Fixed Income Active Management: Credit Strategies INTRODUCTION Credit risk is an important issue for a credit portfolio The credit market also includes: The credit market includes: Ø Ø Publicly traded debt securities (such as corporate bonds, sovereign/non-sovereign government bonds, supranational bonds & commercial papers) Non-publicly traded instruments (such as loans, privately placed securities) 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 2.1 Credit Risk Credit risk is the risk that a counterparty or debtor may not be able to repay the loan Two components of credit risk are: • • 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 INVESTMENT-GRADE AND HIGH-YIELD CORPORATE BOND PORTFOLIOS Investment-grade bonds (IG) vs high-yield bonds (HY) • Ø 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 –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 24 Reading 24 Fixed Income Active Management: Credit Strategies Compared to modified duration, spread duration is a better measure for an IG portfolio consisting of floatingrate 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) valuebased risk measures 2.3 Interest Rate Risk 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 FinQuiz.com 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 Ø IG bonds are usually quoted as spread over benchmark government bonds 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 Reading 24 Fixed Income Active Management: Credit Strategies 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 onthe-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 Practice: Example 2, Reading 24, Curriculum Swap curves are relatively smoother than government bond curves as supply and demand conditions influence some on-the-run government bonds 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 • 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 Two important considerations when evaluating the Gspread and I-spread are: FinQuiz.com • 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 Reading 24 Fixed Income Active Management: Credit Strategies Practice: Example & 4, Reading 24, Curriculum 3.2 Excess Return Credit portfolio managers typically manage portfolios’ interest rate risks and credit-related risks separately Excess return, additional return after hedging interestrate 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 FinQuiz.com 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 Practice: Example 5, Reading 24, Curriculum XR ≈ (s × t) − (∆s × SD) CREDIT STRATEGY APPROACHES 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 Practice: Example 6, Reading 24, Curriculum 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 Reading 24 Fixed Income Active Management: Credit Strategies ∆s is important to consider when: Ø Ø Ø credit spreads are expected to change during the holding period investor’s holding period is shorter than the bond’s maturity investor is comparing bonds of different maturities • 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 ∆s will effectively be zero if investor: Ø Ø • • • • believes that the credit spread will remain the same during the holding period, 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 Practice: Example 7, Reading 24, Curriculum 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 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) 4.1.4) Other Considerations in Bottom-Up Relative Value Analysis Other considerations in bottom-up relative value analysis include: FinQuiz.com Practice: Example 8, Reading 24, Curriculum 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…….’ Reading 24 Fixed Income Active Management: Credit Strategies The 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: • • • 4.2 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 The Top-Down Approach 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 FinQuiz.com 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 highquality 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: 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 for AAA, for AA+, 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 Please refer to CFAI’s curriculum Reading 24, paragraph below exhibit for detail description on how to calculate a portfolio’s average credit quality score • • Compared to arithmetic weighting, in nonarithmetic 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 Reading 24 • Fixed Income Active Management: Credit Strategies 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 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 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 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 FinQuiz.com 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 • • • 4.2.1.2) 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 Practice: Example 9, Reading 24, Curriculum 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 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 Reading 24 Fixed Income Active Management: Credit Strategies FinQuiz.com Advantages: • • 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 • 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, bottomup or combination of the two approaches Both approaches have their own benefits and drawbacks Exhibit below interpret benefits and drawbacks of both approaches Benefits: Gaining informational advantage in individual companies or bonds is relatively easier compared to the overall market Benefits Drawbacks: Gaining informational advantage is very difficult because numerous market participants closely examine industry and economic factors therefore, 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 Bottom-Up Approach Sizable portion of credit returns can be attributed to macro factors Volatility Management: A portfolio’s exposure to interest rate volatility can often be managed with: • Top-Down Approach 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 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 Practice: Example 10, Reading 24, Curriculum 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 Reading 24 Fixed Income Active Management: Credit Strategies FinQuiz.com Guideline 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 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 Portfolio-level risk measures Incorporating ESG into the portfolio management process by a credit portfolio manager involves: 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 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 5.1 LIQUIDITY RISK AND TAIL RISK IN CREDIT PORTFOLIOS Liquidity Risk 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 Reading 24 • • • 5.2 Fixed Income Active Management: Credit Strategies However, 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 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 5.2.1.3) 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 • • 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 FinQuiz.com 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 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 Reading 24 6.1 Fixed Income Active Management: Credit Strategies Relative Value in International Credit Portfolios Sometimes managers find relative value investing opportunities in multiple markets and currencies due to regional differences in credit cycles, credit quality, sector composition and market factors • • • • • 6.2 The effects of credit cycle may vary across regions The issuer’s credit quality may fluctuate across countries due to their regional differences in ratings The differences in sector compositions may provide opportunities to one credit market relative to the other Supply and demand levels may vary globally in corporate bond universe e.g high supply (issuance of corporate bonds) in one country may exceed its desired demand and may contribute to the underperformance of that country’s credit market compared with other credit markets Demand of corporate bonds in any country may vary