Securities held by VaR (Value-at-Risk)-sensitive institutional investors, such as banks, are prone to escalatory selling pressure after an initial shock, in particular if they make up a substantial portion of the portfolio. Nikolaos Panigirtzoglou underscores that the Japanese government bond market has already demonstrated its proclivity to such ‘VaR shocks’. Also on a global scale government bond yields may overtime become more vulnerable, as one of the unintended consequences of quantitative easing.


Flows & Liquidity: VaR shocks, J.P. Morgan Global Asset Allocation, 17 May 2013

“Banks [and many asset managers]…set limits against potential losses in their trading operations by calculating Value-at-Risk metrics (VaR), a statistical measure…to quantify the expected loss, over a specified horizon and at a certain confidence level, in normal markets…[based on] historical return distributions and historical market volatility…This in turn induces banks to raise the size of their trading positions in a low volatility environment, making them vulnerable to a subsequent volatility shock.”

“One of the unintended consequences of quantitative easing [is that] investors who target a stable Value-at-Risk, which is the size of their positions times volatility, tend to take larger positions as volatility collapses. The same investors are forced to cut their positions when hit by a shock, triggering self-reinforcing volatility-induced selling. So QE potentially increases the likelihood of VaR shocks. The proliferation of risk parity investors and funds, which are strict Value-at-Risk investors and are heavily invested in bonds currently, is also likely raising the sensitivity of bond markets to self-reinforcing volatility-induced selling.”

The case of Japanese government bonds

“[In the first half of May 2013] volatility has risen in tandem with yields, with the 60-day standard deviation of the daily changes in the 10y JGB yield jumping to 4bp per day the highest since 2008… similar to the so called “VaR shock” of the summer of 2003. At the time, the 10y JGB yield tripled from 0.5% in June 2003 to 1.6% in September 2003. The 60-day standard deviation of the daily changes in the 10y JGB yield jumped from 2bp per day to more than 7bp per day over the same period.”

“The sharp rise in market volatility in the summer of 2003 induced Japanese banks to sell government bonds as the Value-at-Risk exceeded their limits. This volatility induced selloff became self-reinforcing until yields rose to a level that induced buying by VaR-insensitive investors… it was Japanese banks, Broker/Dealers and foreign investors who sold JGBs at the time. And it was VaR insensitive investors, Postal Savings and domestic Pension Funds and Insurance Companies who absorbed that selling.”

“In terms of their sensitivity to JGB interest shocks, Japanese banks appear [at present] to be more vulnerable than they were in 2003.While Japanese major banks are close to average in terms of their vulnerability to interest rate rises, Regional and Shinkin (i.e. cooperative banks) are the most vulnerable they have ever been….A theoretical 100bp interest rate shock, i.e. a parallel shift in the Japanese bond yield curve of 100bp, would cause a loss…as a % of Tier 1 capital… close to 35% for Regional and Shinkin banks vs. only 10% for Major banks.”

“The maturity mismatch, the difference between the average remaining maturity of assets minus that of liabilities, has risen for all banks over the past few years. But it was the highest ever at the end of last year for Shinkin banks at 2.2 years, and the highest ever for Regional banks at 1.8 years. Major banks had a much lower maturity mismatch of 0.8 years.”

“These maturity mismatches and the sensitivity to interest rate shocks appear to be increasing the chances that the Japanese government bond market will see a higher frequency of VaR shocks and thus more elevated volatility versus other government bond markets. The potential offsetting factor is anecdotal and other evidence that Japanese banks have become more sophisticated in terms of the risk management and have gradually shifted away from mechanical Value-at Risk frameworks towards Stress Testing frameworks…But this is less true for Regional and Shinkin banks for which interest rate sensitivity.”

“These maturity mismatches and sensitivity to interest rate shocks have been intensified by QE because 1) of the mechanical rise in duration as yields decline and 2) because banks struggle to maintain their interest margins by extending the maturity of their bond portfolios so that they can capture extra yield. Indeed, the sharp lengthening of the maturity of the bond portfolios of Regional and Shinkin banks would appear to be a reflection of the pressure QE and a persistent low yield environment exert on banks to extend maturity.”