The risk profile of a credit portfolio, in absolute terms as well as relative to a benchmark index, is largely determined by the weighting of different risk classes. Of course, the allocation of capital to riskier asset classes not only increases risk, but also offers ample opportunities for outperformance.
From a top-down perspective there are various methods to split the corpo- rate bond universe in different risk classes. Here the three most popular approaches are introduced: dividing the universe by rating classes, by degrees of subordination or by the degree of cyclicality of the different industries.
4.2.1 Rating classes
While in a single name context ratings are often criticized for being lagging indicators of credit quality, classifying bonds by rating is one widely used method to reflect the behavior of different risk classes in credit markets.
Many market participants argue that spreads themselves and spread volatil- ities are more timely indicators of an issuer’s credit risk than ratings. They consequently prefer to split the universe in spread class buckets. The disad- vantage of this method is that it leads to relatively unstable compositions of the individual buckets and is less convenient, because the major index providers do not calculate indices based on spread classes. Since the differ- ent rating buckets constitute the corporate bond market as a whole, there is clearly a correlation between overall market fluctuations and the spread changes of the different rating subportfolios.
Figure 4.1 Structure of the tactical asset allocation
Source: Union Investment Tactical asset allocation
Spread class selection Sector allocation Credit curve positioning
Credit research Tactical asset allocation Strategic asset allocation
Investors require a premium for taking on credit risk. Not only does this premium, in other words the credit spread, have to increase with decreas- ing credit quality, but one also expects a higher sensitivity of spreads to changes of the fundamental environment for lower rated credits. As pointed out in Chapter 2, the assets of a company with a higher degree of leverage are nearer to the default threshold than those of a firm with a con- servative balance sheet structure. In terms of the structural model the short put option on the assets of the issuer moves nearer at-the-money with decreasing credit quality, causing the delta to rise. Hence, a falling value of the assets, for example, in periods of a deteriorating economic environment and consequently declining equity markets, leads to a larger change in the credit spread the lower the credit quality of the issuer is.
Figure 4.2 is representative for the characteristics of different risk classes compared to the corporate bond market as a whole, because it covers the boom of the late 1990s as well as the first recession of the new millennium in 2001. Both were reflected in equity markets, first by the technology bubble between 1997 and early 2000, then by the eventual correction of the excesses until the equity markets bottomed in March 2003. The chart shows that none of the rating buckets could decouple from the general trends in the credit market. However, BBB-rated corporate bonds tend to suffer more when credit spreads widen and to benefit particularly from a positive trend in the corporate bond market. AAA-rated bonds conversely have the lowest sensitivity to market fluctuations.
Figure 4.2 Sensitivity of different rating buckets to spread changes in the Merrill Lynch EMU corporate index in the period Dec. 1996–Feb. 2004
Source:Merrill Lynch and Union Investment AAA AA A
BBB
y= 2.16x – 7.56 R2= 0.96
y= 0.91x + 16.06 R2= 0.88 y= 0.40x + 18.03
R2= 0.63 y= 0.24x + 13.41
R2= 0.37 0
50 100 150 200 250 300
20 40 60 80 100 120 140
ML EMU corporate index – OAS
MLEMU corporate subindexby rating – OAS
Another point stands out from Figure 4.2. BBB-rated corporate bonds obviously have a very high correlation to fluctuations of credit spreads in general. Although they made up on average only 25 percent of the Euro investment grade market, the influence of lower rated bonds on market spreads is substantial. Higher quality bonds, on the other hand, exhibit lower correlations to market spread changes. One reason is that their impact on the market direction is less pronounced because they are less volatile. But the second reason is probably more important. Euro corporate bonds are typically valued against swaps, that is the spread versus govern- ment bonds consists of two components: the swap spread and the spread over swaps. As a consequence changes of swap spreads have an influence on the spread of a corporate bond versus duration-matched treasuries. The higher the credit quality and the lower the spread of an issuer, the higher is the fraction of the benchmark spread that is due to the swap spread.
4.2.2 Degrees of subordination
A second method to slice the corporate bond universe, especially the finan- cial sector, is by different degrees of subordination. Chapter 5 discusses the characteristics of different types of bank debt in detail. In summary, Tier 1 preferred, Upper Tier 2 and Lower Tier 2 differ from senior bank debt in two major dimensions: with respect to loss absorption and interest deferral
Figure 4.3 Spread history of different types of Euro bank debt
Source:J.P. Morgan Bank senior
Bank lower tier 2 Bank upper tier 2
Bank Tier 1
0 50 100 150 200 250
Jan. 01 Jul. 01 Jan. 02 Jul. 02 Jan. 03 Jul. 03 Jan. 04
ASW (bp)
features. Both Tier 1 and Upper Tier 2 capital are able to absorb losses. But while missed interest payments are canceled immediately for Tier 1 issues they are repaid at a later date for Upper Tier 2 bonds. On the other hand, Lower Tier 2 debt contains no loss absorption features.
