At the end of June 2009, it wasn’t unusual to see most bond investors looking pale and nervous. After all, they had just experienced an extremely volatile year in the market. The last six months of 2008 had produced massive sell-offs and the first half of 2009 turned in massive rallies. Trying to suppress their queasiness, investors mulled over their concerns for the immediate future. Where would returns come from for the remainder of 2009 and 2010? And what would be the risk or cost of that return?
The whole experience of volatility also had many investors asking more fundamental questions about their approach to the market: “How good is the risk management process that my portfolio is using?” or, “How good is my portfolio manager?” and,“What type of risk management tools do I need to use?” These are all valid concerns, in stable periods as well as volatile times. And the answer to all of them lies in the art and science of fixed-income risk management.
The science of risk management is based on a set of tenets that have proved effective over time—tenets best followed through a combination of strong quantitative risk management systems and a robust investment process. Measurement techniques that are informative, and thorough, consistent selection and divestment processes are simply fundamental to portfolio building.
The art lies in interpreting market conditions, in reading what the market is saying and acting on it. In this, the past year’s volatility has been very instructive. The sell-offs of late 2008 and the subsequent rallies of early 2009 provide some useful lessons regarding risk management. To understand how combining the art of interpreting markets and the science of the selection of individual securities can help in risk management, let’s review the turbulent events of 2008/09. We’ll examine them through the prism of different quantitative measurements, some of which led to mistakes, and others to sounder decisions. Read the full article here.