Portfolio stress-testing II: Dropping interest rates

Portfolio stress-testing II: Dropping interest rates

London, UK – March 24, 2018 – The global financial crisis of 2007-2008 is considered to be the worst one since the Great Depression of the 1930s. In an effort to regain stability and rebuild market confidence within a country’s financial system, central banks globally used a range of tools to inject an unprecedented amount of liquidity in the markets.

The most influential tool is the discount interest rate, which dictates the cost of borrowing. Central banks significantly decreased their discount rates entering ‘zero-interest-rate-policy’ regimes, as rate shifts (most often) have drastic effects on a country’s macroeconomy and financial markets.

These ‘monetary easing’ policies have now started to stall or reverse and central banks are expected, albeit at different paces, sizes, and times, to start increasing their interest rates. This is a balancing act which can test an economy’s strength to endure rate hikes and at the same time prevent an economy from ‘overheating’ due to a decade-long policy of easy money.

Interest rates and bond prices have an inverse relationship; rising rates tend to decrease the price of bonds already traded in the market. Admittedly, investors can always hold a bond until its maturity, without having to sell it on the market and replace it by one of a higher yield (always pending the bond’s credit quality and default probability).

However, for investors who hold multi-asset portfolios, assessing how higher interest rates would affect the behavior and valuation of a fixed income portfolio, is a question of paramount importance. Such examples could include income-focused investors with large fixed income portfolios with long maturities. How safe would such a portfolio be should the relevant central bank enter a protracted period of rising interest rates?

Stress-testing methodologies allow us to gauge a portfolio’s behavior in different scenarios, like ones with higher interest rates occurring across different, short-term or longer-term, maturities. This way, the investor can view the effect that such changes can have on the portfolio valuation.

More specifically, you can sample certain ‘shocks’ on ‘benchmark’ interest rates for selected maturities (e.g. 1month, 3months, 1year, 3years, 5years) and assess the market value changes of the aggregate bond portfolio. The sizes of these shocks can be of either equal size, called a ‘parallel shift’ of the Yield Curve, or more interestingly of unequal ones.

Having stressed-tested a fixed income portfolio via a simulation analysis, you can view the new ‘stressed’ market value of a portfolio and decide if a portfolio rebalancing is necessary. If so, you can look to replace bond holdings with ones that have smaller sensitivity to interest rate shifts.

Stress testing the sensitivity of fixed income holdings is most useful for retirement portfolios, as you should always compare the capital appreciation (or depreciation) potential against the income-generating ability of their holdings. In any case, measuring risk emanating from monetary policy changes can help an investor determine the overall portfolio risk and set hedging strategies to mitigate potential losses.


Posted Makis Ioannou, CEO, KlarityRisk


To learn more contact info@klarityrisk.com.