INVESTMENT-GRADE AND HIGH-YIELD CORPORATE BOND PORTFOLIOS Investment-grade bonds IG vs high-yield bonds HY Investment-grade corporate bonds: • are rated from AAA to BBBB by S&P and F
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Credit risk is an important issue for a credit portfolio
The credit market includes:
Ø Publicly traded debt securities (such as
corporate bonds, sovereign/non-sovereign
government bonds, supranational bonds &
commercial papers)
Ø Non-publicly traded instruments (such as
loans, privately placed securities)
The credit market also includes:
Ø Structured financial instruments (such as
mortgage-backed securities, asset-backed securities)
Ø Collateralized debt obligations (traded
publicly or non-publicly)
Note: Corporate bonds are the largest component of
the credit market
2 INVESTMENT-GRADE AND HIGH-YIELD CORPORATE BOND PORTFOLIOS
Investment-grade bonds (IG) vs high-yield bonds (HY)
Investment-grade corporate bonds:
• are rated from AAA to BBBB (by S&P and
Fitch) or Aaa to Baa3 (by Moody’s)
• have higher credit ratings
• have lower credit & default risk
• offer lower yields
High-yield corporate bonds or speculative grade bonds:
• are rated below BBB1 (by S&P and Fitch) or
below Baa3 (by Moody’s)
• have lower credit ratings
• higher credit & default risk
• offer higher yields
Credit portfolio managers and analysts often conduct
their own independent assessments (usually through
credit models) to evaluate the credit worthiness of bond
issuers Their credit analysis may take into account “four
Cs” – capacity, collateral, covenants, and character or
the extended “five Cs” which includes capital as well
Credit risk is the risk that a counterparty or debtor may
not be able to repay the loan Two components of
credit risk are:
• Default risk, is the probability that a borrower
fails to make scheduled principle or interest
payments
• Loss severity (a.k.a loss given default), is the
amount of loss when default occurs
Credit loss rate = % of par value lost to default for a
group of bonds = bond’s default rate × loss severity
Historically, credit loss rate on HY bonds has been substantially higher than on IG bonds
The most relevant risk considerations for:
• HY bonds are → credit and default risk
• IG bonds are → credit risk, credit migration (credit downgrade) risk, spread risk and interest rate risk
Note: IG bonds and HY bonds not only differ in their
credit and default risk but also in their sensitivity to interest rate changes and liquidity
2.2 Credit Migration Risk and Spread Risk
Credit migration risk is the risk that a bond’s credit quality
deteriorates As the bond becomes riskier, its credit
spread widens and as a result spread risk rises
Sometimes portfolios suffer losses when portfolio managers have to force sell a bond which has been downgraded below IG by credit rating agencies if their portfolios are constrained to hold only IG bonds
Spread duration measures the effects of change in
spread on a bond’s price i.e approximate % increase (decrease) in bond’s price for 1% decrease (increase) in credit spread In a portfolio, IG bonds’ risk is typically measured in terms of spread duration
The effects of spread duration and modified duration
• are almost identical for non-callable fixed rate corporate bonds
• differ significantly for floating rate and some other types of bonds
Trang 2Compared to modified duration, spread duration is a
better measure for an IG portfolio consisting of
floating-rate bonds that typically have little modified duration
but can have high spread duration
Time to maturity (and spread duration) becomes
irrelevant as a measure of risk in the case of default (and
liquidation) All senior-ranked bonds of HY issuers,
irrespective of maturity (and spread duration), will
experience similar credit losses Therefore, investors of HY
bonds emphasis credit risk and market value instead of
spread duration
Credit risk (spread risk and default risk) for IG and HY
portfolios can be managed better if the portfolio
manager is aware of 1) spread duration-based 2)
value-based risk measures
HY portfolios are primarily exposed to credit risk whereas,
IG portfolios are primarily exposed to interest-rate risk
Bond’s yield = risk-free interest rate + spread
Generally, when economic conditions:
• strengthen → risk-free rates increase, and
credit spreads decrease
• deteriorate → risk-free rates decrease, and
credit spreads increase
As we know, spread is typically positive for a security with
credit risk and is zero for a risk-free security Theoretically,
change in risk-free interest rates should have identical
effects on both risk-free and risky securities However, it
has been observed that HY bonds with large credit
spreads are less sensitive to change in interest rates than
