United Kingdom, Intermediaries

Managing risk in an unconstrained fixed income strategy

Learn why we believe the integration of risk management throughout the investment process and the use of multiple lenses are crucial for approaches that span multiple styles, regions, asset types and credit tiers.

Views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only. Your capital may be at risk.

In recent years, the Opportunistic Fixed Income (OFI) Team has published papers on our investment philosophy and idea generation process (“Opportunistic investing: 20 years, 8 lessons”), as well as our portfolio-construction approach  (“Seeking total return from fixed income: The three key ingredients”). In this note, we share our perspectives on risk management in the context of meeting an approach’s1 total-return objective while managing risk across an unconstrained universe.

Moving beyond core fixed income sectors introduces a new set of risks, but if properly managed can add significant diversification (especially from interest-rate risk) to potentially reduce overall portfolio volatility. Since the inception of the OFI approach in 2000, our definition of risk management has broadened and the tools we employ have become more robust. Yet the overarching thesis — integration of risk management into every phase of the investment process — has remained consistent.

There are two key risks we focus on in managing OFI: the risk of underperforming client return expectations and the risk of a permanent loss of capital. At the same time we seek to maintain a volatility profile in line with core fixed income strategies. Below we outline key facets of risk management, from portfolio implementation and beta management to risk measurement, and the investment principles we follow in seeking to meet these objectives.

Risk of underperforming client return expectations

We take the following steps to ensure that OFI’s positioning is consistent with achieving its return objectives and that portfolio risks are intentional, diversified, and appropriately scaled.

  • Portfolio construction: OFI’s three sources of return — structural themes, market-neutral strategies, and tactical ideas — typically have different drivers and low cross-correlations. In this way, diversification and downside mitigation are embedded in the portfolio-construction process.
  • Risk monitoring: Relying on a single risk measure can lead to an underappreciation of risk in an unconstrained portfolio. Our risk-management system incorporates multiple models and look-back periods, flexibility to compare high-volatility with low-volatility periods, factor- and return-based methods, and stress-testing across a variety of scenarios.
  • Risk mitigation: When we anticipate periods of market turbulence, we actively look for attractively priced capital-efficient hedges across derivatives along with what we believe to be safe-haven currencies and bond markets; we identify the latter through quantitative screens such as principal-component analysis.
  • Sizing positions: Exposure to a structural theme usually ranges from 10% to 30% of the total portfolio. We want both our allocation to a theme, and its absolute contribution to overall portfolio risk, to be commensurate with our level of conviction in it. Other considerations in sizing a theme include diversification, how well the theme complements others in the portfolio, and its unique characteristics.

    Since many of the themes are credit-heavy, in sizing our market-neutral strategies we consider how well an absolute return manager diversifies the overall portfolio’s credit exposure. To gauge this, we use a proprietary risk measure, Credit Protection Reliability (CPR), which measures an absolute return manager’s performance in months when high-yield bonds significantly underperform.
  • Breadth of theme: Narrowness in a theme tends to diminish its potential weight in the portfolio. Conversely, broadness and diversity in a theme may cause it to have a larger weight.
  • Age of theme: Generally, we’re a bit more excited when a theme is young; we become less so as the theme becomes more recognized and participation in it by the rest of the market ramps up.
  • Business cycle: Frequently, turns in the business cycle spark structural changes and new potential themes. A downturn can reshape investment and consumption patterns by economic actors, prompting a reorientation of OFI to reflect the new regime.
  • On-the-ground research: Country and company research are a key element of risk management. There is no substitute for meeting face-to-face with government officials and local market actors to gain new perspectives on the return drivers of an investment.

Avoiding permanent losses of capital

Permanent losses of capital inhibit the compounding of investment gains, which diminishes long-term returns. A permanent loss of capital differs from a temporary drawdown resulting from market volatility; it is probably unrecoverable because the investment is unlikely to recoup its value at time of purchase over a reasonable time horizon. A secular rise in interest rates, for example, could inflict lasting capital losses on many bonds issued in the low-yield environment of the past several years. In addition, in a period of rising uncertainty like today, the risk of default resulting in a permanent loss of capital increases.

In our view, the following investment principles help mitigate the risk of a permanent loss of capital.

  • Valuation discipline: We favor assets we view as excessively cheap where market sentiment is apathetic, thereby offering asymmetric return opportunities and a margin of safety.
  • Contrarian philosophy: Our deeply ingrained instinct is to avoid crowded and overvalued momentum trades, which typically are highly vulnerable to market downturns.
  • Sell discipline: Investments are generally sold when prices rise to our measure of fair value, it becomes clear that structural changes we had anticipated are not taking place, or an even better opportunity surfaces elsewhere.
  • Investment universe: We strongly believe that a strategy’s alpha potential is a function of the breadth of its opportunity set. OFI’s unconstrained universe and benchmark-agnostic approach mean that we can avoid holding a security that we judge to have no return-enhancing or risk-mitigating value, simply because it is in the benchmark.
  • Firmwide risk oversight: We seek to have multiple perspectives incorporated in the risk-management process. This process begins with oversight from the team’s independent risk manager, then expands to include oversight from three other senior-level review groups.

Conclusion

Gone are the days when measures of risk such as value-at-risk, tracking risk, and beta generated by a naïve risk model could be expressed in a single-point estimate. Particularly in an unconstrained portfolio, reliance on such estimates overlooks the fact that they have wide margins of error. The OFI approach seeks to build risk management into every phase of the investment process and uses multiple lenses, while at the same time staying closely aligned with our investment philosophy. OFI’s opportunity set is unconstrained — but the volatility profile we’re seeking is not.



1The Opportunistic Fixed Income approach seeks to meet a gross annual total-return target of 5% – 7%.

 


Please refer to the investment risks page for information about each of the following risks:
  • Below investment grade risks
  • Capital 
  • Concentration
  • Credit
  • Currency
  • Derivatives
  • Emerging markets
  • Hedging
  • Leverage
  • Interest rates
  • Manager
  • Short selling

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