Insight

Value at risk and work in progress

October 26, 2020
Value at risk and work in progress

Corporate bond yields are at lower levels than in the past. Is there a danger that they reflect too-optimistic expectations and may expose investors to unexpected risks? To answer, better adopt different approaches and different perspectives.

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. This famous quote, dubiously attributed to the brilliant Mark Twain1, should warn us against one of the main risks of our time and of the investment business: The fact that we have learned to estimate risk with increasingly sophisticated systems does not mean that its measurement is certain, nor that we can be sure that we can control it or avoid it.

It sounds simple, but it’s a hard lesson to learn. On the other hand, measuring risk, to try to manage it the best we can, is a necessary activity for those involved in investing - anywhere. And in particular when dealing with bonds, which today offer increasingly compressed returns, it is essential to assess whether the risk/return profile of an investment opportunity is attractive or not, or suitable for customers.

Let’s take corporate bonds as an important example. When their returns were more generous, some observers just looked at them. And in a world of declining sovereign returns, this was enough to attract some investors to the asset class. Then they moved to spreads. When spreads began to appear compressed, I personally tried to estimate the probabilities of default-implied spreads. In practice, over a certain period of time, I calculated the probability of default for the bonds that are part of a risky index that would make me indifferent - that is, at the end of the period would give me the same return – compared to the investment in a government bond, considered a “risk-free” asset. The higher the implied probability of default, in historical perspective, the higher the degree of skepticism embedded in valuations and prices. Today, it is still at a level close to the times of acute financial distress.

Click here to read our in-depth assessment.

 

Source 1: It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. For attribution information: https://quoteinvestigator.com/2018/11/18/know-trouble/

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  • Data as at 30. September 2020, unless otherwise stated. This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.

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