bonds with smaller credit spreads because in practical
terms, credit spreads and risk-free interest rates are
negatively correlated Notably, the credit spreads of
Caa rated bonds change more in opposite directions
than the magnitude of change in interest rates
Key macro-economic factors (e.g economic growth,
default rates, monetary policy) typically have opposite
effects on interest rates and spreads Therefore, price
patterns of risky bonds more closely match equities
rather than fixed income
Empirical duration: Statistically estimating bond’s
duration using historical market data, usually through
regression analysis (i.e regressing historical market-based
bond’s prices on changes in historical market-based
benchmark yields)
Effective duration: Sensitivity of bond’s price to change
in benchmark yields This is modified duration for option
free bonds and option adjusted duration for bonds with
embedded options
It has been observed that IG bonds have greater empirical duration and
for bonds across all credit ratings, empirical duration is typically smaller than the theoretically based effective duration The results are more pronounced for HY bonds, which have nearly zero sensitivity to interest rate
changes, and Caa rated bonds, in fact have negative empirical durations
Therefore, IG portfolio managers primarily focus on interest rates, yield curve dynamics and portfolio durations, whereas HY portfolio managers emphasize portfolio’s credit risk Though both groups need to be cognizant of all risks
Note:
The relation between interest rates and spreads is only empirically derived, and thus, is not absolute For
example, ‘Taper tantrum’ term refers to a 2013 surge in
treasury yields when Fed announced that it would reduce its mortgage and treasury purchase program As
a result, interest rates rose, and credit spreads widen extensively
2.4 Liquidity and Trading
Liquidity: Ability to trade asset quickly and with certainty
at a price close to its fair market value
• Bid-ask spread − The smaller the bid-ask spread, the higher the liquidity
• Bond’s issue size & overall market size− An individual bond’s liquidity is positively correlated to the bond’s issue size and the overall market size
• Bond dealers’ inventory size− The larger the size of bond in dealers’ inventories, the higher the bond’s liquidity
On average, IG market and issue size is larger than HY market and issue size, that’s why IG bonds are more liquid than HY bonds, and dealers hold comparatively larger inventories of IG bonds This causes trading in HY bond portfolios costlier (higher bid-ask spread) Many HY bonds trade infrequently and are therefore inaccessible Managers have to find substitutes for a new portfolio Bonds’ availability issue also exists in longer-term IG bonds but in lesser extent
Ø IG bonds are usually quoted as spread over benchmark government bonds
Ø HY bonds are usually quoted in price terms because of bonds’ equity-like behavior and sensitivity to spread changes
Practice: Example 1, Reading 24, Curriculum
Trang 33 CREDIT SPREADS
Portfolio managers often separate their analysis of
interest rate risk from credit-related risks (e.g credit
spread risk, credit migration risk, default risk and liquidity
risk) to better understand their contribution to total
portfolio return and risk
3.1 Credit Spread Measures
Credit related measures help investors in composing
their credit portfolios and quickly estimating their return
compensation for taking credit-related risks
3.1.1) Benchmark Spread and G-Spread
Benchmark spread is calculated by subtracting the
similar duration benchmark bond yield from the yield on
a credit security Benchmark bonds are typically recently
issued government bonds However, one problem with
benchmark spread is that finding the similar duration
on-the-run government bond is challenging
G-spread is used by investors when no government
bond exists that has the same maturity as the credit
security The benchmark yield is calculated by a linear
interpolation of yields on two on-the-run government
bonds and the weights of the two government bonds’
yields are derived in a way that their weighted average
duration matches the credit security’ duration
Another advantage of G-spread in portfolio construction
is that investors can hedge the interest rate risk of credit
securities by selling/short selling the two benchmark
government bonds and retaining only the credit spread
of the security
G-spread is used to estimate the changes in price and
yields of option-free fixed income securities for small
changes in interest rates
3.1.2) I-Spread
Interpolated spread (I-spread) conceptually resembles
G-spread with one difference, I-spread uses swap rates
as benchmark rates rather than yields on government
