Managing risk in credit portfolios

Avoiding undue concentration risk helps mitigate the possibility of underperformance

In the aftermath of the global financial crisis, policymakers worldwide have been using unconventional monetary and fiscal policy tools in an attempt to keep the economic machines going. Some of the consequences are both known and measurable – such as budget deficits combined with a lower growth environment, leading to increased debt levels worldwide. However a number of unintended consequences of these monetary experiments are yet to be seen and uncertainties around the effectiveness and relative trade-offs of costs versus benefits still remain. Global interest rates are at their lowest levels in history which means global bonds do not look attractive on a risk-adjusted basis.

“These challenging macro dynamics aside, it is still possible to outperform during increasing and decreasing interest rate cycles, as well as favourable and even unfavourable credit market environments,” says Melville du Plessis, Portfolio Manager at Sanlam Investment Management (SIM). He adds that it is of course important to do thorough research and have a strong, robust investment process to identify and execute on favourable investment opportunities.“ But it is just as important to avoid making unnecessary mistakes. Although it is impossible to have perfect foresight with regard to what the future holds, appropriate risk management and avoiding undue concentration risk is one of the best safeguards against underperformance — and as such help deliver outperformance,” he explains.

Concentration risk is the risk that the portfolio is not diversified enough, e.g. when the portfolio holds only 10 instruments. Fund managers may decrease the number of counters when they have a high conviction that those specific instruments will outperform the fund’s benchmark, or perhaps in an attempted flight to quality or benchmark holdings.

What is the importance of measuring concentration risk in credit portfolios?

Banking crises over the course of history have repeatedly demonstrated the dangers in becoming complacent with inherent risk concentrations. This is true for both corporate issuers as well as financial institutions. The failures of large borrowers like Enron, Worldcom and Parmalat are good examples. For this reason, modelling and management of credit risk are highly relevant for fiduciaries who want to ensure their members achieve optimal retirement outcomes. This is the essence of portfolio risk management.

Explains du Plessis, we need to understand that credit risk in a portfolio arises from two possible sources, systematic and idiosyncratic risk: • systematic risk represents the effect of unexpected changes in macro-economic and financial market conditions on the performance of borrowers. The systematic component of portfolio risk is therefore unavoidable and only partly diversifiable • idiosyncratic risk represents the effects of risks that are particular to individual borrowers. As a portfolio becomes more fine-grained, in the sense that the largest individual exposures account for a smaller share of total portfolio exposure, idiosyncratic risk is (to some extent) diversified away at a portfolio level.

What makes measuring/managing risk in credit portfolios so complicated?

The role played by behavioural finance

Behavioural biases need to be continuously acknowledged – and managed – when making investment decisions. There are some behavioural biases that have been identified, though not as widely recognised, which are particularly important when it comes to credit portfolio management. Risk is not managed by processes or systems, it is managed by people acting as individuals and in groups, responding to uncertainty and making decisions that they deem to be appropriate. Unfortunately, human beings are not always objective or rational actors who make decisions based on pure utility; they are prone to behavioural aberrations. Consequently an approach to managing risk that ignores these human factors is flawed and likely to lead to sub-optimal outcomes.

Diversification or ‘di-worse-ification’

During the financial crisis, a term that gained widespread use was “di-worse-ification”, ie investing in too many assets with similar correlations will result in an averaging effect, to the detriment of the potential investment outcomes. Says, du Plessis, it is the counterintuitive idea that carrying all your investment eggs in one basket might be a better idea than old-fashioned diversification, which should supposedly be a natural counter to systematic risk. But exactly how to apply diversification in a credit portfolio (and whether it differs from other asset class considerations) deserves some special attention. Diversification can be counter-intuitive when it comes to a credit portfolio as the dynamics are different in a credit portfolio compared to traditional equities or multi-asset class funds. For example, the characteristics of the underlying portfolio holdings, the ‘illiquidity premium’ that is attached to corporate bonds as well as the credit risk premium.

The “credit spread puzzle”

Many institutional investors ask why spreads on corporate bonds are so much wider than the expected losses from a default. A reason for this could be that investors can’t diversify away the risk that actual losses in a corporate bond portfolio will exceed expected losses. The skew in the distribution of corporate bond returns implies that achieving such diversification will require an extraordinarily large portfolio. Evidence suggests that such large portfolios are unattainable in the real world. Hence, investors always face the risk that actual losses will exceed expectations. Credit spreads are as wide as they are precisely because they compensate investors for these acute and additional risks.

How much diversification is required in an investment-grade credit portfolio to achieve a desired level of risk relative to a broad credit benchmark?

Two approaches to optimal portfolio construction address this fundamental question. The first seeks to minimize the risk of underperforming a benchmark because of idiosyncratic credit events; the second explores the diversification levels that maximize the information ratio (risk-adjusted outperformance of the benchmark).

How we manage concentration risk….

Due to its numerous ambiguities and definitions, we don’t believe it is possible to measure risk completely accurately, says du Plessis. But we can contain it by building risk management practices into our core investment process. The first rule of investing is to ensure that you allocate capital with an adequate margin of safety, and in a manner that will appropriately reward you for the risk you have taken. At Sanlam Investments we do not believe that concentration risk is always sufficiently rewarded and we therefore minimise it with well-diversified portfolios. We always remain wary of the risk of capital losses and take care not to deliver returns that carry with them an inappropriate level of risk.

A robust risk and investment management practice is still your best defence

We emphasise our in-house (proprietary) risk management tools (such as our credit concentration framework) which we have spent a lot of time refining to understand and counter exposure to the key risk factors identified earlier. The research process will always be the first defence in the risk management process. As part of our investment process, we have a dedicated team that focuses solely on quantifying the various risk measures daily, through our proprietary risk management framework and research process. Portfolio managers use these as input into influence their daily decision-making process.

SIM has implemented a Credit Concentration Risk Management Framework, designed to set explicit limits on credit exposure within client portfolios, resulting in more diversified portfolios. The Credit Concentration Management Systems – which have been built into all the other portfolio management and information technology systems – have been developed in-house and enables real-time management and monitoring of credit positions. This allows portfolio managers, analysts and other stakeholders to keep a close eye on credit risk in client portfolios.