Managing Risk in Fixed Income

 
With Trevor Leydon, Head of Investment Risk for Fixed Income at Aviva Investors

Like a lot of larger firms, we operate a matrix-style control system for risk management. For things that are electronically-traded, obviously, you can have a little bit more rule-based systematic control, and for OTC and phone-based markets, it’s a little bit more challenging. We try and adopt our controls to reflect a variety of factors, from client appetite to our own risk appetite to market depth. We try and use as many tools as we can to effectively control risk.
We make it as systematic and with as much pre-trade compliance and pre-trade checks as we can, within reason. From specific things like; can the client mandate handle this type of instrument, this particular stock or bond, or the size of the order, there are a variety of control mechanisms in place and those have to be factored into the broader decision-making process that we as a house will go through. There are human controls via the PM and the individuals concerned, and our investment managers proactively engage with the risk team and compliance to think about size, and to talk through any particular points that are of concern while they are going through the idea generation phase, and then onwards from that we try to implement the controls so they are inherent going forwards but minimise disruption.
Calculation of risk profiles
As a general rule of thumb where markets exhibit significant depth, things like futures and equities, the rule-based system tends to rebalance itself. If you’re looking at a percentage market volume on a one-day or a five-day or 10-day basis on your portfolio size, then, those will dynamically rebalance themselves to accommodate recent market history, so you do have that element of rule-based, percentage-based systems within any large-scale investment house. But, likewise, we still spend a lot of time as an investment house discussing various liquidity features. For example, this year the FSA has written to many of the corporate bond managers and asked them to talk about liquidity in the corporate bond market. Now, that is, by its definition, overwhelmingly a phone-based market (there are electronic recordings of trade activity, but it’s an imperfect market in terms of depth); some of that is also based around size and feel and absorbing the market knowledge of the professionals, but also making sure that we, as a house, while operating on behalf of our clients, don’t become accidentally concentrated. There is always the risk as an investment house grows bigger that its percentage of a market will grow even though, individually, its managers are relatively small in any one position.
Market structure
There are a couple of broader points in terms of market liquidity. Firstly, there are, certainly on the bond side, systems like TRACE being used for identifying past bond transactions. But because of the nature of the bond market, there isn’t the same sort of trading style, so you don’t see people in and out, in and out every day on the same bond. Liquidity is often in the eye of the beholder; it’s based on speaking to brokers, intermediaries and other cash parties, and investor appetite to take on a position. The market has recognised that one of the ideas in the back of many minds, pre-2007, was that if there were some systematic issues, liquidity would be provided, and indeed we saw the authorities step in across various jurisdictions, for example, access to TARP and TARP-like programs or direct access to Central Bank operations, which functioned as liquidity facilities for many. Nonetheless since then, the private market has stepped back somewhat because regulators are asking banks to scale back their balance sheet appetite. Naturally there is a disconnect between asking the intermediation side of the business to move away and be more capital constrained and have less balance sheet appetite, while maintaining liquidity provision for buy-side investors. It is something that we are quite conscious of and we are continuously seeking to refine our ideas around liquidity because it is a fluid and dynamic environment.
There is always the possibility, as we saw in 2008 that a market(s) can dry up; it is a concern for our investors and naturally it is our concern also. Hence, we look to manage our business to reduce the risk of bumping into market liquidity constraints. We are continuously seeking to refine our ideas because it is a fluid and dynamic situation. And if it is our investors’ concern, it is our concern. And we do our best to ensure that we don’t get into a situation where we bump into that problem.
There are soft elements of the market which I don’t think we’re ever going to see firmed up. But it will be nice, if we collectively spent time thinking about what some of the regulatory changes mean for us as investment houses. If one looks at, for example, recent regulatory action in terms of liquidity, I think everyone has also been operating on the best execution basis towards those standards, and we certainly do maintain all our portfolios in that sense. But proving something is liquid versus will it be liquid tomorrow, is a very difficult thing. We don’t have a set of mathematical principles; we have a set of intellectual constructs which allow us to theorise that something will be liquid tomorrow. There are concerns in the broader market about how liquidity is really measured and what does that mean for individual firms and individual managers, and it is something we are seeking to address; constantly seeking more information, new methodologies, new systems, and new information sources that will help us provide more colour, but as an industry, we’re not quite there.