Fixed income risk attribution

1 Introduction
A fixed income portfolio manager may generate high returns compared to the
benchmark, at least in the short term. But returns tell only half the story. For instance,
it might turn out that the returns are not high enough to justify the amount of risk
taken. So measuring and reporting portfolio risk is crucial for judging portfolio
performance. Furthermore, understanding risk is paramount to controlling it. So it is
important to be able to measure the risk contribution of each investment decision of
the manager to the total relative risk of the portfolio with respect to the benchmark.
We compare the risk of the active portfolio with respect to the benchmark and carve
up the difference between the two into components that correspond to decisions
made by the manager of the active portfolio. While there is a potential for greater
returns when deviating from benchmark positions by taking on more risk, there is also
a concurrent potential for underperformance relative to the benchmark. Therefore, it
is essential to be able to measure the risk exposures of the portfolio vis-`a-vis the
benchmark. We provide a methodology for risk attribution that is rigorous from a
mathematical standpoint and relevant from an investment standpoint.
Although there is now an extensive body of research, both in academia and industry,
pertaining to methodologies in fixed income attribution, there is no industry standard
that may be used as a guide. Much of the work has been focused on return attribution
and paid little attention to risk attribution for fixed income portfolios. Most of the fixed
income return attribution methodologies Fixed income risk attribution that are used
in the industry may be classified into two groups: duration approach and principal
component analysis. We have drawn on some of the general principles of the duration
approach to come up with our own framework for risk attribution. In particular, we
have mounted our risk attribution methodology on a return attribution system that is
similar to that in van Breukelen (2000). This return attribution system is also close in
spirit to the one described by Feser et al (2002). For the risk attribution model, we
have followed the methodology of Mina (2003).
The broad scope of any performance and risk attribution system is to compare the
investment outcomes of the active portfolio and the benchmark and to ascribe the
difference between the two to the decisions made by the manager of the active
portfolio. This general principle applies equally to equity and to fixed income
attributions. However, within this broad outline, the investment processes and the
sources of risk for equity and fixed income portfolios differ significantly. Equity returns
are determined by market segments while fixed income returns are ruled primarily by

duration, yield curve and credit quality. This means that a fixed income attribution
system cannot be obtained by merely tweaking an equity attribution system.
Nonetheless, we draw on the similarities between the two systems to facilitate our
understanding
2 Return attribution
We start by establishing a return attribution system for fixed income portfolios and
then use it to come up with a risk attribution system. The difference in return between
the benchmark and the portfolio are due to different investment decisions made by
the portfolio manager. Return attribution is a way of measuring the contribution of
each of these decisions to the difference in return between the benchmark and the
portfolio. Table 1 lists the return attribution components that we analyze. In the
simplest case, a fixed income portfolio consists of riskless government bonds which
may be denominated in different currencies. For example, Central Banks usually invest
their Return attribution 7 international reserves in sovereign bonds denominated in
different currencies.1 For such a portfolio which has no credit risk, there are two
components of return attribution that we will consider: interest rate and currency. The
interest rate component may further be subdivided into three components: overall
duration, market allocation and security selection.
One of the first decisions is the overall duration of the portfolio. If the manager has an
overall positive view of the bond markets, this will be reflected in a choice of a higher
total duration for the portfolio compared to the total duration of the benchmark.
The next decision concerns the managers view about markets or sectors. The markets
or sectors here could be countries, currency markets, maturity segments, duration
buckets or credit classes. A positive view in a particular market/sector is manifested as
higher allocation in that market/sector compared to the benchmark; this differential
allocation could be achieved by choosing either a longer duration than that of the
benchmark or a larger weight compared to the benchmark or a combination of both.
The final level of drill-down is the selection of a particular security in each individual
market.
Currency attribution is dealt with separately by keeping interest rates constant and
shocking the currency rates to perform return and risk attributions. If we consider a
portfolio which has corporate bonds in it as well, then we need to incorporate return
due to credit bets. And as with the currency allocation, the decision to invest in
corporate bonds, which may offer a higher rate of return, has to be considered
separately. In this case, we shock the credit spreads and perform return and risk
attribution for rating and/or sector allocation and selection.

An important underpinning of the fixed income investment process is the concept of

duration. Duration is also the feature of a fixed income portfolio that differentiates it
from an equity portfolio. Duration measures the sensitivity of the bonds value to
parallel changes in the yield curve. We illustrate the role played by duration in a fixed
income portfolio with the following example. If the manager of an equity portfolio
believes that a particular market is going to perform well, he overweights that market
relative to the benchmark. A fixed income portfolio manager with the same belief
about that market has two alternatives to express his view. He could choose to
overweight that particular market relative to the benchmark, or he could choose the
same total 1 de Almeida da Silva Junior (2004) provides a specific example. 8 Fixed
income risk attribution weight in that market as the benchmark but invest in assets
with a longer duration than the benchmark. A valid return attribution system should
consider this extra degree of freedom.
The best way to understand fixed income return attribution is by drawing a parallel
with the more familiar structure of equity return attribution. The example above
shows that allocation decisions in a fixed income portfolio are made along two
dimensions: weights and duration. The best way to understand fixed income return
attribution is by drawing a parallel with the more familiar structure of equity return
attribution. The fixed income allocation decision may be implemented by changing
either the weight or the duration or a combination of both, that is, by changing the
overall value of weight times duration which is the term WD where W and D refer to
the weight and duration of a sector respectively. So in a fixed income portfolio, WD is
analogous to weight in an equity portfolio. Since we would like to make use of the
product of weight and duration as the equivalent of weight in an equity portfolio, we
express the return the following way: WD r D , where r is the security return. This is
a weighted average of the return where the weights are the product of the true
weights and durations. The term r/D denoted by R is analogous to return in an equity
portfolio.
The first term on the right hand side of equation (3) explains the contribution of active
fixed income management, including choices of overall duration, market allocation
and issue selection. The last term in the equation explains the contribution of currency
allocation to the difference in returns. We will deal with each of these two aspects
individually
In order to undertake a detailed analysis of the fixed income attribution, we now
construct two portfolios: reference portfolio 1 and reference portfolio 2. Here we have
used the terminology of van Breukelen (2000). Reference portfolio 1 differs from the
actual benchmark only in its overall duration, which is that of the active portfolio.
Reference portfolio 2 is constructed such that it has the same overall duration and the
same sector allocation as the actual portfolio. It differs from the actual portfolio only

in issue selection, that is R, at each level. It differs from reference portfolio 1 only in
allocation across sectors or markets. Table 2 shows the differences and similarities of
the four portfolios. Specifically, if we consider a sector A, benchmark and portfolio
allocation for A are given by: WB A DB A and WP A DP A respectively. Similarly, by
security selection for sector A, we mean: RB A and RP A .
So we have the following: (a) the difference in return between reference portfolio 1
and the benchmark explains the overall duration contribution, (b) the difference in
return between reference portfolio 2 and reference portfolio 1 gives the allocation
contribution, and (c) the difference in Return contribution 11 return between
reference portfolio 2 and the active portfolio lays out the selection contribution. We
now take a closer look at each of these three factors in turn.