Managing Risk in Changing Volatility Environments

Executive Summary

Markets display distinct regimes of low volatility and of high volatility. They spend comparatively little time at the average.
Managing risk across changes in volatility regimes is challenging: current risk levels have persistence and can’t be ignored, but the possibility of a switch to a very different regime can’t be ignored either.
Western Asset uses both standard risk assessments (that project forward the current environment) and approaches that help understand possible behaviors in a changed risk environment.
The current risk environment is relatively calm. We do not expect it to stay this way, so we maintain vigilance by using such methods to evaluate risks to our portfolios.
Among other techniques, we find that we can gain insights about changed risk environments from:
- Scenario analysis, whereby a current portfolio is assessed in extreme environments, both historical and hypothetical
- Fundamental analysis of the credit cycle, whereby we use forward-looking indicators of the credit cycle to help form a view as to when defaults will start to pick up
- Examining market and instrument structure to determine where there can be price action that has a disproportionate disconnect from fundamentals in stressed environments

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

The Danger of Calm Seas

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Volatility Regimes

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Exhibit 1
US Stock Market Volatility - CBOE VIX® Index

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Exhibit 2
US Treasury Yield Volatility - Merrill Lynch Move© Index

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Time-Independent Risk Assessments

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Exhibit 3
Scenarios for a Western Asset Global Credit Portfolio

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

The Inevitable End of the Credit Cycle

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Exhibit 4
Average Leverage in US High-Yield Market

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Exhibit 5
Interest Coverage in US High-Yield

Exhibit 6
High-Yield Index OAS vs M& Issuance

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Exhibit 7
In the 2009 Cycle, Spreads Bottomed 2.5 Years Before Defaults Topped

Exhibit 8
High-Yield Typically Outperforms Investments-Grade Early in a Cycle, But Not Necessarily in Back Half

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

The Disconnect Between Fundamentals and Pricing

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Conclusion

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. —John Maynard Keynes

Endnotes

US Federal Reserve Chair Yellen: “This normalization [of monetary policy] could lead to some heightened financial volatility.” http://www.federalreserve.gov/newsevents/speech/yellen20141107a.htm
See Managing Extraordinary Risk, Western Asset white paper, February 2013
Bloomberg/BofA Merrill, spread series ER00.
Annual Default Study: Corporate Default and Recovery Rates, 1920-2013. Moody’s Investor Service. Exhibit 30. The year 1933’s speculative-grade default rate was 15.756%, the highest ever in the study.

© Western Asset Management Company, LLC 2024. The information contained in these materials ("the materials") is intended for the exclusive use of the designated recipient ("the recipient"). This information is proprietary and confidential and may contain commercially sensitive information, and may not be copied, reproduced or republished, in whole or in part, without the prior written consent of Western Asset Management Company ("Western Asset").

Past performance does not predict future returns. These materials should not be deemed to be a prediction or projection of future performance. These materials are intended for investment professionals including professional clients, eligible counterparties, and qualified investors only.

These materials have been produced for illustrative and informational purposes only. These materials contain Western Asset's opinions and beliefs as of the date designated on the materials; these views are subject to change and may not reflect real-time market developments and investment views.

Third party data may be used throughout the materials, and this data is believed to be accurate to the best of Western Asset's knowledge at the time of publication, but cannot be guaranteed. These materials may also contain strategy or product awards or rankings from independent third parties or industry publications which are based on unbiased quantitative and/or qualitative information determined independently by each third party or publication. In some cases, Western Asset may subscribe to these third party's standard industry services or publications. These standard subscriptions and services are available to all asset managers and do not influence rankings or awards in any way.

Investment strategies or products discussed herein may involve a high degree of risk, including the loss of some or all capital. Investments in any products or strategies described in these materials may be volatile, and investors should have the financial ability and willingness to accept such risks.

Unless otherwise noted, investment performance contained in these materials is reflective of a strategy composite. All other strategy data and information included in these materials reflects a representative portfolio which is an account in the composite that Western Asset believes most closely reflects the current portfolio management style of the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from other accounts in the composite. Information regarding the representative portfolio and the other accounts in the composite are available upon request. Statements in these materials should not be considered investment advice. References, either general or specific, to securities and/or issuers in the materials are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendation to purchase or sell such securities. Employees and/or clients of Western Asset may have a position in the securities or issuers mentioned.

These materials are not intended to provide, and should not be relied on for, accounting, legal, tax, investment or other advice. The recipient should consult its own counsel, accountant, investment, tax, and any other advisers for this advice, including economic risks and merits, related to making an investment with Western Asset. The recipient is responsible for observing the applicable laws and regulations of their country of residence.

Founded in 1971, Western Asset Management Company is a global fixed-income investment manager with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São Paulo, Hong Kong, and Zürich. Western Asset is a wholly owned subsidiary of Franklin Resources, Inc. but operates autonomously. Western Asset is comprised of six legal entities across the globe, each with distinct regional registrations: Western Asset Management Company, LLC, a registered Investment Adviser with the Securities and Exchange Commission; Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorized and regulated by Comissão de Valores Mobiliários and Brazilian Central Bank; Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services License 303160; Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services License for fund management and regulated by the Monetary Authority of Singapore; Western Asset Management Company Ltd, a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan; and Western Asset Management Company Limited is authorised and regulated by the Financial Conduct Authority ("FCA") (FRN 145930). This communication is intended for distribution to Professional Clients only if deemed to be a financial promotion in the UK as defined by the FCA. This communication may also be intended for certain EEA countries where Western Asset has been granted permission to do so. For the current list of the approved EEA countries please contact Western Asset at +44 (0)20 7422 3000.