bonds The denominated currency of swap rates and
the credit security should match
Swap curves are relatively smoother than government
bond curves as supply and demand conditions influence
some on-the-run government bonds
Two important considerations when evaluating the
G-spread and I-G-spread are:
• Benchmark must be a representative of credit risk-free rate Yields on government bonds or interbank rates can be a poor representation of benchmark if market believes that there is credit risk in those benchmarks
• Hedging should be done by using bonds (the hedging instruments) that match the benchmark used in spread calculation For example, government bonds in the case of
G spread Otherwise, realized spread will be different than expected spread (e.g if government bonds are used to hedge I Spread)
3.1.3) Z-Spread and Option-Adjusted Spread
Zero volatility spread (Z-spread) and option-adjusted spread (OAS) are particularly helpful in comparing the
relative values across credit securities
Z-spread (applicable in bond valuation based on spot
rates) is a constant spread added to the yield on each
point of the treasury spot-rate curve and bond’s cash flows are then discounted at respective treasury yields plus z-spread to make the present value of the bond’s cash flows equal to its current market price
For option-free bonds, the z-spread measure closely matches the other spread measures
Option-adjusted spread (applicable in bond valuation
based on binomial tree) is a constant spread added on
each node (one period forward rate) of the interest rate tree that makes the calculated value of the security equal to its market price OAS accounts for embedded options
OAS is broadly used to compare relative values of bonds with embedded options
Limitations of OAS
• OAS is a theoretical measure of credit spread and relies on assumptions about future interest-rate volatility
• The realized spread may vary significantly from the calculated OAS because the calculated OAS is merely a simulated average value
3.1.4) Credit Spread Measures in a Portfolio Context
A diversified credit portfolio includes various types of securities, and applying G-spread, I-spread or Z-spread is challenging, therefore, OAS is the most suitable spread
at portfolio-level Portfolio OAS is estimated by calculating a market-weighted average of individual bonds OAS
Practice: Example 2, Reading 24,
Curriculum
Trang 43.2 Excess Return
Credit portfolio managers typically manage portfolios’
interest rate risks and credit-related risks separately
Excess return, additional return after hedging
interest-rate risk, is another helpful tool to manage and assess
credit-related risks Excess return is considered to be the
compensation for taking credit-related risks
Credit spread = excess return (except when security’s
yield or interest rates change, or default occurs)
Excess return (XR) on a credit security assuming no
default
XR ≈ (s × t) − (∆s × SD)
where,
XR = holding period excess return
s = spread at the beginning of the holding period
t = holding period (expressed in fractions of year)
∆s = change in spread during the holding period
SD = spread duration Expected excess return (EXR) including the probability of future default losses
EXR ≈ (s × t) − (∆s × SD) − (𝑡 × 𝑝 × 𝐿) where, p is the annualized expected probability of default and L is expected loss severity
Bottom-up and top-down are two important actively
managed credit strategy approaches
4.1 The Bottom-Up Approach
Bottom-up approach – selecting an individual bond or
issuer from a universe of bonds or issuers with similar
attributes (such as industry, country etc.) based on
investors’ relative value analysis
Bottom-up approach works well when set of companies
have comparable credit risk Sometimes this approach is
also called ‘security selection’ strategy
4.1.1) Dividing the Credit Universe
In a bottom-up approach, the first step is to identify the
universe of suitable bonds, next divide that universe into
sectors and sub-sectors, and then select the most
undervalued bonds based on the relative value analysis
Managers’ performance is usually measured against
some benchmark They often start with the same sector
allocation as the benchmark, however, they can add
value by over/under weighting certain sectors
Benchmark sectors may be too broad or too narrow as
there are no well-defined rules for such classification
However, each sector should include bonds for which
company-level-risks are dominant factors
4.1.2) Bottom-Up Relative Value Analysis
Within each sector, the investor performs relative value analysis to search for the most undervalued bonds The relative value analysis focuses on considering
