A Portfolio Manager Questions a Risk Engine VI:
Fixed Income Performance Attribution Analysis
Yannis Sardis, 7 May 2021
In the last note of our series we discuss how the multi-asset risk analysis framework, KlarityRisk (KR), which we introduced in our previous articles can be complemented by a performance attribution module which can be applied to the Fixed Income allocation of our portfolios and assist a PM in decomposing his returns into their constituent components.
PM: So far, we have discussed the various ways that you can assist me in analyzing my risk sources, on either a constituent or a portfolio level. Can I also identify the component sources that drive the performance of my Fixed Income portfolio?
KR: Yes, our Fixed Income Performance Attribution tool decomposes the total return of your Fixed Income portfolio into the returns due to you holding the selected bonds (i.e. the carry, namely the coupon payments plus the roll-down), or to interest rate movements (yield curve), or to changes of your bond holdings’ credit ratings.
PM: I manage a Fixed Income portfolio, which has been decomposed of High-Yield Corporate Bonds 25%, Investment Grade Corporate Bonds: 25%, Treasury Bonds: 50%. The portfolio realized an annual return of 4%. Can I get a detailed view of what drove my total portfolio return?
KR: Yes, our performance attribution model breaks-down the generated portfolio return into its fundamental sources for each individual security. More specifically, you can break down the performance of each individual Fixed Income investment into its fundamental sources:
- Carry Return: The part of a bond’s return due to the passage of time, consisted of the Coupon Return (the income that accrues over time) and the Roll-Down Return (the change in the clean bond price, provided that the yield curve remains unchanged)
- Yield Curve Return: The part of the return due to the changes in the risk-free yield curve. Our model breaks down the Yield Curve Return into the Shift Return (generated due to parallel shifts of the entire yield curve of the investment) and the Shape Return (generated due to changes in the yield curve shape, i.e. steepening or inversion)
- Spread Return: The part of the return due to the widening or tightening of the bond’s credit spread (i.e. due to the changes of the premium that an investor requires to take for the default risk of the said instrument).
PM: My firm manages a family of Index-Tracking Fixed Income portfolios. Can we assess where our excess returns (above the selected Benchmark) are coming from and thus identify whether our investment decisions were successful (i.e. ‘beat the market’)?
KR: The Fixed Income Performance Attribution module allows you to compare the portfolio’s active total return sources against those of the selected benchmark.
For instance, let us assume that your portfolio aims to track a ‘High Yield Corporate Bond’ Exchange Traded Fund (ETF) and that your portfolio’s total return for the previous year was -5.2%, whereas the benchmark index’s return was -7.8%. Although you are satisfied with the relative outcome, you wish to understand how your asset allocation decisions resulted to that ‘excess’ return. You run our Fixed Income Performance Attribution analysis against the ETF index to realize a reduced weight in sectors affected the most by the Covid-19 pandemic (Airlines, Energy, Leisure Facilities) and an increased weight to sectors affected the least, such as Health Care REITs, Life and Health Insurance.
Moreover, the return decomposition identifies individual instruments that you had given more weight to, the credit worthiness of which was increased, therefore having their market price moving up quite substantially.
PM: Could you be more detailed about the specific Fixed Income fundamental drivers vs our selected Benchmark?
KR: You can break down the active return of each individual portfolio segment into its fundamental sources, namely:
- Carry Effect: It shows the way your asset allocation and security selection decisions impacted the active portfolio returns (Portfolio vs Benchmark), generated due to passage of time, consisted of the Coupon Effect (the active return due to the income that accrues over time) and the Roll-Down Effect (the active return that stems from the change in the clean bond price, provided that the yield curve remains unchanged)
- Yield Curve Effect: It defines the way your asset allocation and security selection decisions impacted the active return (Portfolio vs Benchmark), generated due to yield curve movements, consisted of the Shift Effect (generated due to parallel shifts of the entire yield curve of the investments) and the Shape Effect (generated due to changes in the yield curve shape, i.e. steepening or inversion)
- Spread Effect: It defines the way your asset allocation and security selection decisions impacted the active portfolio return (Portfolio vs Benchmark), generated due to changes in the credit worthiness of the individual investments.
PM: We usually monitor our portfolios’ performance by certain segments, in order to get a more granular view. Does your Fixed Income Performance Attribution module allow for such groupings?
KR: Yes, we can create a granular overview of the sources your total return stems from. The list of segments varies and depends on the information that is maintained in your firm’s accounting system. A sample of the portfolio segments that you can analyze are:
- Industry Sectors/Groups: Identify the performance distribution amongst different Industry Sectors and portfolio Groups, along with how the factors mentioned in the previous questions drive their performance contribution
- Credit Rating: Identify the performance distribution amongst different classes of bonds, based on their Credit Rating along with how the return factors drive their performance contribution
- Any Custom Classification: Analysis can be performed by any Custom Classification that is maintained in your firm’s accounting system, such as custom credit worthiness scores and investment grade vs high yield bonds categories.
Our series of six articles attempted to sketch the main pillars of a holistic approach to risk management and to convey that the evaluation of a portfolio’s risk exposure to normal or Black Swan conditions cannot be adequately covered by a sole risk number but by a selection of metrics and calculation methodologies.
Investors should always ensure that their ongoing pursue of out-performance does not unwillingly introduce uncontrollable long term portfolio risks.
FINVENT Software Solutions is a provider of financial software applications and custom engineering services. The award-winning KlarityRisk platform specializes in investment risk analytics and fixed income performance attribution reporting and it is offered to Private Wealth institutions, Asset Managers, Hedge Fund Managers and Family Offices.
Would you like to know more about our Portfolio and Risk Management solutions? Please contact us at firstname.lastname@example.org and we will get in touch.