Tail Risk Strategies

If rates are really "lower forever", what are the implications for portfolio construction?

Tail Risk Strategies?

The very occasional...
I commenced this occasional on 31Mar19 with a note


The theme continues. Rates are lower, inflation expectations are lower/unchanged and "TINA" - "there is no alternative" to Equities.

What does this mean for portfolio construction?

Imagine your "risk budget" affords a benchmark of 70% "Risk assets" and 30% "Defensive assets" and that you need defensive assets that appreciate and are liquid in a crisis. Call these Sovereign Bonds or Fixed Income including, for example, Australian 10 year Government Bonds. Note also that ~USD 17 trillion (i.e. $USD 17,000 Billion of ~$USD 54 trillion of global sovereign bonds) are trading at negative yields. (Switzerland -0.84%, Germany -0.59%, Japan -0.21% etc.)

It is true that if one buys a 10-year Australian Govt Bond at par (100) which is paying a coupon of 0.87% and the prevailing market rate immediately drops 200bp to negative 1.13%, the price of the Bond jumps to about 121, or  +21%.

However, it is also true that holding Bonds in your 70/30 portfolio is extremely unlikely to enjoy the returns of the last 30 years.

See below the 30 year + returns of Equities, Bonds (US Treasuries), FX and Commodities organised into the best 5% of outcomes, the worst 5% of outcomes and the ("mean") 90% of outcomes. Ref Convex Strategies and DB

History Lessons

  • Bonds have proved to be the perfect complement to risky portfolios (equities)
  • Bonds have provided positive compound returns in 90% of outcomes
  • Bonds have been negatively correlated to equities in times of crisis

Prospective Risks

  • Yields remain close to zero
  • Negative correlation to equities is less certain
  • Bond price appreciation due to further rate declines are less likely and less likely to offset equity losses
  • Shock "normalisation" of bond yields results in unprecedented capital price risk and/or a liquidity crisis? (Remeber 1994?)

Conclusion - Tail Risk Strategies?

  • Investors need defensive instruments that are safe and liquid in times of crisis and protect or offset the 5% of worst outcomes: These are called "Tail Risk" strategies.
  • Bonds are unlikely to exhibit these characteristics - see above.
  • Other alleged defensive allocations to say cash and alternatives do not have these characteristics.
  • Tail Risk strategies decline in value over time. A firm investment belief is required to allocate.
  • Manager selection is paramount. Investors need a strategy that works from a manager that survives...

Thank you

I attended the Volatility Investing Event in Sydney generously sponsored by Optiver and as a guest of Convex Strategies. Thank you, David, Julian et al. Despite the discussion being squarely (or at least mostly) in the left tail and not a happy place(!), the very real implications for portfolio construction and long term investing were well made by each of the presenters. Thanks again.