As a consequence each of the mentioned types of bank capital represents its own risk class. Investors clearly have to be compensated to carry the addi- tional risks compared with senior bank bonds. Figure 4.3 shows that on aver- age the spread differentials between senior bonds and Lower Tier 2, Lower Tier 2 and Upper Tier 2, and Upper Tier 2 and Tier 1 tend to be roughly equal.
But one should note that spread volatility also increases significantly when moving to more subordinated types of bank debt. Again, this can be explained by the Merton model. Since Tier 1 and Upper Tier 2 bonds are designed to absorb losses before holders of senior bonds and Lower Tier 2 suffer a loss, the strike price of their embedded short put option is closer at- the-money than that of senior and Lower Tier 2 bonds. Hence, in absolute terms the delta of the short put is higher, causing larger changes of the value of the option and consequently spreads, when fundamentals change.
Besides fundamental developments the risk appetite of investors is a driver of the spread differentials between various risk classes. Risk appetite in general describes the willingness of market participants to invest in risky assets as opposed to risk-free assets. Clearly, risk appetite is an unobserv- able factor but there are various indicators that are designed to extract a measure for risk appetite or risk aversion from market data. More details on
Figure 4.4 Spread differential between senior and subordinated Euro insurance bonds versus risk appetite
Source:J.P. Morgan, CSFB, and Union Investment
Spread differential insurance subordinated versus
senior CSFB Global Risk
Appetite Index (rhs)
0 50 100 150 200 250
Jan. 01 Jul. 01 Jan. 02 Jul. 02 Jan. 03 Jul. 03 Jan. 04
ASW (bp)
–8
–6
–4
–2
0
2
4
6
Riskappetite
this subject are provided in Chapter 3. With respect to the performance of subordinated bonds versus senior bonds, there is an impact of risk appetite.
Figure 4.4 shows that spreads usually widen when risk appetite falls and tighten when risk appetite increases. From this chart there seems to be a lead–lag relationship between risk appetite and subsequent credit spread changes. If the leading character of risk appetite holds for the future it may provide valuable trading signals for subordinated financials.
4.2.3 Cyclical versus noncyclical sectors
Finally, while the subjects of industry analysis and the identification of rela- tive value between sectors are covered in more detail below, it should be noted that the sector allocation has a substantial influence on the risk profile of a corporate bond portfolio. Sectors differ not only with respect to the goods or services they produce, but also with respect to their sensitivity to the economic environment. Therefore, investors usually distinguish between cyclical and noncyclical sectors. In general, cyclical industries are those where the ability to generate revenues and cash flows is closely linked to the business cycle. Usually, this is due to the fact that the companies in those sectors produce goods or services for private consumption or that belong in the category of capital expenditures. Typical examples of cyclical sectors therefore are the automotive and the capital goods sector.
The breakdown of real GDP in its components highlights the importance of private consumption and investment for the state of the economy. In Q4 2003, personal consumption and investment accounted for 87 percent of US real GDP, that is, these components are major drivers of the economic cycle.
Although the National Bureau of Economic Research (NBER) that is responsible for dating recessions employs a variety of indicators to deter- mine the peak and trough of an economic cycle, recessions are usually char- acterized by declining private demand. Figure 4.5, however, illustrates that this was not true for the 2001 recession. The consumer held up very well, taking on even more debt and thus stretching his balance sheet to the limit.
Tax rebates and incentives like the zero percent financing in the automotive sector supported the high level of consumption additionally, so that the indebtedness of private households reached record highs while the savings rate plunged to extremely low levels by historical standards. This combina- tion explains not only the limited downturn of retail sales during the 2001 recession, but also the sluggish recovery compared to former recessions.
Although the consumer sector did surprisingly well, the spreads of cycli- cal sectors widened massively between the beginning of 2000 and October 2002. Apart from external shocks such as September 11, 2001, there are two economic explanations for this observation. First, the corporate sector increased its leverage dramatically between 1997 and 2001, for the benefit
of shareholders and at the cost of bondholders. The high level of leverage made companies vulnerable to economic downturns. Second, the recession that finally occurred in the United States was not typical in the sense that it was not driven by a lack of private demand, but it was rather driven by overinvestment, overcapacities in many industries and as a consequence there was a decline of business investment. The capital goods sector was directly affected by this development and credit spreads widened substan- tially. The automotive sector, conversely, suffered rather from speculations that the consumer might break away one day. Additionally, the incentive programs weakened profitability in the already fragile automotive sector further and funding gaps in the pension plans materialized following the burst of the equity bubble.
On the other hand, noncyclical sectors like banks and utilities performed reasonably well in 2001, as Figure 4.6 shows. The steepening yield curve helped banks to increase their interest margins and thus to offset the costs associated with the declining credit quality in the customer base. The utility sector again justified its safe haven status that is based on the utility companies’ strong ability to generate cash flows.
Figure 4.5 Retail sales around the 2001 recession in comparison to the previous six recessions
Source:National Bureau of Economic Research 0.95
1 1.05 1.1
May 00 Nov. 00 May 01 Nov. 01 May 02 Nov. 02 May 03
Retail sales (indexed, end ofrecession=1)
2001 recession
Previous 6 recessions (average)
4.3 SECTOR ALLOCATION