Risk management

Making the difference in

fixed income investing
Pictet Asset Management
September 2014

For professional investors only

Overview

Tough times lie ahead for fixed income investors.

The ballooning of public debt across the developed world and the
implementation of ultra-loose monetary policy in the US, Japan and
Europe have forced market participants to abandon conventional
ideas about risk and return.
Complicating matters further is a weakening of market
infrastructure. Tighter oversight of the banking industry has seen
many large investment banks cut back on fixed income trading,
causing a reduction in the number of market makers and a
deterioration of trading conditions in the secondary market.
That all this is occurring at a time when the primary bond market
is witnessing unprecedented growth is a worrying prospect as it
suggests that the asset class may become more vulnerable to bouts of
volatility.
Bond investing is arguably more risky than it has ever been.
It is against this backdrop that the analysis, control and mitigation of
risk are taking on a more prominent role in the management of fixed
income investments.
To achieve long-term investment success at a time when the fixed
income market is undergoing significant upheaval, a deeper
understanding of how risk manifests itself at the security and
portfolio level is critical.

Risk management Making the difference in fixed income investing

Fixed income
risk management
at Pictet Asset
Management at
the heart of the
investment process

Risk management has always been

central to the fixed income investment
process at Pictet Asset Management.
Our Fixed Income Risk (FI Risk)
management professionals are
members of a standalone unit that is
part of the fixed income investment
team; it reports directly to the Global
Head of Fixed Income.
Each fixed income risk manager is a
specialist within a specific fixed
income asset class and works closely
with portfolio management teams.
By structuring the team in this way,
risk managers develop a deeper
understanding of the investment
processes of the strategies under their
supervision, which enables them to
respond to the changing conditions in
fixed income markets. The FI Risk
team also includes quantitative
analysts, who bring their own
distinctive insights to the management
of our bond investments.
The FI Risk units duties span a broad
spectrum of risk management
activities, from portfolio risk analysis
and performance monitoring and
attributions to the provision of
insightful and timely quantitative
research that guides investment
positioning.

Pictet Asset Management

The teams approach to managing risk

is guided by three main principles:
- Portfolios must be managed
according to specific tracking error
(TE)/ Volatility and/or Value-at-Risk
targets
- Risk targets are set according to a
clients own tolerance for risk
- Diversification of risk is a key
objective for portfolio managers
The team is responsible for evaluating
and managing the risks associated
with each investment decision,
eliminating unintended risks from
portfolios and ensuring investment
professionals have a clear and holistic
view of their portfolios risk profile. It
also seeks to ensure that portfolios
risk profiles are in keeping with both
investment managers philosophy and
the strategys long-term return
objectives.
Over several years, the team has
developed a set of customisable
analytical tools that have been
adapted to meet the constantly
changing needs of our investment
managers and clients.
For all these reasons, our fixed income
risk professionals play a major role in
the construction of our bond
portfolios.

It is the teams quantitative,

investment-focused approach and
the development and deployment of
customised quantitative models that
set our fixed income risk team apart
from those of our peers.
In recent years, there have been many
occasions when the quantitative
analysis provided by the FI Risk team
has validated the investment stance
taken, led to changes in a portfolios
positioning or been instrumental in
the development of new strategies
and risk measurement techniques.

The FI Risk team immediately

informed portfolio managers of this
deviation. As it turned out, the
temporary shift in the portfolios risk
profile was intentional but required
monitoring nevertheless. The
investment and risk teams
subsequently worked in tandem over
the following days to ensure the risk
exposure remained within target
levels.

Timely market risk monitoring

In one instance in the summer of 2013,
our risk team detected an unusually
abrupt shift in the risk profile of one of
our global credit strategies.
A deeper analysis revealed that the
spike in the portfolios annualised
volatility and Value at Risk (VaR)
stemmed from a tactical trade in credit
default swap indices and credit
default swaptions, contracts which
give bond investors protection against
the risk of default.

