Want Better Portfolio Results? Monitor and Assess Risk More Often



Are rates the sole determinant when evaluating your credit union’s portfolio risk? If so, you are likely overlooking a lot of other factors that are impacting your rate of return. Learn what these key variables are and how they can lead your CU to better portfolio results.

Investors often get overly focused on evaluating portfolio risk based solely on the framework defined by their respective regulatory agency. For depositories, this framework tends to define risk as a function of parallel changes in rates. However, changes in the level of rates are not the only risk affecting portfolio returns; other macro factor risks are also typically present, such as the slope of the yield curve or changes in spreads.

Macro factor risks are market variables that contribute to an asset’s yield, affect asset pricing, and drive return and return variance. Therefore, effective portfolio management requires managers to measure and monitor the ever-evolving risks that exist within the portfolio. More importantly, it requires them to determine how those risk factors, in aggregate, impact portfolio performance. Furthermore, frequent monitoring of these factors provides vital information to the investor, telling the manager whether to stay the course or consider a shift in allocations.

Macro factor risks impacting fixed income portfolios can be broken into five different categories: 1) the level of interest rates; 2) the slope of the yield curve; 3) market spreads; 4) volatility and 5) prepayments. Each of these variables has an impact on a particular asset’s price and also plays a major role in driving return and variance.

Level of Rates

The absolute level of rates is a function of the state of the economy and policies set forth by central banks and governments (monetary and fiscal policy). Sensitivity to changes in interest rates is most often measured by effective duration, which represents an asset’s price elasticity for a given parallel shift in interest rates. Duration is a key component of the portfolio management process. Investors use the metric as a target to manage the portfolio. In a liability-driven investing framework, aiming for this target sets the mark as that of the institution’s liabilities. Getting the duration of the portfolio right and maintaining that target is one of the most important factors in determining whether or not a portfolio will meet the goals set by an institution.

Curve Slope

Slope is defined as the difference between short- and long-term rates, with many market participants choosing to use the two- and 10-year parts of the curve as the basis for the measurement. The slope of the curve can be thought of as an expression of the market’s macroeconomic outlook. Changes in slope are typically described as flattening (spread between two- and 10-year tenors) or steepening (spread between two- and 10-year expands), as shown in Exhibit 1. An inverted curve (negative spread between two- and 10-years) is also possible but fairly rare.


For assets with embedded options, like call/prepayment options, caps and floors, the slope of the curve can have a major impact on valuation and performance. A steeper yield curve will push forward rates higher and will move call options farther out of the money; a flattening yield curve will have the opposite effect as lower forward rates push the option farther in the money. 

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