Opinion – Grain in Grain: A fixed income that only goes up may have greater risk than one that fluctuates negatively

Intuitively, we believe that an asset that fluctuates has more risk than one that does not fluctuate. However, risk cannot be measured by this characteristic alone. I explain which risk investors should consider more in fixed income and why an asset with greater fluctuation may have less risk.

The volatility measure, that is, the dispersion of returns, is commonly used to estimate the risk of assets. However, when it comes to fixed income, it may not be the most appropriate in some cases.

The fact that it does not fluctuate negatively may just be the price marking feature.

The Brazilian investor has barely gotten used to bank assets, such as CDB, LCI and LCA. These have always been marked on the acquisition curve. This means that every day, its price in the portfolio is the theoretical one, that is, updated by the calculation of the contracted profitability adjustment.

These also have the advantage of being guaranteed by the Credit Guarantee Fund (FGC). Therefore, they are safe against the worst risk of fixed-income securities.

Private bonds issued by companies, such as debentures, CRI and CRA can also be marked on the curve. This feature has an end date, but I’ll leave it to comment on that at another time.

The difference is that private bonds issued by companies are not guaranteed by the FGC. Therefore, care must be taken with them.

The biggest risk of a fixed income bond is not that of variation, but that the bond issuer does not honor its payment. In this case, it is possible to lose up to 100% of what was invested.

The risk in some cases is greater than investing in a diversified equity fund, as in this case the probability of losing 100% is very low. But, the bottom will fluctuate much more.

I know that comparing with an equity fund is not appropriate, but with private credit fixed income funds.

Wrongly, investors tend to prefer lower volatility to lower credit risk. But, this last risk is much worse.

Private credit fixed income funds may fluctuate negatively. But they have two advantages over a single private bond. Its dispersion and monitoring by a specialized team mitigate the risk of the investor having possible credit losses.

So, be careful when comparing only the return and fluctuation of private credit funds with those of curve-marked private credit securities in your portfolio.

In the investment fund, you know exactly the return you have and the price of the bonds is already adjusted for credit risk. While in a private bond, you may be deluded by the stability of the return and only discover the reality when the worst has already occurred.

Comment here if you know someone who has suffered from default on private credit.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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