by David J. Merkel, Aleph Blog

Here are two arti­cles to read on risk parity:

Pro: Pick Your Poison

Con: The Hid­den Risks of Risk Par­ity Portfolios

I’m on the “con” side of this argu­ment, because I am a risk man­ager, and have traded a large port­fo­lio of com­plex bonds.  For addi­tional sup­port con­sider my arti­cle Risks, Not Risk.  Or read the sec­ond half of my arti­cle, “The Edu­ca­tion of a Cor­po­rate Bond Man­ager, Part X.” There is no generic risk in the mar­kets.  There are many risks.  Inter­est rate risk and credit risk are dif­fer­ent top­ics.   There are bonds that have inter­est rate risk but not credit risk — long Trea­suries.  There are bonds that have credit risk but not inter­est rate risk — cor­po­rate float­ing rate notes, my favorite exam­ple being float­ing rate bank trust pre­ferred securities.

It is not raw price volatil­ity that dri­ves invest­ment results as much as the under­ly­ing dri­vers of the volatil­ity.  For fixed income, I described those in the two arti­cles linked in the last para­graph.  Dur­ing non-credit-stressed times, a bank’s 30-year float­ing rate trust pre­ferred secu­rity is roughly as volatile as a five-year non­callable bond that it issues.  But dur­ing times of credit stress, the first secu­rity becomes volatile, whereas the sec­ond one doesn’t.  The first moves in line with 30-year swap yields, LIBOR, and long junior bank spreads.  The sec­ond moves in line with 5-year Trea­sury yields, and short senior bank spreads.  The under­ly­ing dri­vers have lit­tle in com­mon, and when things are calm, their volatil­i­ties are sim­i­lar, because the dri­vers aren’t mov­ing.  But when the dri­vers move, which in this case is one cor­re­lated dri­ver, credit stress (30-year swap & junior bank spreads go a lot higher), the volatil­i­ties are very dif­fer­ent, the first one being high and the sec­ond one low.

Thus equat­ing volatil­i­ties across a bunch of asset sub­classes, invest­ing less in the volatile, and lev­er­ing up the non-volatile, is hard to do.  His­tory embeds all the curiosi­ties of the study period, and calls them nor­mal, and that past is prologue.

From the Pick Your Poi­son arti­cle above, what I think is the (lose) money quote:

Gund­lach insists most money man­agers mis­un­der­stand junk bonds, com­par­ing them to 5-year Trea­surys to deter­mine how rich their yields are, when the cor­rect com­par­i­son should be to 30-year Treasurys.

How can Gund­lach com­pare junk bonds, which do bet­ter when the econ­omy heats up, with long-term Trea­surys, which get killed when the econ­omy revs up and the Fed raises inter­est rates?

That’s irrel­e­vant, he responds. The thing to look at is volatil­ity, because that tells you the odds you will have to sell at a loss when you need to raise cash in an emer­gency. On that basis, junk bonds that were trad­ing at a seem­ingly rea­son­able spread of 5 per­cent­age points, or 500 basis points, to 5-year Trea­surys in mid-2011 were actu­ally trad­ing at an intol­er­a­bly low 250-basis-point spread to the proper bond. (By then Dou­ble­Line had cut its junk bond allo­ca­tion from 10% to 1%.) Sure enough, junk fell 12% as the year went on, and the spread to 30-year Trea­surys has dou­bled since mid-2011.

“It’s called risk par­ity,” Gund­lach says. “There’s only two investors who seem to under­stand it—me and Ray Dalio,” the highly suc­cess­ful man­ager of $122 bil­lion (assets) Bridge­wa­ter Associates.

Per­son­ally, I don’t think Gund­lach makes his money that way for his funds, but in case he does, how should a good bond man­ager view junk bonds?

First, ignore Trea­suries — they aren’t rel­e­vant to the price per­for­mance of junk bonds.  I’ve run the regres­sion of Trea­suries vs junk bond index yields many times.  It’s barely sig­nif­i­cant for BBs, and insignif­i­cant there­after.  Sec­ond, look at stock mar­ket indexes of indus­tries that lever up and issue junk debt.  Junk cor­po­rate debt is a milder ver­sion of junk stocks, i.e., the stocks that issue junk debt.

Third, a corol­lary of my first rea­son, real­ize that risks with junk aren’t dri­ven by spreads, but yields.  With highly lev­ered, or very junior debt, it does not trade on a spread basis, but on a price basis.  Any­one look­ing at spreads will see too much volatil­ity ver­sus yields and prices.

But mere volatil­ity won’t tell you the risk­i­ness.  Indeed, when eco­nomic times are good, junk will do well, and long Trea­suries do poorly.  Now, maybe that makes for a very noisy hedge, but I wouldn’t rely on it.

And, volatil­ity is a sym­met­ric mea­sure, which as bond yields get closer to zero, the sym­me­try dis­ap­pears.  Most asset classes dis­play neg­a­tive skew and fat tails, which also makes volatil­ity prob­lem­atic as a risk measure.

Going back to my first piece on the topic, if I were apply­ing risk par­ity to a bond port­fo­lio, it would mean that I would have to buy con­sid­er­ably more of shorter and higher qual­ity instru­ments, and lever them up to my tar­get volatil­ity level, some­how with spreads large enough that they over­come my financ­ing costs.  Now, maybe I could do that with mis­priced mort­gage secu­ri­ties, but with the prob­lem that those aren’t the most liq­uid beast­ies, par­tic­u­larly not in a cri­sis if real estate is weak.

I guess my main mis­giv­ing is that lev­ered port­fo­lios are path-dependent, as pointed out in the GMO piece above.  You can’t be cer­tain that you will be able to ride through the storm.  The abil­ity to finance short-term dis­ap­pears at the time it is most needed.

Now, if you can get lever­age after the bust, and invest in beaten-up asset classes, you can be a hero.  But that’s a time when only the most sol­vent can get lever­age, so plan ahead, if that’s the strat­egy.  If an investor could con­sis­tently time the liquidity/credit cycle, he could make a lot of money.

As the GMO piece con­cludes, the only bench­mark that every­one could hold would be a pro­por­tion­ate slice of all of the assets in the world, which implic­itly, would strip out all of the lever­age, because one would own both the shares of the com­pany, and the debt it owes, and in the right proportion.

So I don’t see risk par­ity as a sil­ver bul­let for asset allo­ca­tion.  I think it will become more prob­lem­atic, as all strate­gies do, as more peo­ple show up and use it, which is hap­pen­ing now.   First in the hands of the mas­ter, last in the hands of a sorcerer’s appren­tice.  Be careful.

PS — I have respect for the skills of Gund­lach and Dalio.  I’m just skep­ti­cal about what hap­pens to risk par­ity when too many use it, and use it with­out under­stand­ing its lim­i­ta­tions.  And, here is a nice lit­tle piece about Bridge­wa­ter and its strate­gies.

Read more from the author/contributor here.

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