FIG. 1 A SPIKE IN PORTFOLIOS SPREAD VOLATILITY PROVIDES A TRIGGER

FOR HEIGHTENED RISK MONITORING
Annualised Vol (in %)
8
7
6

Total Ex-Ante Vol (%)

Interest rate
Spread
FX
Vega

7
6

-1

-1

06

05

04

03

02

.20
13

. 20
13

. 20
13

. 20
13

. 20
13

01
. 20
13

A quantitative,
investment-focused
approach to risk

Source: Pictet Asset Management, Data taken from analysis of EUR High Yield strategy

Risk management Making the difference in fixed income investing

Standalone tracking error is another

measure that is regularly monitored to
gauge the risks a portfolio is exposed
to. Standalone TE breaks down a fixed
income portfolio's risk into its
individual components interest rate,
inflation, spread etc and looks at each
in isolation; in doing so, standalone TE
assumes there is no correlation
between these factors. It gives
managers a clearer idea of the risk on a
specific position when another one that
diversifies it is closed. This risk
measure enables the FI risk team to
monitor the diversification within a
portfolio from various angles.

A multi-faceted risk approach

In response to the changing needs of
its clients, Pictet AM has launched a
number of innovative fixed income
strategies in recent years. Many of
these give portfolio managers the
discretion to invest across a broad
range of fixed income markets and the
freedom to express both negative and
positive views on securities and asset
classes. In order to provide investment
managers of these funds with the
clearest possible view of the risks in
their portfolios, the FI Risk team uses
several analytical tools that go beyond
measuring a portfolios TE or VaR.
These range from those that measure a
portfolios gross and net exposure to
more advanced metrics such as the
duration time spread (DTS) and the
DTS ratio (see glossary), which are
used to gauge the portfolios credit
beta.

Portfolios are regularly submitted to

stress tests to assess the impact of
shocks on their returns. By modelling
a number of possible future scenarios
for each risk factor, the fixed income
risk team can forecast changes in the
value of the portfolios investments
and hence its overall gain or loss
under different market conditions.

FIG. 2 DTS ANALYSIS OF A CREDIT PORTFOLIO, BY SECTOR

Basis points
600

600

500

500

400

400

300

300

200

200

100

100

-200

Technology
Cons., Non-Cyclicals
Other Sectors

Sovereign
Cons., Cyclicals

07
. 20
14

06

. 20
14
05

04

. 20
14
03

. 20
14
02

Telecommunications
Energy
Index

. 20
14

-200

. 20
14

-100

01
. 20
14

-100

Government
Capital Goods

Financial
Basic Industry

Source: Pictet Asset Management

FIG. 3 DIVERSIFICATION INDICATOR FOR VARIOUS FIXED INCOME PORTFOLIOS

Pictet-World Government Bonds fund

PI CH-Foreign Bonds fund

0.6
300
200
0.4
100
0.2

Pictet Asset Management

.20
14
06

Source: Pictet Asset Management

07
. 20
14

. 20
14
. 20
14
06

. 20
14
05

. 20
14
04

. 20
14
03

05

04

. 20
14
03

. 20
14
02
. 20
14

01
. 20
14

-200

02

01
. 20
14

-100

. 20
14

0.0 0

Telecommunications
Technology
Sovereign
1.0
Government
Financial
0.8
Energy
0.6
Cons., Non-Cyclicals
Cons., Cyclicals
0.4
Capital Goods
Basic Industry 0.2
Index
Other Sectors 0.0

. 20
14

600
Diversification
ratio
1.0
Pictet-EUR Government Bonds fund
500
Pictet-EUR Inflation Linked Bonds fund
0.8
400

02

Basis points

Practical quantitative guidance

The FI Risk team has also developed
models that allow investment
managers to understand the
behaviour of credit spreads, aiding
portfolio construction. For our
high-yield debt investment team, for
instance, our quantitative risk
specialists performed a detailed
regression analysis of speculativegrade bonds risk premia. The analysts
found that risk premium or spread
was heavily influenced by the
volatility of the European stock index,
the default rate of high-yield bond
issuers and the yield spread between
peripheral European and German
government bonds. The output from
this model has now become part of the
macroeconomic, or top-down, analysis
conducted by the high-yield bond
investment team.

