Investors often spend a great deal of time assessing portfolio risk based on regulatory guidelines. Such an approach tends to define risk as a function of parallel changes in rates, although changes in the level of rates aren’t the only risk affecting portfolio returns. Other macro factor risks typically include the slope of the yield curve or changes in spreads.

Macro factor risks are market variables that contribute to an asset’s yield and affect asset pricing, thereby driving return and return variance. Effective portfolio management requires managers to measure and monitor evolving risks within the portfolio. How those risks factor, as a whole, affect portfolio performance. Further, frequently monitoring these factors provide valuable information to investors that can help them decide whether to stay the course or consider a shift in allocations.

There are five categories of macro factor risks that can affect fixed-income portfolios: level of interest rates, slope of the yield curve, market spreads, volatility, and prepayments. Each variable can impact a particular asset’s price while also playing a major role in driving return and variance.

Level of Rates

The absolute level of rates is a function of the current state of the economy, as well as central banks’ policies and fiscal policies. The sensitivity to changes in interest rates is most often measured by effective duration, which represents an asset’s price elasticity for a given parallel shift in interest rates. Duration is a key component of the portfolio management process that investors use as a target to manage the portfolio. In an institution’s liability-driven investing framework, the duration sets the mark of the institution’s liabilities. It’s important to get the portfolio duration correct and maintain it in order to determine if a portfolio will meet the institution’s goals.

Curve Slope

Slope is the difference between short- and long-term rates. Many market participants choose to use the 2- and 10-year parts of the curve as the basis for the measurement. The slope of the curve is an expression of the market’s macroeconomic outlook. Changes in slope are typically described as flattening or steepening, as shown in Exhibit 1. An inverted curve is also possible, but is fairly rare. The slope of the curve can have a major impact on valuation and performance for assets with embedded options, like call/prepayment options, caps and floors, pushing them farther in or out of the money.

Investors can monitor this risk through the use of partial or key rate durations, as shown in Exhibit 2. Key rate duration is closely related to effective duration, but it only moves one rate on the curve, rather than shifting the entire curve. The results help managers identify the part of the curve that carries the most portfolio sensitivity.

Market Spreads

Fixed-income investors responsible for risk management must place an emphasis on changes in rates. Outside of Treasury securities, bond portfolios also have exposure to changes in spreads. Assets can be sensitive to both changes in swap spreads (spread of swaps to Treasuries) and their asset-specific spread.

Swap spreads are often thought of as a liquidity premium in the market. The expansion of swap spreads during the financial crisis offers a prime example, as seen in Exhibit 3

Further, individual assets have their own specific spreads that represent the perceived level of risk. For instance, agency MBS have wider spreads to swaps than agency bullets because of the uncertainty of mortgage cash flows versus the more definitive cash flow of a bullet. Understanding the spread duration can help better determine the sensitivity to spread changes of a marginal investment or of their portfolio.

Floating-rate securities may be the clearest example of the difference between the impacts of spreads versus rates. Because of the frequent coupon resets, floating-rate bonds tend to exhibit little sensitivity to changes in rates, with effective durations ranging between 0% – 0.50%. However, these types of securities may have spread durations in the 6% to 9% range, which makes them more vulnerable to changes in spread, see Exhibit 4.

Volatility

Throughout a trading day, interest rates will move up and down and, as mentioned, will impact value and returns. The deviation of rates over time is represented as volatility, and the level of volatility plays a role in valuation and performance. Two types of rate volatility that impact fixed-income investments are implied and actual. Implied volatility is the standard deviation of forward rates around their mean and is used in the valuation of options, such as those found in MBS and callable bonds. Actual rate volatility represents the actual variance in rates over a specific timeframe. Actual and implied volatility can diverge significantly over time and play a major role in the portfolio’s performance, illustrated in Exhibit 5.

Prepayments

It’s important for investors to understand the changes in prepayment estimates in portfolios that have an allocation to mortgage assets. Variations in the expectations of prepayments can significantly affect calculations of yield, return and duration. Investors should note that mortgages are a varied sort and, thus, repayment estimates will vary based on different collateral characteristics, such as age and coupon. Additionally, the risk factors noted earlier also will play a role in driving estimates. As an example, a steeper yield curve will lower prepayment expectations as forward rates move higher and borrowers become less likely to refinance their loans.

Monitoring Risk

As managers build out and maintain portfolios, it becomes imperative to closely watch the risks mentioned. Instead of simply evaluating an asset’s risk at the point of the trade, investors must regularly monitor the portfolio’s risk exposure, given the non-stationary nature of these macro factor risks. The use of a multi-dimensional risk analysis (MDRA) is an effective way of doing this. The analysis will model the impact of changing rates, slope, spread, volatility, and prepayments on a portfolio, as exemplified in Exhibit 6.

Macro factor risks can be measured and observed in the market, and investors should understand how they will drive value and returns at any specific point in time. By understanding each of these risks through frequent monitoring, managers can be equipped with vital feedback about how their portfolios are performing and, as a result, provide investors with the information needed to make portfolio adjustments.


Hafizan Hamzah is a Director in the Investment Management Group at ALM First. ALM First Financial Advisors, LLC provides asset-liability management, investment management, hedging services and other strategic and financial services for over 200 financial institutions across the United States. Mr. Hamzah can be contacted at [email protected].The Investment Management Group can be contacted at [email protected].

Hafizan Hamzah

Director, Invesment Management Group at ALM First