The PACER PERSPECTIVE
December 2021

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Putting Risk Into Context

The Case for Dynamic vs Static Risk Management

- Michael Mack, Portfolio Manager

Despite near all-time low yields, fixed income investments continue to see inflows. This has left many commentators perplexed as to why investor dollars have continued to flow into an asset class where returns are much lower than ever before. The answer to this lies in how fixed income helps manage risk in the overall portfolio.

Over time, stocks have been known to generate higher returns, but at the cost of much higher drawdowns. These sharp drawdowns are often too much for investors to handle, forcing many to turn to fixed income. The chart below shows the performance of Bloomberg Barclays US Agg Index (AGG) during major equity market drawdowns as compared to the S&P 500 Index. Notice how fixed income has been able to avoid losses in these periods, and instead has been able to generate gains during the declines. These gains serve as a timely offset to the losses from equities, allowing a diversified investor to experience much smaller declines in their overall portfolio.

Source: Pacer Advisors, Bloomberg
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

The table below shows where each major fixed income category falls based on these risks, ranging from very low to very high. We can see which types of fixed income investments are on the higher end of credit risk – high yield corps, bank loans, short duration – and which are more exposed to interest rate risk – long term treasury bonds, investment grade corps, core fixed income.

Fixed Income Categories:

Source: Pacer Advisors

As seen in the previous examples, there are less favorable outcomes which emerge from credit risk and interest rate risk. This calls for a strategy that takes into account both risks. To test this, an indicator could be beneficial in determining the prevalence of certain risk levels throughout a market or economic cycle. Our preferred method is through use of the risk ratio. The risk ratio looks at the performance between high yield bonds (more credit sensitive) and U.S. Treasury Bonds (more interest rate sensitive). When high yield bonds are outperforming, investors are often compensated for taking on credit risk, whereas when U.S. Treasury Bonds are outperforming, investors are often compensated for interest rate risk.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

By incorporating U.S. Treasury Bonds into the risk calculation, we are able to detect potential credit events before they show in the credit markets. While this may not always work, and may be slow to react during periods of extreme volatility, this allows for the opportunity to reduce credit exposure before a major decline in credit occurs. As shown below, significant drawdowns incurred by high yield bonds and U.S. Treasury Bonds heavily depend on where the risk ratio is.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

By moving from high yield bonds to U.S. Treasury Bonds, we are shifting the type of risk from credit risk to interest rate risk. This puts investors in danger of rising interest rate periods like we saw in 2013. However, the chart above shows most of the significant declines in U.S. Treasury Bonds have come during periods when the risk ratio is positive, thus the strategy would be invested in high yield bonds. By utilizing the risk ratio as a guide to determine which level of risk to take, investors could potentially avoid the significant drawdowns often found when following the market’s trend.

Zooming back out to look at the overall portfolio, we can see the potential advantages to using the risk ratio. The risk ratio peaks tend to occur in advance of the peaks in the S&P 500, providing an advance signal to the portfolio to reduce risk. The peaks tend to occur in following order: risk ratio=> high yield bonds=> U.S. Stocks.

Source: Pacer Advisors, Bloomberg

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

Pacer Trendpilot^® US Bond ETF

Pacer ETFs saw a need for a fixed income strategy that takes into account credit risk and interest rate risk. By allocating between the S&P High Yield Corporate Bond Index and the S&P U.S. Treasury Bond 7-10 Year Index, the Pacer Trendpilot® US Bond ETF (PTBD) seeks to navigate turbulent markets through a combination of the Pacer Trendpilot trend following strategy and the risk ratio.

To determine the trend, the fund uses the 100 Day Simple Moving Average (SMA) of the relative return of high yield bonds versus 7-10 Year U.S. Treasury Bonds. When the relative return is above its 100 Day SMA, the trend is positive. If it is below, the trend is negative, and the fund will begin its switch into U.S. Treasury Bonds.
 

Bloomberg Barclays US Agg Index: Broad based, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. 
ICE US Treasury 7-10 Year Bond Index Includes publicly-issues U.S. Treasury securities that have: 1. a remaining maturity of greater than seven years and less than or equal to ten years and 2. Have $300 million or more of outstanding face value, excluding amounts held by the Federal Reserve.
iBoxx USD Liquid High Yield Index Consisting of liquid U.S. dollar-denominated, high yield corporate bonds for sale in the United States.