Interest rate and credit risk are rewarded in the long-term
The current low interest rate environment leads to a scarcity of investment opportunities After 30 years of falling interest rates, yields are near historical lows – investment opportunities are scarce. But as alternatives are limited, bond quotas
remain high with most investors.
Risk premia for interest rate and credit risk Academic studies reveal a systematic risk premia for interest rate and credit risk, as both risks are rewarded in the long-term. A forgoing of these risks means repeatingly lower returns for investors (carry & roll-down
effect for duration and credit risk) due to forgone risk premia.
Over the last 30 years an investment in long-term corporate bonds yielded 4.28% p.a. (250% cumulative) higher returns than an investment in short-term treasuries.
Only problem: Higher drawdowns
Drawdowns in interest rate markets Historically, periods of rapid rise in interest rates have been rare. Over the last thirty years only three such occurences lead to negative annual returns. Nonetheless, in the current low yield environment bonds are vulnerable to an increase in yields and therefore enlarged drawdowns.
Drawdowns in credit markets Crises in credit markets have increased in frequency and significance in recent years. Especially in times of a systemic crisis (Financial crisis 2008, European crisis 2011) corporate bonds are subject to substantial price corrections and rising credit spreads.
Fixed Income Risk Indicator (FIRI):
The systematic risk engine for fixed income
How can regimes of high interest rate and credit risk be identified? The Fixed Income Risk Indicator (FIRI), which has been exclusively developed by Finreon AG, is a combination of two risk engines and allows to identify interest rate and credit risk regimes in the bond market.
Interest Rate Indicator (IRI)
The «Interest Rate Indicator (IRI)» is based on a multitude of daily measures. The result – the current interest rate regime – is shown as a risk signal: Red for rising rates, yellow for stable rates and green for falling rates.
Credit Risk Indicator (CRI)
The «Credit Risk Indicator (CRI)» is based on a multitude of daily measures as well. The result – the current credit risk regime – is shown as a risk signal: Red for high credit risk, yellow for normal credit risk and green for low credit risk.
Implementation: Systematic duration and credit management with Finreon Fixed Income Risk Control®
Finreon Fixed Income Risk Control® solutions manage duration and credit exposure dynamically and systematically through the Fixed Income Risk Indicator (FIRI). This way investors can profit from risk premia on interest rate and credit risk, while at the same time controlling for drawdowns. Thereby, Finreon Fixed Income Risk Control® is ideally suited to optimise the risk/return profile of fixed income securities and circumvent the scarcity of investment opportunities in the current low yield environment. With a systematic risk control, bonds become «investable» again.
