Structural Risk Premia in Fixed Income Markets
Structural risk premia (SRP) arise from drivers such as risk, liquidity, leverage aversion, institutional constraints and market segmentation.
While SRP do entail some form of risk, we believe a rigorous and risk-aware approach to exploiting them is of benefit to our clients and therefore worthy of pursuit.
Fixed income markets can offer persistent sources of returns (or premia) that arise from the inherent structure of the markets and the nature of their participants. Aside from “term premium” and “credit risk premium”, which are well understood, several factors within the term structure of interest rates and across bond sectors offer potential opportunities for total return investors to add excess returns in fixed income portfolios.
These structural risk premia (SRP) are often utilized by fixed income managers as part of their overall investment strategy but are not often categorized and communicated to clients as SRP. Our portfolio management teams are focused on identifying, measuring and combining these premia in effective ways to drive more robust results in our fixed income portfolios as well as help investors understand what is driving their returns. Structural risk premia exist globally and range from simple to complex, both in their definition and implementation. In this article, we highlight a few examples of these premia and provide a framework with which to assess their persistence and applicability for different types of portfolios.
SRP arise from drivers such as risk, liquidity, leverage aversion, institutional constraints and market segmentation. Since these premia arise from market structures or the preferences of participants, their persistence relies on the continuity of those factors and their applicability depends on an investor’s relative tolerance or constraints with respect to the factors – key considerations when exploiting SRP in investment strategies. While these SRP do entail some form of risk, we believe a rigorous and risk-aware approach to exploiting them is of benefit to our clients and therefore worthy of pursuit.
Examples of Structural Risk Premia
Term Structure of Interest Rates
Within the term structure of interest rates, there are several forces at play that can create structural opportunities. The first is market segmentation. Different segments of government yield curves may see pricing misalignments because they are driven by different supply and demand forces. For example, money market funds are required to maintain a maturity of less than 397 days and corporate defined benefit pensions and life insurance companies face regulation that strongly encourages demand for long-duration assets. This creates a potential opportunity for investors not subject to such constraints.
The second opportunity is convexity. Convexity refers to the non-linear relationship of bond prices to movements in interest rates. Bonds with positive convexity gain more in price terms when their interest rates fall than they lose in price terms when their rates rise by the same amount. Convexity tends to increase with maturity; therefore the higher positive convexity of long bonds is desirable to fixed income investors, especially when investors anticipate higher rate volatility. However, that convexity comes at a price because bonds with higher convexity get bid up and their yields compress, relative to bonds with lower convexity. Those willing to sell convexity (i.e., go underweight higher convexity bonds and overweight lower convexity ones) can often earn a risk premium for doing so.
The combination of various structural dynamics can result in better risk-adjusted returns in short-maturity government bonds versus long-maturity ones.
A third structural opportunity arises from leverage aversion. Investors who cannot use leverage often wish to buy longer-dated bonds in pursuit of higher returns, which can lead to longer maturities becoming expensive. Investors willing to relax the leverage constraint can potentially earn higher risk-adjusted returns by underweighting these expensive long-dated bonds and overweighting medium- and short-dated ones with fewer buyers.
The combination of these structural dynamics can result in better risk-adjusted returns in short-maturity government bonds versus long-maturity ones. One way to express these structural opportunities is via butterfly trades that go long the middle versus shorting either or both ends of the rate curve. Figure 1A shows the cumulative returns to a 2-5-10 butterfly trade. This takes a long position in 5y US Treasuries while taking duration-neutral and dollar-neutral short positions in 2y and 10y Treasuries. The trade is net short convexity. Also shown is the Bank of America Merrill Lynch MOVE Index, which is a measure of rate volatility. From 2007 to 2011, rate volatility was rising, already high or just receding from a high level, all indicative of heightened volatility aversion. As soon as volatility rose, investors began to overpay for the high-convexity 10y bonds and their yields compressed relative to 5y bonds. From then on, the butterfly trade performed well. Even after volatility peaked, volatility aversion persisted, extending the efficacy of the trade. Post 2011, the returns were flat to negative, corresponding to an easing of volatility.
One can sharpen the above trade by explicitly adapting it to different volatility regimes. Figure 1B shows that the Sharpe Ratio of the above butterfly trade increases during periods of higher volatility. This evidence also reaffirms that volatility aversion (or a preference for convexity) is one of the main structural drivers of this premium.
The Sweet Spot in Credit
Certain structural dynamics also create opportunities for investors in credit. First, general risk aversion and demand for liquidity can lead to corporate bond spreads exceeding levels that are justifiable by realized defaults alone. Second, institutional constraints with respect to ratings and a market structure bifurcating investment grade and high yield bonds have led to a kink in the ratings curve. This offers investors the chance to capture better risk-adjusted returns that center on BB bonds, but also extend to BBBs and Bs. Lastly, similar to term structure dynamics, market segmentation and leverage aversion can result in better risk-adjusted returns in short maturity credit relative to long maturity credit. The combination of these structural dynamics implies that investors who are not subject to these constraints should consider buying short duration, higher yielding credits as opposed to longer duration, lower yielding credits.
General risk aversion and demand for liquidity can lead to corporate bond spreads exceeding levels that are justifiable by realized defaults alone.
Figure 2 shows market-priced credit spreads (Option-Adjusted Spread) by rating bucket, averaged over the period from 2002 to 2017 and plotted against the corresponding average expected default loss spreads (computed from Moody’s estimates of default probabilities and average loss given default). The difference between the two reflects the credit risk premium arising from the risk aversion of credit investors, which is quite substantial. It also suggests BB bonds are the sweet spot on the ratings curve.
Implementation of SRP
Market structures change over time as do behaviors associated with market participants. So SRP need to be reviewed regularly in order to determine their continued efficacy. Furthermore, as many of these premia exist due to constraints that many investors face, a thorough understanding of what product and investor types they are applicable for is critical. Lastly, as these premia are not directly available for sale and fixed income markets are still highly fragmented, effective implementation becomes critical in successfully harvesting them and requires significant investment and trading expertise.
We have highlighted these structural risk premia as examples of what can be captured in fixed income markets and to provide a framework with which to assess their persistence and suitability for different types of portfolios. Looking ahead, we are focusing our research efforts on identifying a range of structural risk premia that can be implemented in a transparent way with the aim of producing robust and consistent results for our clients.