At Treasure part of the work of our Investment team is to do research on financial markets to further enhance our quant driven fixed income strategies. We review here some of our recent findings.
Risk parity is a portfolio construction approach that does not rely on predicting the future relative performance of assets but it turns out that in the case of fixed income markets, it can perform as well as strategies which actually aim at forecasting returns.
What is Fixed Income?
Fixed income investments commonly involve bonds. When you buy a bond, you're essentially lending money to an entity in exchange for regular interest payments and the return of your initial investment when the bond matures. The interest rate on a bond, known as the coupon rate, is usually fixed at issuance, hence the term "fixed income." Fixed income returns are primarily influenced by two factors: interest rate risk (duration) and credit risk.
What is Risk Parity?
Risk Parity is an investment strategy rooted in the belief that markets are roughly efficient, meaning there are no free lunches – returns should align with risk. This strategy suggests that if investment opportunities are similar across different assets, you should spread your investments equally to enhance your chances of success. Risk parity involves allocating equal risk to each investment, aiming for consistent returns.
Two factors are driving fixed income assets
Simplifying fixed income to its two dominant return factors, duration and credit spread, reveals that these factors aren't perfectly correlated. Their returns and losses can occur at different times, offering diversification opportunities. Efficient market theory suggests that over time, the return-to-risk ratio of duration should be similar to that of pure credit. This allows investors to create a well-balanced portfolio that benefits from diversification and rebalancing.
If investment A is 2x as risky as investment B then we have to invest 2X in investment B assuming –
1) we approximate that they have the same return/risk ratio over the long term
2) we want them to return an equivalent amount to our portfolio over time, Return Parity!
Said sequentially, assume equivalent return to risk ratio, estimate risk units, calculate notional dollars to invest and expect equal notional returns.
Risk Parity for Fixed Income
So isolating the investment universe to fixed income, and simplifying to the two dominant return factors, duration and credit spread, what does a fixed income risk parity portfolio look like? What does the data say?
First, duration and credit spread are not perfectly correlated creating the opportunity for diversification benefit:
Their volatilities (risk estimates) fluctuate through time:
The volatilities lead to different notional allocation percentages through time:
If we implement risk parity with a US government bond and pure credit spread exposure with monthly risk estimates and rebalancing, we end up with the following return stream.
While this return stream may not appear impressive, it serves as a potential benchmark for fixed income investments – a thoughtful, balanced, and straightforward strategy based on solid financial theory. Comparing it to a more complex strategy that uses predictive models (red line), we find that the performance is similar or better over the long term. Simplicity often leads to robustness with fewer potential points of failure.
Conclusion
The risk parity strategy explored here provides a foundation upon which you can construct a more complex portfolio with additional factors or alphas to enhance returns and manage risk. This simple risk parity approach is theoretically and empirically attractive and should, at the very least, be considered a benchmark when evaluating or creating a fixed income portfolio.
