Key Rate Risk: Looking Beneath the Surface of Interest Rate Volatility

by Manpreet Hochadel, CFA, and William Mirrer
J.P. Morgan Investment Analytics & Consulting
manpreet.s.hochadel@jpmorgan.com, william.x.mirrer@jpmorgan.com

“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.”

Interest rate volatility can cause significant anguish and distress to fixed income managers and investors.  As interest rates fluctuate over time, yields and returns can change dramatically, creating uncertainty.  Duration and its derivatives have been universally used, since the mid-70’s, to evaluate risk on fixed income.  In particular, effective duration, or the sensitivity of a bond’s price to changes in interest rates, has commonly been used to assess the interest rate risk that a particular bond or portfolio is exposed to.   While effective duration does give good insight to yield curve positioning, it lacks the breakdown necessary to measure and analyze conscious interest rate strategies.  Since effective duration makes the assumption that interest rates are shifting on a parallel basis, one may ask how to look at risk from non-parallel shifts, which is usually the case in fixed income environments.  One answer is key rate duration. 

Key rate duration is defined as the measure of interest rate sensitivity of a security or portfolio to specific key rates on the yield curve, holding all maturities constant.  Yield curves typically go through stages that involve steepening, leveling, and curvature.  As yield curves experience shifts that are not parallel, a more in-depth risk tool that brings the true risk of cash flow volatility to light becomes essential.  This analysis becomes indispensable for managers and investors that are passive to an index and need to determine any mismatches in their portfolio relative to an index.  In conjunction with such complementary tools such as Value at Risk (VaR) and the dollar value of one basis point (DV01), key rate duration offers managers a means to examine their risk exposures.  In our opinion, key rate duration also provides an excellent source of information for plan sponsors in determining what type of risks their managers are taking against their respective index. 

Plan sponsors can use such data to understand the active risks their managers have undertaken and determine their suitability for the totality of the plan.  Sponsors can use this information to help them understand why a specific manager has over- or under-performed their relative index, while maintaining similar, if not the same, total fund risk profile of the index.  Key rate risk is especially important to defined benefit pension plans that rely heavily on liability driven investing (LDI) to ensure that their assets can meet obligations to their beneficiaries over time.  In an LDI strategy, in which plan sponsors attempt to match the plan’s cash flows with those of their liability streams, larger funds may have long-term obligations that are subject to considerable changes in interest rates. 

Key Nodes

Being able to differentiate risk into multiple key rates allows analysts to better understand risk relative to their benchmark and to prevent any unnecessary mismatches in the underlying duration of the portfolio’s maturity buckets.  Typically, key rate durations are measured along eleven key rates along the spectrum: 3 months, and 1, 2, 3, 5, 7, 10, 15, 20, 25, and 30 years.  However, any key rates along the yield curve may be used to compute the key rate duration of a portfolio.  The points that are chosen along the curve drive the analysis, since the impact of the change in interest rates will be most volatile further down the maturity spectrum.   The ability to identify different shifts along key rates will provide portfolio managers and asset owners with adequate tools to perform fixed income strategies such as hedging and immunization¹ .  Such strategies require more information and data than that which the more conventional effective duration and convexity measures may offer.  If an investor’s intent is to negate partial or all interest rate exposure, it is necessary to determine the underlying effects of different key nodes and how they contribute to the fund’s risk profile.

By definition, key rate duration measures the impact that a change in rates will have, varying across individual nodes, such as 1 years, 2 years or 3 years.  As term structure shifts occur, the measurement of how each individual piece varies is calculated and approximated through linear interpolation of the specific shift.  This statistical measure is used to break down each node shift individually, creating an analysis that focuses on the underlying term structure shift.