compensation for credit-related risks (expected excess return) versus expected magnitude of credit-related risks For two issuers that have similar credit-related risks, credit spread measures can be used to identify the bond with higher credit spread because that bond is expected to have greater potential for excess return
For issuers with different credit-related risks, the decision is based on whether expected excess return is sufficient for taking additional credit risks In this regard, two useful sorts of information are:
• Historical default rate information based on credit-rating categories
• Information on average spread level for each sector and credit rating
The following two equations of excess return and expected excess return are very useful in analyzing the bond’s credit risk
Excess return XR ≈ (s × t) − (∆s × SD) Expected excess return EXR ≈ (s × t) − (∆s × SD) −
(𝑡 × 𝑝 × 𝐿) The value of ∆s (change in credit spread) is not known in advance and is based on investor’s expectation
Practice: Example 3 & 4, Reading
24, Curriculum
Practice: Example 5, Reading 24, Curriculum
Practice: Example 6, Reading 24,
Curriculum
Trang 5∆s is important to consider when:
Ø credit spreads are expected to change during
the holding period
Ø investor’s holding period is shorter than the
bond’s maturity
Ø investor is comparing bonds of different
maturities
∆s will effectively be zero if investor:
Ø believes that the credit spread will remain the
same during the holding period,
Ø is comparing two bonds of equal maturity and
plans to hold the bonds till maturity
• In case credit spreads remain unchanged, when
choosing between two bonds of similar maturity
and default-loss expectations, prefer the bond
that has higher spread
• When choosing between two bonds of similar
maturity and spread, prefer the bond that has
lower default losses
• In security selection decisions, in addition to
excess return, other three important
considerations are liquidity, portfolio
diversification and risk Sometimes, investors give
up excess return for liquidity i.e investors may
prefer the bond with lower excess return if two
bonds differ significantly in their riskiness or
liquidity
• Investor may choose a bond based on his
expectation of total return instead of excess
return, in case, he is not hedging interest rate
risk, or he is not managing interest rate and
credit risk separately
4.1.3) Spread Curves
A spread curve is the fitted curve of credit spreads for
each bond of an issuer plotted against either the
maturity or duration of each of those bonds
Spread curves are helpful in conducting relative value
analysis
4.1.4) Other Considerations in Bottom-Up
Relative Value Analysis
Other considerations in bottom-up relative value analysis
include:
• Bond structure: Investors should take into
account various bonds’ features (e.g callable debt) and bonds’ priority in the capital structure
(e.g senior/subordinated debt)
• Issuance Date: When selecting a bond, the
investor should consider his holding period and liquidity needs Generally, recently issued bonds
by entities with frequent bond issues are considered to be highly liquid and trade at narrower bid-ask spread, however, such bonds offer lower excess return Off-the-run issues of the same issuer are considered to be less liquid and provide more compensation for investors
• Supply: When an issuer announces new bond
issue, value of the issuer’s existing bonds decreases and spread widens The possible explanations for spread widening are:
o Increased supply
o Price concession on new issue- to induce demand
o New issue is treated as a signal of increase in issuer’s credit risk
• Issue Size: Generally, the larger the bond’s issue
size, the higher the bond’s liquidity & value, and lower the bond’s spread Such bonds are traded more frequently and are held by large number of market participants The amount of debt outstanding plays an important role in the weighting schemes of many traditional bond indexes However, the relation between issue size and spread is not always well-defined Sometimes the relationship is inverse i.e very large issue leads to wider spreads
4.1.5) Bottom-Up Portfolio Construction
First, the investor identifies a model portfolio with appropriate position sizes of sectors and individual bonds Second, the investor buys bonds in a way that the actual portfolio’s risk exposures closely match the model portfolio’s risk exposures
Regarding portfolio position sizing, the investor can use market value or spread duration metrics i.e
• the investor may purchase bonds of equal market value as that of the model portfolio
or may build larger position in attractively valued bonds
• Alternatively, spread duration can be used for sizing the positions
For detail, refer to 4.1.5 ‘Bottom-Up Portfolio Construction' 4th paragraph starting from
‘As an example of spread duration…….’
