The old Wall Street expression is “They don’t ring a bell at the top.” This snarky adage is usually employed by those saddened financial managers who ride a successful investment to a peak and then watch in horror as it reverses course to a level below their cost basis. They lay the blame at the feet of the amorphous market that failed to signal it was time to exit the ride.
A pity this notion is misguided, since the market frequently “rings the bell.” It is just that most market participants are not listening. Perhaps they should be listening now.
As I have detailed in the past, there are effectively only three risk vectors in the fixed income markets: duration, credit and convexity. I like to summarize these divining risk characteristics as “When investors receive their returns,” “If investors receive their returns” and “How investors receive their returns.”
Duration risk is usually measured as a function of the shape of the yield curve (as opposed to yield level): the greater the absolute shape (steep or inverted), the larger the embedded risk of an interest rate change. (See Viewpoint – October 2014, “ Financial Market Cognitive Dissonance.”) An investment’s credit risk tends to be assessed via its spread to a benchmark Libor rate. Finally, an investment’s convexity risk, often associated with its exposure to path dependency (via embedded or explicit optionality), is usually summarized as a single measure of implied volatility.
And despite the seeming dissimilarities, these risk vectors have exhibited a relationship over the moderate horizon as active investment managers change their risk allocations to optimize along the efficient frontier.
A few illustrations may help. In Figure 1, the gooseberry line is the spread of the CDX investment grade (IG) five-year (a basket of investment grade credits), while the Syrah line is the implied volatility of a one-year option on the 10-year swap rate.
1. Markets often signal their turning points in advance; it’s just that most investors are not listening.
2. Duration, credit and convexity are the three main measures of risk.
3. At present, all three risk measures have compressed, with duration and convexity more than a full standard deviation below their averages.
4. While perhaps policy-driven, the tides of risk will flow eventually.
5. “It’s never different this time.” Are you listening?
Harley Bassman is an executive vice president and portfolio manager in PIMCO's Newport Beach office, focusing on convexity products.
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