fixed income investors lose now for a time horizon of less than three years.

 

It is thus much more optimal if a fair assessment of risk versus return trade-off embedded in an investment strategy is made at the time of investment. Of course, this is easier said than done since by definition the assessment of expected return must be higher than potential risk at the time of investing, else the investment wouldn’t have been made in the first place. Also, some of the assumptions underlying the initial assessment of risk versus reward trade-off may themselves undergo a change. This is especially true in context of the current global environment wherein both international linkages and the dynamism inherent in these linkages are arguably higher than they have ever been in the past. Given this, a better trade-off to focus on is the expected return versus manageability of risks taken in pursuit of those returns.

 

Assessing Manageability of Risks

 
There are two legitimate risks that investors can take in fixed income in order to endeavor to earn more than the ‘risk free’ rate: Duration risk and credit risk. The former works via a daily mark-to-market channel and hence offers more short term volatility in return profile (although the longer term profile may actually be much more stable). The latter works more as a binary risk, it either manifests or it doesn’t. This is especially true in a market like ours where there is hardly any secondary market price discovery for lower rated credit assets. Thus change in credit quality doesn’t get dynamically reflected in price changes.

 

Now consider these risks from the perspective of manageability. At the point of investment, when either of these risks is first assumed, the fund manager makes a due assessment of the risk versus reward trade-off. Only when the trade-off seems favorable does the risk get initiated. This goes without saying and should be true for any rational decision maker even if the quality of decision making itself (or the relative assessment of risk versus reward) may depend upon the strength of the research process, experience of fund manager, etc. It also goes without saying that once a risk is assumed, it gets monitored on a regular basis for evolving developments and / or change in view.

 

The difference really lies in the ability to respond in terms of curtailment of risk if the view changes on evolving developments. In the case of duration risk since the underlying market is active and frequently traded, the risk can be managed on a continuous basis. Thus when investors worry that investment horizon is now three years and what happens if view changes in between, the worry may not be material so long as the underlying duration fund has an actively managed philosophy. An actively managed fund will cut duration if the view changes. Therefore, the investor’s risk here is not the inability of the fund manager to address the risk but rather that the fund manager’s view itself turns out to be wrong. Whereas in the case of credit risk there is neither any meaningful secondary market for lower rated credits nor the means to hedge risks via a well functioning derivative market. Hence there is little that can be done on an ongoing basis to address an evolving view of risk versus reward. Of course, the bond itself may have covenants in place that may provide a safeguard. However it may be borne in mind that unless the covenant diversifies risk to a third party and is not exclusively linked to the issuer itself, it may mean little in a time of extreme stress.

 

Conclusion and Summary

 

Credit and duration are both legitimate risks undertaken in pursuit of ‘excess’ returns. The point we have continually pushed against over the past few years is the propensity to only consider duration as risk and credit as ‘accrual’; simply because duration manifests itself continually via daily volatility whereas by its very nature credit risk doesn’t manifest itself regularly, especially given our relatively illiquid secondary market. An added point that we have been making lately (please refer our note: “The Macro Reason to Reassess Credit Risk”, dated 19th August for details) is that unlike in the period starting 2009, credit risk is facing significant headwinds today. And given our view that a strong cyclical recovery in nominal GDP growth is unlikely in the foreseeable future, we think these headwinds are here to stay. Hence, we have argued that the current point in the macro-economic cycle suggests that investors should prefer duration over credit risk.

 

The current note brings out an added disadvantage that credit risk suffers from in a market like ours: once undertaken, and unless mitigated by direct covenants in the deal itself, credit risk cannot be managed on a daily basis like duration risk can. A summary of key points made here is as follows:

 

1. Long term investors have to focus on both expected return as well as risk when investing. This is because there can be significant costs to intermediate period re-balancing.

2. Since this trade-off can always change with changing triggers, the focus should be on expected return versus manageability of risks taken.

3. Duration risk can be managed on an ongoing basis since it is backed by a robust secondary market where one can buy and sell.

4. The same is not true for credit markets which makes the ongoing management of the risk difficult.

5. The current phase marks significant macro headwinds to credit risk and hence makes the focus on manageability of risk all the more relevant.
 

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