Practice: Example 7, Reading 24,
Curriculum
Important
Refer to CFA Curriculum, Reading 24, 4.1.3 for
illustration of spread curves through bonds of
two telecommunication companies, Verizon
(VZ) and AT&T (T)
Practice: Example 8, Reading 24, Curriculum
Trang 6The decision of choosing the portfolio sizing metric
between market value or spread duration is based on
the relative importance of portfolio’s default loss risk
versus credit spread risk
• When default losses are the primary
concern, generally in HY bond portfolios,
then market value is a better measure of risk
• When spread change is the primary
concern, generally in IG bond portfolios,
then spread duration is a better measure of
risk
Managers usually match the portfolio’s sector weightings
with that of the benchmark, however, managers often
under or overweight certain sectors based on their
relative value analysis
Sometimes securing the desired bonds is problematic
Some common alternatives to deal with this problem
are:
• Substitution: When investor’s most preferred
bond is unavailable, the investor may
choose the next best available substitute
bond
• Indexing: Temporarily invest in some suitable
index funds until the desired bonds are
available For example, benchmark bonds,
ETFs, total return swaps on the benchmark
index, credit default swap index derivatives
etc
• Cash: Holding cash can be a useful option if
it is expected that investor’s preferred bonds
will be available for purchase shortly
Top-down approach – focuses on formulating a view on
the overall picture of the economy by identifying
macroeconomic trends and then selecting bonds that
will perform better under such conditions based on
investor’s views
Some key macro-economic factors include: economic
growth, overall corporate profitability, default rates, risk
appetite, changes in expected market volatility, credit
spreads and interest rates, industry trends, currency
movements etc
The investor then identifies sectors which are likely to
outperform and/or underperform based on her views on
macro-economic factors The investor then
overweights(underweights) sectors by
purchasing(selling/short-selling) bonds in the sectors that
have relatively favorable(unfavorable) macro outlook
Investors often use broader sector divisions in top-down
approach as compared to bottom-up approach
4.2.1) Credit Quality
In top-down approach, determining the portfolio’s credit quality is an important consideration
• A credit portfolio that holds more low-quality bonds tends to outperform the benchmark when credit spread narrows and default rates are lower
• A credit portfolio that holds more high-quality bonds tends to outperform the benchmark when credit spread widens, and
defaults rates are higher
Two key components of investor’s credit quality decision that are highly influenced by macro-economic factors are:
• Expectations for the credit cycle (measured through changes in default rate overtime)
• Expectations for credit spread changes Historically, it has been observed that there is a reasonable correlation between default rates and:
• real GDP growth rates (i.e sharp decline in real GDP growth often result in substantial increase in default rates)
• credit spreads (i.e changes in credit spreads are good predictor of changes in default rates one year ahead)
4.2.1.1) Measuring Credit Quality in a Top-Down
Approach:
Some common approaches to assess a portfolio credit quality are:
1 Average credit rating
Portfolio’s average credit quality can be assessed using arithmetic weighting or non-arithmetic weighting
a) Under arithmetic weighting approach, a
numerical weighting (in sequence) is assigned to each credit rating (i.e 1 for AAA, 2 for AA+, 3 for AA and so on) In this way, a portfolio’s market value weighted average is calculated
b) Under non-arithmetic weighting approach,
numbers assigned to credit rating categories are not in a linear manner rather the
numbers increase rapidly as ratings decline
• Compared to arithmetic weighting, in non-arithmetic weighting, the average credit rating is two notches below
• When a portfolio has a broader credit range, arithmetic weighting approach tends
to overestimate the portfolio’s credit quality and underestimate its credit risk
Please refer to CFAI’s curriculum Reading 24,
paragraph below exhibit 9 for detail description
on how to calculate a portfolio’s average credit quality score
Trang 7• When a portfolio has a narrow credit range
(i.e consisting of bonds in the same rating
category), using non-arithmetic weighting
underestimate the portfolio’s credit risk
compared to using arithmetic weighting
2 Average OAS
To calculate a portfolio’s average OAS, each bond’s
individual OAS is weighted by its market value
OAS indicates a portfolio’s credit quality, but it does not
fully explain the risk of credit spread volatility
3 Average spread duration: Spread duration specifies
how a portfolio’s value changes if spread changes
A weighted-average spread duration clarifies the
risk of credit spread volatility
4 Duration times spread (DTS): DTS, (duration x OAS),
tends to explain both average OAS and average
spread duration Portfolio’s DTS is a weighted
average of its individual bond’s DTS DTS is more
comprehensive but less intuitive than average OAS
or average spread duration
4.2.1.2) Excess Return in a Top-Down Approach
A portfolio’s expected excess return EXR is calculated as:
EXR ≈ (s × t) − (∆s × SD) − (𝑡 × 𝑝 × 𝐿)
To calculate a portfolio’s EXR, a portfolio manager using
top-down approach, can incorporate values of default
losses and credit spread changes based on his
expectations
4.2.2) Industry Sector Allocation
A portfolio manager’s industry allocation decisions may
significantly affect a portfolio’s performance compared
to its benchmark
In making industry allocation decisions (whether to
overweight, underweight or equally-weight relative to
benchmark), a portfolio manager may use:
