I once heard an interesting analogy for assessing risk tolerance. What yield compensation would you demand in return for selling a stranger the right to wake you sometime in the future by dropping a tarantula onto your face? For me, it would be quite high. I suffer from arachnophobia, and would not sleep well until the deed was done. But for others, it may not be so great. Maybe they’re not as scared of spiders, or they’re convinced it’ll be years before the stranger arrives? Either way, it tells us something about our threshold for living with risk.
This would also make for an interesting Reverse Dutch Auction. Reverse Dutch Auctions are a method that airlines typically use to determine a ‘clearing price’ at which a desired number of ticket holders will forgo their seats on an overbooked aircraft. An airline representative raises the price until he/she has enough volunteers. In the analogy above, the sleepers are travelers, and, instead of relinquishing seats on a flight, they are selling futures in fear (i.e., ‘fear futures’). The buyer is the spider dropper, and she/he will raise the compensation until sufficient volunteers are on board. Note, the Treasury Department employs Dutch Auctions to determine the price and yield of U.S. Treasury issues. The auction participants submit a series of order sizes and yields into a central computer. The computer then optimizes the book by filling the orders from the lowest yields on up. This continues until the entirety of the issue is subscribed. All participants whose orders were filled are then sold their size at the final and highest clearing yield in the order book.
Now imagine those ‘fear futures’ clearing in the fixed income market at a relatively high price or tight spread (to ‘fear-free’ Treasuries). The clearing price suggests that investors are willing to forgo unencumbered sleep for a modest amount of additional yield. The fear of spiders had waned – after all, they hadn’t dropped for a couple of years, so maybe they won’t for a couple more? This collective mindset permeated the bond market as we entered 2020. Spreads were relatively tight to historical levels, and risks were perceived as low. Little did we know that large, hairy critters were lurking in the dark. Then they dropped in March. Just as they crawled over our faces, the stranger re-appeared and offered to buy another round of ‘fear futures’. What is your price now? NNNNNOOOOOOOOOOOO TTTTHHHHAAAANNNNKKKKKKSSSSSS!!!!!!!
Of course, if you were to agree to sell at that peak of fear, you’d be paid most handsomely. The visceral sensation of a spider crawling across your eye socket is far more frightening than the abstract concept of “risk” at some point in the future. And, if the stranger is dropping spiders on many investors that same night, market clearing yield levels could skyrocket – for the same risk! The difference is that you and the rest of the market are collectively experiencing gut-wrenching visceral fear right now. But, after a couple nights of peaceful sleep, the market’s compensation demands may subside. After all, no news is good news – both with bonds and spiders.
This boom-bust mentality isn’t just confined to the emotional cycle of individual investors. It can be institutionalized in our risk metrics. Fixed income risk models such as tracking error tend to promote a “close the gate after the horse has left” approach to active management. Case in point – typically, one of the main ingredients in tracking error models is ex-post volatility. The higher the recent spread volatility (and spread widening increases volatility far more than spread tightening), the higher the tracking error. Vice versa when spreads are calm and relatively tight. If the investor wishes to keep risk constant through this cycle, the model is effectively telling she/he to sell at lower prices and buy at higher prices. This is like trying to drive a car by only using the rearview mirrors. What we forget is that when risk gets us into trouble, it can also get us out.
By nature, fixed income spreads are mean reverting. As a bond approaches maturity, the pull-to-par effect can be a powerful mark-to-market healer of even the sharpest widening events. This is provided that the bond does not default; however, adverse price action does not necessarily equate to higher default risk. Only a real-time assessment of the bond’s intrinsic fundamentals can tell us that. So, individual bonds are much like individual spiders – certain fanged hairy ones may not be as dangerous as other smaller, hairless ones. The key is to know the difference. That is the essence of great bottom-up security selection.
At IR+M, we’ve studied spiders of all shapes and sizes. We believe we can identify the most poisonous ones and keep those out of our clients’ portfolios. Others require us to lean on our experience through market cycles in order to assess fair compensation. But in those rare market moments when big, hairy tarantulas are dropping, we believe we can add the most value. We don’t relish tarantulas crawling across our faces, but we believe our collective bottom-up wisdom steadies our emotions and gives us the confidence to transform market fear into benchmark beating returns over time.
Sources: The above examples are for illustrative purposes only. Actual results may differ. Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.