depending on the composition of investor type and investor preferences Varying macro trends, sector credit quality, investor flows across regions, changing credit spread levels are some factors that may cause valuation differences among countries Emerging Markets Credit Some differences between credit markets in emerging countries and credit markets in developed countries are given below Concentration in commodities and banking Compared to developed market indices, a substantial portion of emerging market indices comprises of commodity producers and banks Emerging market banks exhibits high exposure to commodity sectors Government Ownership Many emerging market bonds are government owned or partially/solely controlled by the government A primary advantage is that investors may get explicit or implicit support from government during unfavorable financial situations A key disadvantage is that nondomestic bondholders may face uncertainty in the contractual rights and interests as part of a debt restructuring On average, recovery rates for emerging market bonds are lower than in developed markets Credit Quality Emerging market credit universe is usually concentrated in the lower portion of IG and upper portion of HY rating spectrum compared with the developed market bonds This difference is due to the “sovereign ceiling” to corporate bond issuers, applied by the credit rating agencies Sovereign ceiling implies that a company is typically rated not higher than the sovereign credit rating of its country 6.3 Global Liquidity Considerations When investing in multiple markets, credit portfolio managers should consider illiquidity issues Level of liquidity in bond market varies across countries The liquidity in a developed credit market is often reflected through its market value, number of issuers, dealers, investors, size/frequency of new bond issues as well as transparency of its trade reporting systems Investors typically demand higher premiums for holding emerging market securities 6.4 The size of emerging market corporate bond universe has increased tremendously and is now approximately equal to the size of US HY credit market FinQuiz.com Currency Risk in Global Credit Portfolio Currency risk is a major risk of investing in global credit markets, as unfavorable currency movements can easily nullify investors’ expected returns Credit managers can use currency swaps to hedge foreign exchange exposures 6.5 Legal Risk Complex laws and regulations, unique bankruptcy laws, influence of government officials or equity holders on legal systems in some less developed markets, are some additional sources of risk faced by international credit portfolio managers STRUCTURED FINANCIAL INSTRUMENTS Structured financial instruments include securities (such as MBS, CDS, ABS, CDOs, covered bonds) that are backed by collateral or pool of assets and assist in shifting risk exposures Some benefits of adding structured financial instruments in portfolios include: • Potential for higher portfolio returns Credit tranching feature generates various risk return outlines Risk-averse investors may prefer senior Reading 24 • • Fixed Income Active Management: Credit Strategies tranche, whereas, risk-tolerant investors may invest in mezzanine or residual tranche Potential for relative value opportunity: Credit securities and structured finance instruments differ in their characteristics, valuation and risk exposures Improved portfolio diversification: Structured finance instruments are often backed by types of assets that are quite heterogeneous and have very different fundamental drivers Note: US structured finance market is largest in the world, however, many non-US investors invest in US structured finance instruments as well 7.1 Mortgage-Backed Securities MBS and residential MBS (RMBS) represent a significant portion of structured financial instruments MBS provide potential for portfolio diversification Other advantages include: • • • • 7.2 Liquidity: Agency RMBS, one of the most liquid credit market, can be backed by US government agency (Ginnie Mae) or by US government sponsored enterprises (Fannie Mae or Freddie Mac) Agency RMBS typically offer similar returns and better liquidity than highquality corporate bonds Exposure to real estate: Residential MBS (RMBS) and commercial MBS (CMBS) can be used to express targeted or levered investment opinions on the real estate sector Exposure to expected changes in interest rate volatility: Agency MBS are almost free from default-risk because their payments are guaranteed by either US government agency or US government sponsored enterprises However, agency MBS are subject to prepayment-risk (when interest rates decrease) or extension-risk (when interest rates increase) Investors may purchase corporate bonds with embedded options to profit from changes in interest rate volatility but relative to agency MBS, they are usually less liquid and have higher default risk Real-estate cycle and credit cycle often behave contrarily in various economic circumstances Investors can identify the divergent fundamental trends in corporate and real estate markets and can adjust portfolio weights accordingly to improve their portfolio returns Asset-Backed Securities Asset-backed securities (ABS) are usually backed by non-mortgage assets such as: automobile loans, automobile lease receivables, credit card receivables, student/personal loans, bank loans, account receivables etc ABS provide portfolio diversification and potential FinQuiz.com for return, in addition, investors use ABS to express their views on particular sectors 7.3 Collateralized Debt Obligations Collateralized debt obligations (CDOs) are backed by various types of debt obligations and offer credit tranching feature such as senior bond classes, mezzanine bond classes, subordinated bond classes (residual/equity tranches) etc CDOs are usually backed by corporate bonds or loans, therefore, CDOs not offer much diversification benefits and unique exposure to sector/market factors However, following are some benefits of including CDOs in the portfolio Relative Value: CDOs may trade at different prices relative to their underlying collateral based on investors’ default rate expectations For example, an investor who believes that a CLO (CDO collateralized by leverage loans) is selling at relatively lower price based on his default loss expectation, can take advantage of this opportunity by selling corporate bonds and purchasing CLO tranches with higher spread Exposure to Default Correlations: Relative values of senior and subordinated tranches of a CDO are influenced by the correlations of expected defaults within the underlying collateral Please refer to CFA Institute’s Curriculum Reading 24, 7.3 Collateralized Debt Obligations Point Exposure to Default Correlations Leverage Exposure to Credit: Mezzanine and equity tranches offer high-risk high-return features similar to highly leveraged investing 7.4 Covered Bonds Covered bonds, another type of structural financial instruments, are bonds issued by financial institutions, usually banks that are backed by a segregated pool of assets named ‘cover pool’ Covered bonds provide duel protection for creditors because in the event of default, bondholders have recourse against organization as well as the covered pool assets Compared to corporate bonds or ABS, covered bonds are less risky and offer lower yields An investor can reduce portfolio risk by buying covered bonds issued by a bank and selling that bank’s corporate bonds Practice: Example 11, Reading 24, Curriculum ... conducting relative value analysis 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) 4.1.4)... usually quoted in price terms because of bonds’ equity-like behavior and sensitivity to spread changes Practice: Example 1, Reading 24, Curriculum Reading 24 Fixed Income Active Management: Credit... 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),