An active role in product

development
The FI Risk team also has a major part
to play in the development of new
fixed income products, helping
formulate risk guidelines that serve
the investment needs of both clients
and portfolio managers.
During the development phase of
Pictet AMs new range of short
duration fixed income strategies, the
FI Risk team performed several
analyses aimed at establishing
investment parameters for the funds
in the product family.
For each of these strategies, the FI Risk
team was able to provide detailed
guidance on the suitability of
investments by maturity, credit rating
and currency. The analysis also
encompassed the selection of each
portfolios reference index, VaR limits
and country exposure caps.

Risk management Making the difference in fixed income investing

Fixed income risk

management
inextricably linked
to the investment
process

These positive interventions are

possible thanks to Pictet AMs
sophisticated risk management
system, an integrated RiskMetrics
platform.
The system uses advanced risk
methodologies and automated
risk analytics that enable it to
monitor and model the extent to
which an individual security
affects a portfolios risk-return
profile. It can also accurately
determine how a portfolios
exposure to different countries,
industry sectors and ratings
categories can affect its returns
and volatility.
The FI Risk team has adapted
and continously seeks to
improve this system so that it
meets the needs of our investment
processes. The credit model, for
instance, was recently enhanced to
more accurately capture a
portfolios idiosyncratic risks.

The risk team uses a number of

statistical tests to check the validity of

the risk model including the Kupiec
and Christoffersen tests.

Pictet Asset Management

Each day, the team runs an

average of 30 sets of risk
analyses per portfolio that
capture changes in a portfolios
risk profile along a number of
different dimensions.
These analyses are based on two
types of daily risk reports the
manager summary report and the
more detailed risk attribution
report. The manager summary
report provides a snapshot of the
portfolios risk exposure as
indicated by their VaR and
annualised TE/Volatility, grouped
by investment team. Alerts are
generated automatically whenever
a portfolios specific level of risk is
reached.
Through the more detailed risk
attribution report, meanwhile,
investment managers receive a
comprehensive analysis of the
sources of risk inherent in their
portfolios an in-depth risk
decomposition that captures the
proportion of a portfolios VaR
or TE/Volatility that is
attributable to interest rates,
currency, yield spread, volatility
and inflation.1

FIG. 4 REGULAR RISK MONITORING BREAKING DOWN VOLATILITY BY RISK TYPE

Ex-ante volatility, %

1.0

1.0

0.5

0.5

0.0

0.0

-0.5

-0.5

FX
Interest rate

06

. 20
14
05

04

03

02

Vega
Spread

07
. 20
14

1.5

.20
14

1.5

. 20
14

2.0

. 20
14

2.0

. 20
14

2.5

01
. 20
14

2.5

Total Ex-Ante Vol (%)

10-Day VaR at 95% (%)
Source: Pictet Asset Management; Data taken from analysis of Absolute Return Fixed Income Strategy

FIG. 5 DECOMPOSING RISK BY CURRENCY AND RISK TYPE

Ex-ante volatility, %

1.5

1.0

1.0

0.5

0.5

0.0

0.0

-0.5

-0.5

-1.0

-1.0

USD-SPREAD
NZD-FX
EUR-SPREAD
Other factors

USD-FX
GBP-FX
DKK-IR

TRY-IR
GBP-SPREAD
BRL-IR

06

05

04

03

02
USD-IR
JPY-IR
EUR-IR

NOK-FX
GBP-IR
BRL-FX

07
. 20
14

1.5

.20
14

2.0

. 20
14

2.0

. 20
14

2.5

. 20
14

2.5

. 20
14

3.0

01
. 20
14

3.0

NOK-IR
EUR-FX
AUD-FX

Source: Pictet Asset Management; Data taken from analysis of Absolute Return Fixed Income Strategy

Risk management Making the difference in fixed income investing

Ensuring reliability
of risk models backtesting

To ensure our VaR risk model is

accurate and robust, its results are
back-tested regularly. The VaR figures
are checked against actual returns.
Backtests are carried out for all Pictet
AMs flagship funds every quarter.
Figure 6 shows the outcome of these
back-tests for one of our strategies.
In this instance, the VaR models
predicted daily returns for the
Pictet-Local Asia Emerging Market
Debt fund are compared to the funds
actual returns. Under a VaR with a
confidence level of 95 per cent, the
proportion of daily returns falling
outside the VaR figure should be on
average 5 per cent for the model to be
considered reliable.

