We've convinced readers several times through our intuitive visualizations that the market decline currently underway can't simply be explained by looking at historical norms. The current market dynamics are telling a unique story about the undercurrents of asset behavior.

Take for instance, "Fixed Income." It's that canonical asset class that garners the second half of portfolio allocation parlance -- 80/20, 70/30, 60/40... In all of these coptic number combinations, the second value indicates the amount an investor should allocate towards Fixed Income in an effort to reduce risk in the portfolio at large.

And yet, as an asset class with such a refined mandate of risk reduction, investors have seen highly varied outcomes in the subclasses of Fixed Income over the past two weeks.

Cumulate Return Since the Decline Began

The first market correction occurred on Friday, the 21st of August. Therefore, the chart below looks at cumulative return of the major sub-classes of Fixed Income from market close on the 20th of August to market close yesterday, the 1st of September.

fi-ret

In fact, the return of Fixed Income subclasses has been anything but fixed during this market decline. Usually, treasury bonds are the bastion of safety when it comes to market dislocations -- For example the 10 year yield dropped to an all-time low of 1.695% during the 2011 September correction. Not this time.

From the chart above, you can see the only subclass of treasuries that has not experienced decline is Short Term Treasuries (1 - 3 years). Medium Term Treasuries (7 - 10 years) and Long Term Treasuries (20+ years) have experienced declines of roughly 1/4 of a percent and nearly 3% respectively. For comparative purposes, the iShares Core Aggressive Allocation, ticker, AOA has dropped 4.5% since the correction began. Long Term Treasuries have experienced a loss 65% as great as an aggressively allocated portfolio... take a minute, that's a big deal.

Also surprisingly, low credit quality corporate bonds -- also known as High Yield -- has been one of the greatest sources of risk reduction in the current decline. The often-quoted dogma is that "high yield bonds act like stocks during market decline." However, High Yield has not only accreted positive return (albeit marginal) over the past two weeks, but also hedged risk most effectively (as can be seen in the final chart).

Risk Sources in Fixed Income Subclasses

Our prior posts have demonstrated the value of intuitive visualization when considering sources of risk. Specifically, an investor shouldn't just care about how risky an individual asset is, but should also analyze the risk of an asset using some measure of co-movement.

Below we provide both of those measures -- Expected Extreme Risk and Contribution to Portfolio -- for the Fixed Income subclasses.

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Note how the expected extreme loss of High Yield debt is only slightly higher than Medium Term Treasuries and Investment Grade Corporate debt. This chart is akin to showing, "if market dynamics were to change (i.e. the structure of covariation were to change), which subclasses might we expect to exhibit the most risk given today's volatility information."

In our upcoming post, we will go through a more cohesive description of how we frame risk at Viziphi, and how our tools make those concepts easily accessible to users. However, it suffices to say that the investors should not just be thinking about the information available in the market today, but what might happen should we see a shift in the co-movement structure.

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The investor should take note that the two single greatest sources of risk in the Fixed Income subclass, given today's market dynamics, is Long Term Treasuries and Medium Term Treasuries, and one of the greatest sources of diversification is High Yield Corporate Debt.

If you're still reading this post, you shouldn't be... you should be checking your brokerage account to see how much exposure you've got to those two subclasses, because this is a significant shift from the way that risk has been hedged using Fixed Income in past market environments.

Summary

Historical anecdote doesn't suffice in understanding how investor's portfolios are being impacted by the current market environment. Core tenets of asset allocation -- like using Fixed Income to broadly reduce portfolio risk -- can fail to provide the most effective guidance to hedging risk in different market environments.

Measurements like Contribution to Extreme Loss and Expected Extreme Loss help investors quantify risk in ways to respectively understand how:

  1. The current market environment is driving asset subclass risk within the portfolio
  2. Aggregate risk could change given a shift in asset co-movement

Both measures are vital in constructing a coherent picture of risk and should be leveraged when attempting to make prudent portfolio allocation decisions.

 

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