The world has many ways to measure risk, but if the recent financial crisis has taught us anything, it is that asset price is the great equalizer in the fixed income markets. When global markets began to crash over a year ago, traditional measures of risk in credit markets became completely decoupled from asset prices. The ensuing market turmoil churned up the major structural weaknesses in our financial system and exposed them to plain sight.
This disruption did have one positive outcome: It taught market participants a critical lesson about the importance of developing a more robust approach to assessing risk and value in portfolios.
Nearly every investor we’ve spoken with over the past year agrees there is a need for change in the discipline of credit and risk valuation as it relates specifically to price and price risk. At the same time, however, it has been difficult to coalesce all of the pieces necessary to deliver truly comprehensive methods for security and portfolio valuation. This is the next step the market needs to take.
A Multi-Model Credit Discipline
To get to that point, we need new and innovative methods of analysis that build on the lessons of the crisis and clearly identify the relationship between risk and asset price for all credits in all types of market conditions. Investors need to be able to easily deploy an analytic discipline that moves beyond traditional notions of risk management, static benchmarking and probability of default metrics in order to incorporate a comprehensive, cross-asset view of credit quality.
What we learned from the experience of the last year is that the vital risk assessment process is an evolutionary one that must address the dynamic nature of change that accompanies rapidly evolving financial markets and products.
Sophisticated investors are now demanding a reliable cross-asset, cross market perspective that incorporates those components of risk that drive changes in market valuation. Included in this view should be an understanding of an asset’s risk to price, capital structure issues, volatility, liquidity and more.
Risk to Price
Dozens of variables have direct and indirect impacts on asset prices: probability of default, loss recovery, interest rate risk, liquidity and volatility, to name a few. When these variables start moving in different directions, asset price is going to be impacted. It all boils down to a basic question: does a bond’s yield adequately compensate its owner for the credit and market risks being faced? Often, traditional analysis does not provide a sufficiently clear answer to that question. Accordingly, we have been working on a scoring methodology designed to assist investors in determining the extent that a bond’s yield is commensurate with the risks it incorporates.
Investors need to be able to quickly and accurately identify the scope of these impacts under many different market conditions. By developing methods to evaluate the price of an asset relative to variables that incorporate both market and credit risk, it is possible to determine gaps in risk to price and, therefore, spot potential mispricing.
