Fixed-income markets have weathered a series of financial crises since 2008, forcing institutional investors to discard old assumptions and seek a risk management framework suited to the new, ever changing environment.
The rapid onset of crises highlighted the need to better understand credit risk without relying on credit ratings, which were slow to anticipate changing market conditions. And it was just as important to recognize the end of one crisis to see the warning signs of the next event. The early signals of the 2011 euro crisis could have been missed against the backdrop of the extreme events of 2008, but stood out against the calm that had returned in late 2009, for example.
These changes suggest a need for an updated approach to modeling fixed income. New risk factors may be needed to recognize the decoupling of old relationships, new risk exposures may be needed to signal changing market regimes, and new connections may be needed between risk and portfolio management:
- Credit: Market turbulence could require a view of risk that supplements backward-looking volatility with forward-looking indicators to recognize transitions between risk regimes.
- Rates: Quantitative easing and negative interest rates have fundamentally changed interest-rate dynamics. Rather than assume the term structure of traditional interest-rate models, investors may increasingly see a need to manage exposures to each key rate individually.
- Basis risk: Drops in dealer inventories have increased illiquidity and driven a wedge between closely related securities – such as cash bonds and credit default swaps, or on- and off-the-run Treasurys. Tools to manage basis risk are likely needed to prepare for the further breakdown of the theoretical ties between these assets during times of market stress.
- Risk management practices: Policy and regulatory changes have placed risk management front and center in the investment process.
The new MSCI Fixed Income Factor Model introduces a suite of tools designed to address these changes and provide insight into portfolio drivers of risk and return. These tools can be used to make more informed investment decisions, support robust risk management processes and more effectively communicate outcomes with clients and stakeholders.
A diagram of MSCI’s fixed-income risk framework is shown below. Portfolio risk is decomposed into fundamental sources that drive its risk and return profile. By more clearly understanding these sources and their magnitudes, institutional investors may be better able to align outcomes with their investment goals.
MSCI’s fixed-income risk framework
Fixed-income risk is decomposed among various classes of factors. The spread factors denoted (*) use duration times spread (DTS) exposures. Currency, equity, commodity and private asset factors are also modeled but not shown here.