• quantitative tools such as regression analysis
• information on spreads at sector level
• other considerations, such as her beliefs and
views on credit fundamentals
• financial ratio analysis at sector level
• comparing sectors on spreads versus
leverage basis
4.2.3) Interest Rate Measurement and
Management in a Top-Down Strategy
Bottom-up managers primarily focus on security
selection, and typically, match their interest rate
exposure to that of the benchmark, whereas, top-down
managers take into account macro factors, and may actively manage their portfolio’s interest rate risk
4.2.3.1) Measuring Interest Rate Exposure Effective duration, which consider optionality of a
portfolio’s credit securities, is a primary tool to monitor and manage interest rate risk for parallel shifts in the yield curve
Key rate durations fully measure a portfolio’s exposure to
non-parallel shifts in the yield curve
Effective convexity is used by portfolio managers to
benefit from interest rate volatility of bonds with embedded options
• Increase (decrease) portfolio’s effective duration, if interest rates are expected to fall(rise) more than what the market is pricing
• Adjust portfolio’s key rate durations to profit from non-parallel shifts (flattening or steepening) in the yield curve
• Increase(decrease) portfolio’s convexity if interest rate volatility is expected to increase(decrease) more than what the market
is pricing
4.2.3.2) Managing Interest Rate Exposure
Credit managers manage portfolio’s interest rate exposure using various approaches such as, maturity management, derivatives, volatility management etc
Maturity management: involves obtaining portfolio’s
targeted effective duration and key rate durations by selecting appropriate credit securities
Advantage:
• No involvement of derivatives
Disadvantages:
• It is impossible to separate credit security selection and credit curve management from duration and yield curve management
• Matching key rate durations closely is challenging because desired bonds in all maturities are not always readily available
• Absolute return portfolios often require zero or closely zero interest rate exposure, which is nearly impossible to achieve without the involvement of derivatives unless the portfolio totally holds floating-rate notes or very short
maturities bonds
Derivatives: Buying the most attractively valued bonds
on spread basis and then using derivatives to manage the portfolio’s effective duration and key rate durations
Practice: Example 9, Reading 24,
Curriculum
Trang 8Advantages:
• Key rate duration can be controlled separately
from credit curve management
• It is easy to shift exposure quickly because of
liquid interest rate derivatives markets
Disadvantages:
• Subject to their willingness and/or ability, not all
investors can use derivatives
• Using derivatives for smaller portfolios is
unfeasible
Volatility Management:
A portfolio’s exposure to interest rate volatility can often
be managed with:
• credit securities by using callable bonds or
agency pass-through securities etc
• derivatives by using options
4.2.4) Country and Currency Exposure
Credit managers sometimes take exposure to some
other currency and/or country by using credit securities
or derivatives
Using credit securities
If interest rate difference between two currencies is
expected to change, buy(sell) securities in the currency
in which yields are expected to fall(rise) and vise versa
Investor may take currency exposure, by buying or
selling more bonds issued in a particular currency
relative to the benchmark
Using derivatives
Managing currency exposure using forwards and futures
rather than credit securities is more common because
forwards and futures are highly liquid and enable
investors to separate currency risks from other risks
4.2.5) Spread Curves in Top-Down Approach
In top-down approach, spread curves are useful in
conducting relative value analysis, particularly for a
large credit segment (such as, at industry, currency or
index level)
For example, a top-down manager may have a view
that a particular credit spread is expected to steepen or
flatten or that two particular spread curves are
expected to converge or diverge etc., and in order to
take advantage, the manager may change the
portfolio composition accordingly
4.3 Comparing the Bottom-Up and Top-Down Approaches:
A portfolio can be constructed using top-down,
bottom-up or combination of the two approaches Both
approaches have their own benefits and drawbacks
Exhibit below interpret benefits and drawbacks of both
approaches
Practically, investors often employ a combination of
both approaches to credit strategy For instance,
• An investor may start by selecting a particular industry or region using a top-down approach, next
he may select a bond of a particular company through relative value analysis using bottom-up approach
• Alternatively, an investor with primary focus on bottom-up approach, may monitor and manage top-down macro-economic factors as well
4.4 ESG Considerations in Credit Portfolio Management
ESG (environmental, social and governance) factors are especially pertinent to the credit portion of fixed income mandates, therefore such mandates require ESG considerations in their portfolio investment process Some common ways to incorporate ESG factors are:
Relative value considerations
Companies and industries with poor ESG practices tend
to have higher credit risks for numerous reasons For example, companies with poor
• labor laws, suffer work stoppages, strikes, lawsuits etc
• pollution control mechanisms, face environmental lawsuits and fines
• corporate governance, are vulnerable to fraudulent accounting practices
Practice: Example 10, Reading 24, Curriculum
Top-Down Approach
Benefits:
Sizable portion of credit returns can be attributed to macro factors
Benefits
Gaining informational advantage in individual companies
or bonds is relatively easier compared to the overall market.
