Analysis of Bond Portfolios in an ALM Context

Abstract

A system is implemented that simulates a bond portfolio over the long-term of liabilities. It pays all liabilities and extracts continuously a fixed percentage of remaining liabilities to stakeholders while maintaining a strategic asset allocation. This fixed percentage is proposed as return measure in an ALM-context with risk derived from its distribution. Tabled inputs completed with simple coherent inductive models for interest rate changes and spread changes allow to map return and risk as function of market probability in a deterministic white-box approach. Aim is to provide insight in the dependency of return potential and risk drivers on the bond allocation, on assumptions and on market conditions in order to improve allocations, understand risk, specify risk-appetite, facilitate capital management and budgeting. Examples are based on an actual €10billion insurer portfolio. Current market conditions favor short bond duration, reducing government bonds and mixing in some high yield bonds. Duration matching now decreases return potential and increases risk so that Solvency 2 regulation is counterproductive from a quantitative risk perspective. Bond portfolios are less risky in an ALM-context than in an assets-context due to the mitigation of loss by a balance of opposing forces when bonds are reinvested. Their downside is resilient to increasing correlation. This system is the kernel of a system for all assets but first focus is exclusively on bonds for their weight in current allocations and their pricing characteristics.