Recent events in credit markets have reminded us (somewhat painfully) of the impact of idiosyncratic risk. So what is idiosyncratic risk, and how might you protect yourself against it or take advantage of it?
Idiosyncratic risk is unique to a certain asset or company, and it’s hard to predict. When a truly idiosyncratic event occurs − such as the recent VW fraud or the BHP dam failure − investors are often caught unaware.
With so much focus on risks in the macro environment − for example, central bank rate decisions, and regulatory change − idiosyncratic credit risk is sometimes forgotten. And where it is remembered and highlighted, the focus is often around visible risks like merger and acquisition (M&A) activity or specific challenges encountered by individual companies in greenfields projects like mines, tollways or power stations.
Sensible position sizing an effective but passive safeguard
Traditionally, the most effective defence against idiosyncratic risk is diversification. In a perfectly diversified portfolio of corporate bonds, the cost of the failure of any individual bond is insignificant. In the real world however, perfect diversification is unattainable, and would in any event be cumbersome and costly.
In our view, sensible position size limits are an acceptable safeguard. These idiosyncratic events are often not systemic and – assuming there is a competent process of credit analysis and screening – are not likely to strike frequently. There is no need to over-engineer risk controls here. A safe rule of thumb is to limit individual position size to perhaps 1% of a portfolio.
However, limiting position size is an effective but passive strategy.
Active risk mitigation opens door to opportunity
An active risk-mitigant is to be in a position to react to the credit event quickly. Analyse the risk event promptly, form a clear view and then deal with the position immediately.
In response to adverse credit events, market liquidity is often available to the nimble investor, but it's fleeting. Good analysis and quick decision making is the key to capitalising on this liquidity. But remember, in some cases the facts will be almost unfathomable.
This approach may also enable the investor to take advantage of any subsequent panic or market dislocation. If you have managed your risk well and if your analysis generates a tradeable view, you may be in a position to offer liquidity to the market and potentially benefit from the higher liquidity premium that will come from any rush to the exit.
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This article is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act. Any information referenced in this article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.
The author is an employee representative of Perpetual Investment Management Limited (PIML) ABN 18 000 866 535 AFSL 234426.