Drawbacks:
Gaining informational advantage is very difficult because numerous market participants closely examine industry and economic factors therefore, expectations regarding interest rates, economic cycles, and other macro factors are often reasonably reflected in credit market prices
Drawbacks
Sizable portion of credit returns is attributed to macro factors, therefore it is difficult to earn substantial returns without exposing the portfolio to macro factors Bottom-Up Approach
Trang 9Guideline constraints
The IPS section of many portfolios set forth prohibitions on
purchasing securities of companies that are involved in
certain activities or sell controversial products or prohibit
purchasing bonds of some governments/countries with
poor human rights protections or weak social laws etc
Portfolio-level risk measures
Incorporating ESG into the portfolio management
process by a credit portfolio manager involves:
Monitoring of exposure to ESG-related risk factors: a
portfolio manager may limit or avoid exposure to those
sectors or companies that are involved in questionable
business practices
Targeting an average ESG portfolio score: A portfolio
manager may consider ESG scores or ratings (derived internally or provided by some external party) in her portfolio investment process She may prefer bonds with ESG ratings that meet or exceed certain target or skip bonds with very low ESG ratings
Positive impact investing opportunities:
Sometimes managers invest certain percentage of their portfolio in companies that have a positive social or environmental impact e.g green bonds, not-for-profit organizations’ bonds, bonds for low-income housing projects Green bond funds are those specifically invested in environment-friendly projects
5 LIQUIDITY RISK AND TAIL RISK IN CREDIT PORTFOLIOS
Liquidity is very important in credit investing Corporate
bonds are relatively illiquid compared with sovereign
bonds issued by large developed markets One major
reason is the availability of information i.e market data,
price data and other pertinent information is readily
available for sovereign bonds but is very limited for
corporate bonds
Liquidity has become a significant concern for credit
investors after 2008-2009 global financial crises New
regulatory constraints caused a drop in corporate bond
holdings by brokers/dealers, which further reduced
credit market liquidity
On the contrary, growing electronic trading platforms
(ETPs) have improved credit market liquidity by shifting
credit market from dealer-denominated to a more open
and competitive market
5.1.1) Measures of Secondary Market Liquidity in Credit
Some measures such as trading volume, spread
sensitivity to fund outflows and bid-ask spreads are used
to evaluate liquidity in secondary markets
i) Trading Volume:
After 2008-2009 global financial crises, trading volume in
credit markets both in US HY and US IG bonds has
declined
ii) Spread Sensitivity to Fund Outflows:
Large withdrawals from credit funds severely affect their
liquidity ‘Spread sensitivity to fund outflows’ indicates
how bonds prices and spreads are affected for a given
percentage outflow The effect is more pronounced for
HY market compared to IG market In both HY and IG
markets, the spread widening relative to percentage
outflow was highest during and just after the global
financial crises
iii) Bid-Ask Spreads
Bid-ask spreads are also used to measure liquidity, but the data should be analyzed carefully Highly volatile market conditions negatively affect bid-ask spreads, later the spread levels tend to stabilize after a brief period of volatility
5.1.2) Structured Industry Changes and Liquidity Risk
Post 2008-2209 financial crises, the credit market has experienced reduced liquidity and significant structural changes such as considerable:
• increase in cost of capital for dealers and
• decrease in dealers’ ability and willingness to maintain large bond positions
Two key reasons for these structural changes are that:
• new regulations restricted dealers’ ability to take risk and hold inventories
• dealers themselves become more risk averse and reduced their balance sheet size
On the positive side, it has been observed that as a result
of these structural changes, the concentration of US HY and IG bonds among the funds has decreased Assets under management are now more widely dispersed among credit investors, which has increased liquidity in credit markets