The green dots in Figure 6 show those

instances when the actual daily return
was in line with the estimate
generated by the model. The orange
dots below the red line indicate those
occasions when the realised return
was outside the predicted range. In
this case, the back-test confirms the
model was robust.

FIG. 6 ABSOLUTE VAR BACKTESTING FOR AN EMERGING DEBT PORTFOLIO

Daily Returns (%)
2.0

Abs 1D-VaR-95%

1.5

Percentage of exceptions: 4.5%

2.0

Basel Test
Kupiecs p-value: 0.562
Christoffersons p-value: 0.096

1.5

1.0

0.5

0.5

0.0

0.0

-0.5

-0.5

-1.0

-1.0

-1.5

-1.5

-2.0

-2.0

07
. 20
11
09
. 20
11
11
. 20
11
01
. 20
12
03
. 20
12
05
. 20
12
07
. 20
12
09
. 20
12
11
. 20
12
01
. 20
13
03
. 20
13
05
. 20
13
07
. 20
13
09
. 20
13
11
. 20
13
01
. 20
14
03
. 20
14

1.0

Source: Pictet Asset Management

10

Pictet Asset Management

Regular risk reviews

The manager summary and risk

attribution reports also serve as the
basis for more detailed risk reviews
between risk professionals and their
investment counterparts.
Every week, members of the risk team
and investment professionals meet to

Risk budgeting

In addition, risk budgeting meetings

are held twice a year with
investment teams and the head of
fixed income. They give the FI risk
unit the opportunity to work with
the investment teams to:
- review the allocation of risk
between the different sources of
return for each portfolio over a set
period
- understand the reasons for any
deviation from pre-determined
risk budget targets.

Performance attribution

The risk team complements its risk

analysis with the regular monitoring
of portfolio performance. Portfolio
returns are monitored on a daily
basis and unusual deviations are
analysed through a proprietary
performance attribution system.
Detailed performance attribution
analysis is also provided to
investment managers on a monthly
basis. This ex-post review allows
investment managers to review their
risk allocation.

discuss the results of the risk analysis

of their respective portfolios. The
reviews focus on metrics such as the
historical evolution of a portfolios
risk profile by VaR and TE/Volatility
the concentration of risk and the
contributors to risk.

In our view, an effective way to

dampen the volatility of returns and
keep unintended risks to a minimum
is to embrace diversification at every
stage of the portfolio construction
process. It is important to recognise
that each source of return is also a
potential source of volatility and risk.
This is why the risk team work closely
with investment managers to ensure
the portfolios risk budget is efficiently
distributed across a portfolios sources
of return (currency, duration, spread,
etc.)

A more comprehensive review is also

carried out at least twice a year. In this
process, Pictet AM managing partners,
the head of fixed income, investment
managers, and the fixed income risk
team meet to analyse each portfolios
performance and risk exposure.

FIG. 7 MONITORING FRAMEWORK

Market risk management

Performance monitoring and attribution

Daily

Control of risk limits (TE, VaR)

Monitoring of performance to identify

and analyse unexpected variations

Weekly

Risk reviews by investment teams

Control of internal guidelines*

Performance analysis

Monthly
Semi-annual

Risk budgeting meetings by investment teams

Quality review meetings with the top management

Performance attribution adapted

to each investment process (YTD, QTD, MTD)

*Compliance department controls contractual guidelines and regulatory limits on a daily basis
Source: Pictet Asset Management

