What’s the Score: Risk in Fixed Income Portfolios

Perhaps more than other asset classes, fixed income is strongly affected by the overall market environment. Interest rates, inflation, economic growth…all of these factors and more affect asset prices in fixed income. So, for our investment team, it’s incredibly important to establish a consistent context for our portfolios. We use a proprietary risk assessment tool that we call the Dynamic Risk Score (DRS). The DRS is designed to provide a consistent communication of our market outlook among our investment teams. Moreover, the DRS is a determinant of our portfolios’ stop-loss limit and a communication tool for the current risk-taking environment.

I’ll explain how it works. The DRS is a 10-point scale where a score of 1 represents the worst risk-taking environment and a score of 10 represents the best risk-taking environment. Once it’s determined, our investment teams use this score to guide their investment decisions and adjust the level of risk in their portfolios as market conditions change.

The DRS works on the idea that a good strategic investment idea isn’t always synonymous with a great tactical investment idea. The importance of the risk environment means that determining when to act is as influential as how to act. In order for the DRS to be strategically as well as tactically sound, it must be applicable and actionable. Our challenge in employing the DRS in this manner lies in the ability to determine how to efficiently adapt a portfolio to changing market conditions. We’ve tackled this challenge by creating a method of measuring the current risk-taking environment that lends itself to action (when necessary) as well as flexibility.

How is it determined?

The actual score is reviewed at least once per month through independent macro risk assessment. This assessment is conducted by our investment strategy team comprising sector portfolio manager heads and our chief investment officer. For example, in the current global economic environment, a DRS score can be determined by

  • Heightened equity and U.S. Treasury volatility
  • Uncertainty regarding global inflation and growth; timing of possible interest rate hikes; willingness of Europe to implement large-scale sovereign asset purchases; effectiveness of Bank of Japan quantitative easing policies; and the path and implications of oil prices.

The analysis of these factors results in a single score that is applied across all portfolios. The application of one score, determined by an investment strategy group, allows for reliable, cohesive, and applicable risk-to-reward communication within the marketplace.

What’s important to remember?

Our DRS isn’t a black-box model and isn’t linked to any particular asset allocation. Additionally, the score isn’t proscriptive and doesn’t require portfolio managers to take immediate action. In fact, portfolios have often reduced risk prior to the score changing. Instead, the value of the DRS lies in its ability to provide flexibility in relation to the probability of risk reduction and generation of returns.

At the end of the day, when managing portfolios, the dynamic risk score permits us to incorporate top-down macro themes alongside bottom-up fundamental credit research, allowing for a strengthened portfolio position within a fluctuating macro environment.

Since we implemented the DRS  evaluation in 2009, our score has ranged from 3 to 8, with the current score (as of 23 March 2015) being a 6. Going forward, we’ll provide you with any changes and updates to the DRS score in future blog posts.

 

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The information in this article has been derived from sources believed to be accurate as of March 2015. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

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