Safety measures concerning the Coronavirus COVID-19. Read more about the measures.

x

Non-technical summary of ESM Working Paper 72: 
Regime-based portfolio optimisation: A Hidden Markov Model approach for fixed income portfolios

 

The paper presents a method for managing fixed income investments that adapts to changing market conditions. Rather than assuming that the market remains constant, the approach divides the environment into distinct “regimes” such as periods of high and low volatility, enabling portfolio managers to adjust their strategies—shifting towards more conservative investments during turbulent periods and taking on additional risk when conditions are stable.

This method employs a two-step process that starts by distilling the complex behaviour of interest rates into a single indicator, effectively summarising the main movements of the yield curve. This indicator is then used in a second step to automatically detect shifts in market volatility. By doing so, the approach provides a more dynamic way to manage risk, ensuring that the portfolio is continuously aligned with current market conditions.

The paper applies this strategy to US, German, and French government bond markets and finds that it generally improves both the accuracy of risk targeting and the overall risk-adjusted returns. The benefits become even more pronounced when the approach is extended to include Sovereign, Supranational, and Agency (SSA) bonds. Overall, this regime-based strategy offers investors a more responsive way to optimise fixed income portfolios by matching investment decisions to the prevailing market environment.