Risk management Making the difference in fixed income investing

11

Concluding
remarks

A risk management approach for a changing investment

landscape
The financial crisis and the monetary and regulatory shifts it
unleashed have turned fixed income investing into a riskier
enterprise. At Pictet Asset Management, understanding and
managing risk has always been a fundamental part of the fixed
income investment process.
The strength of our risk management stems from two factors
the first is that our fixed income risk management team has
developed a quantitative investment-focused risk management
approach that is deeply embedded in the investment process.
The second is that such analysis is conducted to ensure that
investment decisions are subjected to rigorous and impartial
scrutiny.
In a period likely to be characterised by increased market
volatility, this in an approach that benefits our investment
managers and, ultimately, leaves investors better placed to meet
their long-term investment objectives.

TEAM PROFILE

The FI Risk unit is a team of eight. The current head took

responsibility for building the team in 2000, while most of the
team members have been working together for at least six years.
Over time, this stability has enabled the team to develop a
robust set of tools specifically designed for the analysis of fixed
income portfolios, which they have been adapting to respond to
the changing conditions in fixed income markets.

12

Pictet Asset Management

Glossary of
risk management
metrics

The Value-at-Risk (VaR) of a portfolio

is an estimate of the maximum capital
loss that the portfolio can be expected
to experience within a specified
holding period, and with a specified
confidence level. Instead of expressing
the loss in absolute terms, Relative
VaR measures that loss relative to the
benchmark loss over the period. The
FI Risk unit VaR is based on a Monte
Carlo method in which 1,000 possible
scenarios are simulated.
Tracking Error (TE) quantifies the
degree to which the performance of a
portfolio differs from that of its
benchmark. It is defined as the ex-ante
standard deviation between portfolio
returns and the benchmark returns,
based on a parametric methodology,
which assumes that portfolio returns
are normally distributed.
Effective Duration is the approximate
change in a bonds price that will
result from change in its yield. It is
used for both conventional bonds and
those with embedded options or
redemption features.
Spread Duration measures the price
sensitivity of fixed income
investments to shifts in their yield
spread (the difference in yield
between the security and benchmark
government debt).
Effective Convexity measures the
effective duration change that results
from a change in a bond's yield.
DTS (Duration Times Spread)
captures the sensitivity of a bonds
price to a relative change of its yield
spread. It is calculated by multiplying
the spread duration of a bond by its
credit spread (in basis points).

The DTS ratio compares the

funds DTS to that of its reference
benchmark.
The diversification indicator takes a
value between 0 and 1, with 1 being a
perfectly diversified portfolio.
(1-{Total Risk / sum of stand-alone
risk by category})
Basel test: The Basel Committee
recommends a recording of daily
exceptions of the 99% VaR over the
last year. 1 percent of 250, or 2.5
violations are expected on average
over the last year. The Basel
Committee has decided that up to
four exceptions are acceptable, which
defines a green light zone. Five or
more exceptions and the fund falls
into a yellow or red zone
Kupiecs p-value: The Kupiec test is a
statistic test that verifies if the
observed frequency of violations
(exceedances of VaR) is close to the
expected number of exceptions. The
VaR Model fails the Kupiec test if the
p-value of the defined statistic is
below a specific value. This test is
unconditional as it does not take into
consideration whether the exceptions
are independent or not.
Christoffersens p-value: This test
supplements the Kupiec test by testing
the independence of exceptions. It
formalises the notion that when
exceptions are not independent, the
probability of an exception tomorrow,
given that there has been an exception
today, is no longer equal to the
confidence level.

Risk management Making the difference in fixed income investing

13

14

Pictet Asset Management

Contacts
For further information, please visit our websites:
www.pictet.com
www.pictetfunds.com

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Information used in the preparation of this document is based upon sources believed to be reliable, but no representation or warranty is
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This document has been issued in Switzerland by Pictet Asset Management SA and in the rest of the world by Pictet Asset Management
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For US investors, shares sold in the United States or to US Persons will only be sold in private placements to accredited investors pursuant to
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Copyright 2014 Pictet - Issued in September 2014

Risk management Making the difference in fixed income investing

15

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