Analysis of risk parity approach for sovereign fixed-income portfolios in Eurozone countries

Abstract

The recent development of the European debt sovereign crisis, led the bond investors to think twice before investing their wealth. The traditional index bond management used during the last two decades such as the market-capitalization weighting scheme has been severely called into question. In order to overcome these drawbacks, alternative weighting schemes have recently prompted great attention, both from academic researchers and market practitioners. One of the key developments was the introduction of passive funds using economic fundamental indicators. In this dissertation the author constructed five portfolios composed of the Eurozone sovereigns bonds. The models were the Market Capitalization-RP, GDP-RP, Ratings-RP, Fundamental-Ranking RP and Fundamental-Weighted RP models, with the last three models were created exclusively for this thesis. Both Fundamental models are using a range of ten country fundamentals. A variation from other studies, this dissertation applied the Risk-Parity concept only which is an allocation technique that aims at equalizes risk across different assets. This concept has been applied by assuming the Credit Default Swap as proxy for sovereign credit risk. The aim of this study was to investigate whether the fundamental approaches outperformed the other models on risk-adjusted returns. Moreover the dissertation compared all these models in terms of performance, concentration and weighted average ratings. By analyzing the whole period between 2006 and 2014, it was found that both the fundamental models gave very appealing results in terms of risk-adjusted returns. The best model was resulted to be the Fundamental-Ranking RP model followed by the Fundamental-Weighting RP model. However on a yearly basis and sub-dividing the whole period in 3 equal periods, the results show mixed performance and risk-adjusted returns. From this study, the author concluded that over the long term, the fundamental bond indexing triumphed over the other approaches by offering superior return and risk characteristics. Thus one can use the fundamental indexation as an alternative to other traditional models.