Unlocking Fixed Income Insights: The Power of Risk Parity

Balance Risk and Return
Luca Rassenti & Ben Verschuere
September 21, 2023

At Treasure part of the work of our Investment team is to do research on financial markets to further enhance our quant driven fixed income strategies. We review here some of our recent findings.

Risk parity is a portfolio construction approach that does not rely on predicting the future relative performance of assets but it turns out that in the case of fixed income markets, it can perform as well as strategies which actually aim at forecasting returns. 

What is Fixed Income? 

Fixed income investments commonly involve bonds. When you buy a bond, you're essentially lending money to an entity in exchange for regular interest payments and the return of your initial investment when the bond matures. The interest rate on a bond, known as the coupon rate, is usually fixed at issuance, hence the term "fixed income." Fixed income returns are primarily influenced by two factors: interest rate risk (duration) and credit risk.

What is Risk Parity?

Risk Parity is an investment strategy rooted in the belief that markets are roughly efficient, meaning there are no free lunches – returns should align with risk. This strategy suggests that if investment opportunities are similar across different assets, you should spread your investments equally to enhance your chances of success. Risk parity involves allocating equal risk to each investment, aiming for consistent returns.

Two factors are driving fixed income assets

Simplifying fixed income to its two dominant return factors, duration and credit spread, reveals that these factors aren't perfectly correlated. Their returns and losses can occur at different times, offering diversification opportunities. Efficient market theory suggests that over time, the return-to-risk ratio of duration should be similar to that of pure credit. This allows investors to create a well-balanced portfolio that benefits from diversification and rebalancing.

If investment A is 2x as risky as investment B then we have to invest 2X in investment B assuming –

1) we approximate that they have the same return/risk ratio over the long term

2) we want them to return an equivalent amount to our portfolio over time, Return Parity! 

Said sequentially, assume equivalent return to risk ratio, estimate risk units, calculate notional dollars to invest and expect equal notional returns.

Risk Parity for Fixed Income

So isolating the investment universe to fixed income, and simplifying to the two dominant return factors, duration and credit spread, what does a fixed income risk parity portfolio look like? What does the data say?

First, duration and credit spread are not perfectly correlated creating the opportunity for diversification benefit:

Their volatilities (risk estimates) fluctuate through time:

The volatilities lead to different notional allocation percentages through time:

If we implement risk parity with a US government bond and pure credit spread exposure with monthly risk estimates and rebalancing, we end up with the following return stream.

While this return stream may not appear impressive, it serves as a potential benchmark for fixed income investments – a thoughtful, balanced, and straightforward strategy based on solid financial theory. Comparing it to a more complex strategy that uses predictive models (red line), we find that the performance is similar or better over the long term. Simplicity often leads to robustness with fewer potential points of failure.


The risk parity strategy explored here provides a foundation upon which you can construct a more complex portfolio with additional factors or alphas to enhance returns and manage risk. This simple risk parity approach is theoretically and empirically attractive and should, at the very least, be considered a benchmark when evaluating or creating a fixed income portfolio.

More from the Blog

Stay Updated with Finance and Economy News | The Weekly Treasure
The Weekly Treasure, Week of November 27th, The $100k Tool Bag Orbiting Around the Earth

Explore the latest economic trends, finance insights, and fintech updates. Housing paradox, EU warnings, S&P earnings, Fintech insights, and a quirky $100k tool bag orbiting Earth!

Read More
Resourcesembedded financial services
From Niche to Norm: The Evolving Landscape of Embedded Financial Services

Examine the evolving landscape of embedded financial services, tracing its journey from a niche concept to a norm in the financial industry.

Read More
Resourcesembedded investments
Unlocking Value with Embedded Investments: Opportunities and Challenges

Delve into the concept of embedded investments, exploring both the opportunities and challenges they present in the financial landscape.

Read More
Treasure Technologies Inc.
1324 Clement St
San Francisco, CA 94118
* Returns are projected based on current performance and are gross of fees. Treasure's fee is 35 basis points on Assets Under Management. There is no fee for Treasure Cash. Returns are subject to change daily.

** Treasure Cash accounts are held at Grasshopper Bank, N.A., our FDIC partner bank. Return differentials based on national average checking account rates as of 5/24/2023. Source: FDIC

Website is operated by Treasure Investment Management, LLC ("Treasure"), a wholly-owned subsidiary of Treasure Technologies, Inc., and an investment adviser registered with the U.S. Securities and Exchange Commission ("SEC"). Brokerage services are provided to clients of Treasure by Apex Clearing Corporation ("Apex"), an SEC-registered broker-dealer and member FINRA.

Investing involves risk, including loss of principal. The contents of this website are provided for information purposes only and do not constitute an offer to sell or a solicitation to buy securities. Past performance is no guarantee of future returns.