5.1.3) Management of Liquidity Risk
Following are some ways, credit portfolio managers use
to manage portfolio’s liquidity
• Holding cash: Post crises, managers have increased the percentage of holding cash
in the portfolios
• Managing position sizes: Typically, more liquid securities are likely to have greater weights in the portfolio, all else equal
Trang 10However, evaluating the portfolio’s liquidity
and profitability tradeoff is an important
consideration
• Holding liquid non-benchmark securities:
Using liquid IG bonds or treasuries as a cash
surrogate may provide incremental yield
over cash
• Using credit default swap (CDS) index
derivatives: CDS derivatives market is
relatively more active and is traded
significantly more than credit market
• Using credit ETFs: The credit market
experienced exponential growth in IG and
HY credit ETFs following the financial crises
Credit ETFs allow investors to obtain quick
and diversified exposure in the credit
markets However, volatile markets can drive
the market price of ETFs away from their net
asset value
Tail risk is a risk that there are more actual events in the
tail of a probability distribution than predicted by a
probability model Tail risk events can result in very large
negative portfolio returns It is challenging to model or
predict tail risk events
5.2.1) Assessing Tail Risk in Credit Portfolios
Managers can practice the following techniques to
assess tail risk in credit portfolios
5.2.1.1) Scenario Analysis
Scenario analysis technique tests the portfolio
performance under specific (acceptable but unusual)
circumstances This technique often predicts portfolio
returns for large changes in spreads, bond prices or
scenarios based on actual or hypothetical events
5.2.1.2) Historical and Hypothetical Scenario Analysis
• Historical scenario analysis assumes events
that have occurred in the past e.g global
financial crises, prolonged default cycle in
HY bonds, periods when defaults were
concentrated in some specific sectors etc
• Hypothetical scenario approach assumes
unusual events (e.g large changes in
interest rates, currencies, credit spreads etc.)
that have not occurred but can cause
sizable changes in bond prices
5.2.1.3) Correlations in Scenario Analysis
Evaluating potential changes in correlations between security prices is very important During periods of financial crises, correlations tend to move closer to 1.0 Therefore, significant increase in correlations among security prices in a well-diversified portfolio can be viewed as a warning sign for some negative event
5.2.2) Managing Tail Risk in Credit Portfolios
Two steps in managing tail risk are:
1st step → identify potential tail risk events in credit portfolios
2nd step → protect against tail risk events through portfolio diversification and tail risk hedges
5.2.2.1) Portfolio Diversification
Managers may reduce portfolio exposures to sectors that are likely to suffer if tail risk event occurs The manager may tilt weights towards securities that are expected to benefit if the negative event occurs Maintaining a well-diversified portfolio typically, improves portfolio’s risk-adjusted returns
Portfolio diversification in tail risk management has some restraints
• Finding attractively valued securities that can protect against every tail risk is challenging
• Securities that are expected to benefit from negative events may not have high
sensitivity to such events
5.2.2.2 Tail Risk Hedges
In tail risk hedge strategy, managers use securities or derivatives that act as insurance in tail risk event situations Some commonly used instruments are buying put options, CDS or credit spread options on relevant bonds for hedging purposes
Limitations of tail risk hedging involves its costs vs benefits consideration i.e
• Buying insurance increase cost and lower portfolio returns
• When probability of tail risk event increases, cost of tail risk hedging rises sharply
• Investors, who are not allowed to use derivatives, face additional problems in hedging tail risk
6 INTERNATIONAL CREDIT PORTFOLIOS
Credit investors should consider global implications
particularly when they manage portfolios including
bonds issued in multiple currencies and countries The
significance of global effects exists even when a
portfolio holds bonds issued in a single country as many companies generate revenues outside their country or
go overseas to buy or make products