Analysis takes a second look at the convergence in market risk between key corporate-bond indexes
Contrary to the common sense of market observers, traditional value-at-risk (VaR) models suggest that investment-grade bond portfolios’ risk levels are starting to show an uncanny resemblance to their high-yield counterparts. But according to researchers from MSCI, that’s not the whole story.
“As reflected by market-weighted benchmarks, we found that the IG and HY corporate-bond markets now have comparable market risk when measured by MSCI-derived VaR at the 99.9% quantile,” said András Bohák, executive director, Risk Management and Liquidity Core Research and Andras Rokob, vice president, MSCI Research.
In a recent blog post, the two said that as of February 2021, the gap in risk between the high-yield and investment-grade categories for a one-year horizon was at its lowest level of the past two years.
To explain this, they noted that aside from volatility in credit spreads and government-bond yields, model-derived measures of market risk are also affected by bond-market duration. While the duration of the IG market rose sharply over the past two years – as of Q1 2021, the duration of the SCI US IG Corp Bond Index stood at eight years – the duration of the HY market has been comparatively steady, hovering at approximately four years.
“The convergence in market risk between HY and IG can be mostly explained by this divergence in bond durations between the two credit segments,” Bohák and Rokob said.
But looking beyond the market risk of the two segments as measured by VaR, they noted that the long-term average default probability of HY bonds is around 20 times higher than that of the IG index. In other words, market-VaR models might fail to account for the dynamics of actual defaults even as they incorporate variations in default expectations through credit-spread volatility.
To determine how much impact explicitly considering default events could have on measured risk, the two compared three metrics – the MSCI market VaR, a credit VaR measure that looks at default risk only, and an integrated VaR that integrates movements of both market-risk factors and default events – for both IG and HY. They replicated that analysis over one-week, one-month, and one-year periods.
“As the risk horizon is extended beyond one week, defaults turn into a key risk driver for HY,” they said. “At the one-year horizon, the pure default risk (19.8%) outweighs the market risk (14.1%), and the integrated market-default risk (24.9%) becomes almost twice as large as the market risk itself.”
As for IG, they found that default risk at the one-year horizon stayed modest at 4.4%, and the level of integrated risk matched that of market risk.
“In short, investors might want to consider explicitly including defaults in their risk modeling, which may help better differentiate the HY and IG bond universes in long-term risk management and asset allocation,” Bohák and Rokob said.