Exhibit 1: Key Rate Contribution

As depicted in Exhibit 1, each key rate contribution is measured in terms of interest rate shifts before and after the node.  There is a linear movement between each key node, representing a minimum and maximum risk contribution per key rate.  For example, if we look at the 2, 5, and 10 year nodes, we can determine that the risk contribution is computed in a linear manner.  For the 5 year node, the contribution begins at the 2 year, maximizes at the 5 year, and diminishes to zero at the 10 year node.  This ensures that each key rate has its own contribution and the total of all of the key rate durations will sum up to the portfolio’s effective duration. This analysis assumes that there is no change in spot rates before and after each key rate, leaving the results independent of changes in other key node shifts.  This assumes the peak of the shift occurs directly at the median of each key rate, starting with the lowest point at the beginning of the node and diminishing to zero at the end of the node.  By doing so, we measure the effective duration by key rate and not by an overall parallel shift in the yield curve² .

Deriving Key Rates

To better display this data, we have constructed a hypothetical U.S. Treasury portfolio with an effective duration of 3.20 years and compared the volatility of cash flows with the U.S. portion of the Barclays Global Treasury Index, excluding maturities over 7 years (effective duration of 3.20 years).  While the total effective duration of both the portfolio and benchmark is identical, understanding what lies beneath the surface is critical.

Exhibit 2: Sample Portfolio vs. Benchmark
 

In Exhibit 2, the manager has chosen to underweight securities in the two to three year bucket.  Meanwhile, the manager has chosen to overweight intermediate term structure risk, with the largest deviations (active risk) at the 7 year key rate.  In a scenario involving yield curve steepening, in which intermediate to long-term interest rate increases, the portfolio would come under significant pressure relative to the benchmark due to more active risk being absorbed by the manager’s position on the curve.  This would result in underperformance relative to the benchmark.  As we can see from Exhibit 2, although the portfolio mirrors the benchmark’s total risk profile, the mechanics of the portfolio are quite different from that of the benchmark in the underlying positions. 

Multiple Benefits

Key rate duration portfolio analysis can also be viewed as an attribution tool.  The breakdown that this analysis provides shows the true granular contribution of the manager’s investment decisions.  The sum of all the underlying key rate duration contributions will equal the total effective duration of the portfolio or benchmark.  When used in conjunction with benchmark data, key rate duration analysis can determine the amount of interest rate risk the manager or portfolio is undertaking (on an absolute basis), and the deviation from the benchmark, or active risk (on a relative basis).  The magnitude of active risk can be defined as the variance of duration allocation among various segments of the portfolio versus that of the benchmark.    Having the capabilities to determine how to monitor the fund’s duration allocation can not only assist managers in creating an active risk profile similar to that of the benchmark, but also bring transparency to the reasoning behind manager’s alpha, or the lack thereof.

Pension plan sponsors need to be able to determine the impact that cash flow volatility will play in liability streams.  Key rate risk may provide the insight to truly understand the active risk and outcome of the fund.  Erratic changes in interest rates may have a large impact on the funded status of pension plans.  Typically during periods of interest rate decreases, pensions will see their present values of benefit obligations (their liabilities) increase, while their asset values may not rise.  This can contribute to pension funding status volatility, which may create problems in successfully controlling the risk of the surplus or deficit.  Key rate duration analyses may capture mismatches in liability streams and help determine what adjustments need to be made to effectively hedge interest rate risk.

As investors continue to search for risk measures that help maintain their investment goals while exposing risk, they must keep in mind that the underlying effects explain the final outcome of the fund’s risk to reward profile.  Managers cannot diversify away the effects of external interest rate movements, but they can adjust their overall exposure to that of a reference point, particularly with liabilities and cash flow streams.  In the current volatile environment, investors have come under pressure to ensure that risk is being exposed and controlled, and not ignored.  Key rate risk is a means to help investors understand why their fund has performed the way it has, and what they might do in the future to improve performance.

For a copy of our complete white paper “Key Rate Risk: Looking Beneath the Surface of Interest Rate Volatility”, please contact Manpreet Hochadel at manpreet.s.hochadel@jpmorgan.com.

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