(August 9, 2013) — UBS has rattled its sabre against risk parity funds, saying the losses witnessed in May and June this year were merely a “mild foretaste of what is to come”.
In a whitepaper entitled “Will risk parity go wrong… again?” strategists Stephane Deo and Ramin Nakisa argued that if significant negative returns was the response to the Federal Reserve’s hint that it would start to taper its asset purchase, the response to the onset of tapering was “likely to be more severe”.
Given there is still no real timetable for tapering, the effect of tightening on fixed income assets is also unknown, UBS’s strategists continued, leading them to develop a “speed limits” theory for analysing the susceptibility of fixed income to rising yield.
“We define the speed limit of bonds as the rate at which yield can increase such that it wipes out coupon income. Given the extraordinarily low coupon of most developed market sovereign debt, speed limits are below 2.5 basis points per month for treasuries, bunds, gilts and Japanese government bonds (JGBs). Investment grade is little better at 5.9 bp/month and even high yield corporate bonds can only absorb 13.1 bp/month,” they wrote.
Add in the fact that historically the Fed tends to hike in 25 bp increments, and it is possible to anticipate repeated mark-to-market losses in the entire fixed income space each time the Fed moves, said UBS.
“Not only treasuries will be affected by the Fed’s policy rate change—the high correlation between yield curves suggests the Fed may drag other sovereign yield curves higher with it in a process of policy contagion. This will destroy the sentiment of investors used to seeing treasuries, bunds, gilts and JGBs as safe stores of wealth, and may catalyze a large-scale re-allocation into equity,” they concluded.
As one of the biggest players in the risk parity space, Bridgewater’s CIO Bob Prince unsurprisingly disagreed. He told aiCIO that the onset of tapering was not going to lead to large hits of All Weather, because the surprise element isn’t there—the markets are already pricing tapering in.
“What happened in the second quarter [of this year] was similar to what happened in 1994. In the second quarter, risk premiums rose, adversely affecting all assets due to a rapid, substantial change in the discounting of future monetary policy,” he said.
“Prior to the second quarter, that tightening was not priced in. Now it is. So an incremental similar affect would have to be driven by a comparable surprise, relative to the tightening which is now priced in.”
The markets are already discounting that five-year US treasury rates will rise to about 4.3% by 2018, up around 3% from today’s level of 1.4%, Prince argued.
If interest rates rise as discounted, the effect will be minimal, he continued. They would have to rise much faster than what is discounted in order to have a similar effect as the second quarter.
“Losing periods occur when there is an actual or a discounted tightening of liquidity conditions. And the opposite is also true. Higher than normal returns, such as we experienced in the past couple of years, occur when liquidity expands and risk premiums fall.”
Not everyone is convinced however. Robert White, a client portfolio manager in the global multi-asset group at JP Morgan, told aiCIO he would find it “very hard” to discern how risk parity products built around a framework of leveraged fixed income positions would be an attractive investment option in the current environment.
“When there’s a negative performance of the underlying assets, history has dictated that the leverage goes out at an increasing rapid pace, causing a much more violent move in the price of the underlying asset class. I believe that this could happen again,” he said.
“If you look at what happened in 1994 and 1998, that’s really relevant to this. There was a lot of leveraged money invested in various forms of relative value fixed income. As those trades started to go against them they were forced to deal with redemptions, and unwind and decrease leverage.
“The movements that happened in the underlying asset classes were amplified and that had broad implications across the capital markets. There’s a very real possibility that happens again.”
Could this be the most testing time yet for risk parity funds? And what do you think of today’s providers? Let us know what you think in aiCIO‘s third annual risk parity investment survey by clicking here.
Related Content: Risk Parity: What Happened? and Risk Parity: What’s Next?