In hindsight it is very clear that credit risk is material and that there is real default risk and not just volatility. Risk is fine, and institutional investors are in the business of taking and allocating risk, but you need to get paid a return for the risk that is taken.
Before the financial crisis, the credit risk being assumed by many institutional portfolios was much higher than most thought. This is because the overall length of the last credit cycle and relatively mild down cycles in credit over the last two decades led most to believing that the credit risk was negligible. The quantitative models also seemed to confirm that the risk was small. As a result, investment managers were inclined to try to outperform their benchmarks by ratcheting up the credit exposure. When credit spreads began to widen somewhat during 2007, and then dramatically in 2008, all the outperformance of the previous years — and more — was lost.
There have always been warnings about the need for independent credit analysis and the need for investors to stop depending on rating agencies and sell side research. It is now clear that more buy side investors should have paid attention to them. Credit research and analysis is a learned skill, and it takes time, resources and expertise. Today, after 2008, this expertise is much more in demand and appreciated.
The lesson learned is that credit risk is more than volatility. Investors need to be compensated for the risk that they are assuming. Without good fundamental credit research and expertise, the returns won’t compensate for the risk being taken.