The Risk series of The Wire looks to help investors improve the way they assess and measure risk within their portfolios and to also help manage those risks more proactively.
In this article we focus on why volatility is something investors should consider when evaluating risk and constructing their fixed income portfolio.
Why does volatility matter for risk?
Volatility is one of a variety of ways to consider what risk exists within a portfolio. It is considered to be a particularly useful metric of risk largely because it can be measured relatively simply; is well-established through its use in a variety of financial research; and has also been regularly employed by numerous funds and asset managers to track changes in the risk of their portfolios.
Much of this research has tended to focus on portfolios of shares or individual shares. However, volatility can be applied to most types of financial assets since it only requires a changing price series to calculate.
The measurement of volatility
If you have invested in any market previously, including equities on the Australian Stock Exchange (ASX), you would have noticed that prices tend to move every day as new information, macroeconomic data, supply, demand and other news is incorporated in the prices. These price movements are directly relevant to understanding volatility, not only by observing how frequently the changes occur but also observing how big the moves are.
In financial mathematics, the best way to examine these moves has been to identify an average value and then look how much dispersion (or variance) there has been from that average value over a certain period of time, which is also known as measuring the standard deviation.
Intuitively, many investors know that a financial security that moves up or down by 5% every day is a higher “risk” security than one that moves up or down by only 1% every day, and that is precisely what the standard deviation (and volatility) is designed to measure.
When we talk about volatility of a bond, what we are examining is the standard deviation of a series of daily returns of a bond or portfolio. These daily volatilities can then also be adjusted to show them on a monthly or annualised basis.
Measuring bond risk with volatility
Volatility is not the only measure of risk that exists, especially for the purpose of risk management, but its widespread use has made it a very significant tool for assessing portfolio risk and also to provide context to investor returns.
For bonds, credit risk is an equally important type of risk to assess (and which is discussed in more detail in our Credit and Interest risk article in The Wire’s Risk series). However, credit risk is generally harder to compute with numerical precision and requires both qualitative and quantitative judgment to assess properly.
At the same time, investors who prefer to hold investments to maturity may be less concerned with the relevance of volatility since a known capital repayment will occur at (or before, where the bond is callable) maturity absent any payment default.
Where volatility matters most is where investors actively trade and manage their bonds with some frequency or where an investor wants to maximise their trading returns in a defined period of time. Volatility will then give the investor a deeper understanding of how often and how much a bond might trade higher or lower in price, based on the bond’s historical volatility.
Bonds can improve your risk-adjusted return
One of the very favourable aspects of bonds is that they are, on average, far less volatile than shares. Even high yield bonds with their relatively higher credit risk can often move significantly less than even the largest capitalisation shares within the ASX 200. This means they can create better risk-adjusted returns for portfolios.
When financial professionals talk about a risk-adjusted return, what they often mean is the Sharpe ratio of an investment or portfolio of investments. This formula measures how much an investment or portfolio has provided in returns additional to a riskless investment versus how much volatility the financial asset exhibited over that same period of time:
Again, because volatility is a way of measuring risk, the Sharpe ratio is then one way to capture the size of an asset or portfolio’s return relative to the size of the risk taken to make the return.
When you look at the historical performance of Australian shares versus Australian corporate bonds over the past 20 years, bonds were the standout winner when looking at the Sharpe ratio as your risk-adjusted return (using the average yield of the 1 year Australian sovereign bond as the risk-free return):
Source: Bloomberg
In that time, the ASX 200 demonstrated an annualized volatility of 13.4% versus annualized volatility of Australian BBB Corporate Bonds of only 2.9%.
While past performance is not a reliable indicator of future performance, historically allocations to bonds helped investors achieve better risk-adjusted returns, at least as measured by the Sharpe ratio.
Given bonds are very likely to continue to be low volatility investments, as well as structural reasons why they will tend to normally exhibit less volatility than shares, adding a mix of bonds to your share portfolios will likely help minimise your risk when investing, while also diversifying your overall portfolio.
For further discussion on the benefits of diversification, please see our article on Diversification in the Risk series of The Wire.
FIIG Securities can help you invest in bonds, get in touch with us here.