INVESTING IN CORPORATE BONDS AND CREDIT RISK

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1 INVESTING IN CORPORATE BONDS AND CREDIT RISK

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3 Investing in Corporate Bonds and Credit Risk FRANK HAGENSTEIN, ALEXANDER MERTZ AND JAN SEIFERT

4 Frank Hagenstein, Alexander Mertz and Jan Seifert 2004 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act First published in 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin s Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN DOI / ISBN (ebook) This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Hagenstein, Frank Investing in corporate bonds and credit risk / Frank Hagenstein, Alexander Mertz, and Jan Seifert. p. cm. (Finance & capital market series) Includes bibliographical references and index. 1. Bonds. 2. Investments. 3. Credit Management. 4. Risk management. I. Mertz, Alexander, 1973 II. Seifert, Jan, 1971 III. Title. IV. Finance and capital markets series HG4651.H dc

5 Contents List of Tables List of Figures Preface Foreword viii xi xx xxi 1 Introduction Background Organization of the Book Setting for Credit Management 4 2 Investment Process Basic Structure of an Investment Process for Credit Portfolios Diversification of Ideas Quantitative Analyses 13 3 Strategic Asset Allocation Overview of the Top-down Research Process Macroeconomic Environment Valuation Market Technicals 63 v

6 vi CONTENTS 4 Tactical Asset Allocation Overview Spread Class Selection Sector Allocation Credit Curve Positioning 98 5 Credit Research Introduction The Bottom-up Approach for Industrial Companies Financial Institutions High-Yield Investing Introduction Description of the High-yield Market Drivers of the High-yield Market Crossover Credits/ Fallen Angels Risk Management in High Yield Relative Value Credit Derivatives Introduction Credit Default Swaps Collateralized Debt Obligations Credit Indices Index Selection Exchange Traded Funds The Role of Ratings Reducing Information Asymmetry Ratings and Credit Spreads The Perspective of Buy-and-hold Investors The Perspective of an Active Manager Ratings and Risk Management Portfolio Construction Introduction Statistical Properties of Bond Returns Portfolio Optimization with Skewness and Kurtosis Illiquidity and Portfolio Construction Out-of-sample Performance of Optimized Portfolios Long-term Characteristics of Corporate Bond Portfolios 285

7 CONTENTS vii 11 Total and Absolute Return Strategies with Credits Multicurrency Investing Asymmetric Risk Management for Corporate Bond Portfolios Risk Management Management of Systematic Risk in Credit Portfolios Reducing Nonsystematic Risk Through Diversification Modeling Default Risk in Credit Baskets 314 References 321 Index 329

8 List of Tables 2.1 Stylized balance sheet Factors of the Altman z-score model Structure of the markets for Euro and US Dollar denominated investment grade corporate bonds as of October 2003 (in percent) Selected industries and their main event risks Index characteristics of the Merrill Lynch EMU Corporate Index and the subsector automotive per Feb. 29, Alternative strategies to change the portfolio exposure to a certain sector Income statement according to US GAAP Balance sheet positions according to US GAAP Main working capital ratios Cash flow statement according to US GAAP A classification of cash in- and outflows from operating, investing and financing activities Cash flows from operating activities (direct method) Cash flows from operating activities (indirect method) Computation of free cash flow from operations using the indirect method Behavior of convertible bonds in different life cycles Correlation matrix among different asset classes (Dec. 97 Jan. 04) Qualitative and quantitative factors applied in the company selection process 148 viii

9 LIST OF TABLES ix 5.12 Major event risks for companies Average principal loss rate and recovery rate according to seniority as of Dec Risk-weighting scheme for banking book items Trading book capital requirements Banking book capital requirements Risks of bank capital to investors Notching methodology of the three major rating agencies for bank capital Comparison between the cost of common equity and the cost of Tier 1 preferred Definitions of Moody s corporate bond ratings Monthly total return correlation between various asset classes Jul Dec Correlation of monthly returns of corporate bonds by rating classes Corporate average rating transition matrix in percent, Rating transitions for high-yield corporates The change in bond prices over a 12-month horizon Cumulative average default rates Recovery rates by security and priority in Europe and the United States (in percent) ( ) Distribution of years to default from original issue date 1989 Sep bonds from companies which were downgraded from investment grade into high yield by either Moody s or S&P during Analysis approach for Fallen Angels and other troubled credits Categories of troubled companies (December 2003) Average ratings for selected US high-yield industries in Feb Criteria for the selection of benchmark indices Cumulative default probabilities of corporate bonds for the period Recovery rates for defaulted US corporate bonds for the period One-year rating migration probabilities for US investment grade corporate bonds Example for the calculation of expected excess return for a 1-year investment horizon Descriptive statistics of Merrill Lynch US bond indices during the sample period Jan Sep

10 x LIST OF TABLES 10.2 Composition of MRPs, TPs and ERPs based on the mean variance (MV), shortfall risk (LPM) and Corning Fisher (CF) framework for the sample period Jan Sep Risk/return characteristics of MRPs, TPs and ERPs based on the mean variance (MV), shortfall risk (LPM) and Corning Fisher (CF) framework for the sample period January 1987 to September Composition of MRPs, TPs and ERPs based on the mean variance (MV), shortfall risk (LPM) and Corning Fisher (CF) framework for the sample period Jan Sep after adjustment for serial correlation in index returns Risk/return characteristics of MRPs, TPs and ERPs based on the mean variance (MV), shortfall risk (LPM) and Corning Fisher (CF) framework for the sample period Jan Sep after adjustment for serial correlation in index returns Second-order stochastic dominance efficient sets for the out-of-sample performance of optimized portfolios Maximum position limits for corporate bonds with an implied investment grade rating in an absolute return portfolio with a maximum drawdown of 0.5 percent Examples for the calculation of the Herfindahl Index 302

11 List of Figures 2.1 Structured investment process for the management of credit portfolios Evans Archer diagram of risk versus diversification Skill required to achieve a certain information ratio depends on the frequency of the implementation of independent trades A given information ratio is achieved by various combinations of skill and breadth Pay-off patterns for debt- and equity holders at maturity of the liabilities Projected and realized asset value in the Merton model Cumulative default probability assuming a hazard rate of 4 percent Option of the management to alter the capital structure Structure of the research process of the strategic asset allocation Moody s Baa corporate bond spread versus long-term treasury bonds Dependency of US big three automotive manufacturer s rating from the business cycle Moody s Baa corporate bond spread versus Fed Funds Target Rate Moody s Baa corporate bond spread and index of help wanted advertising Equity-based metrics of leverage Level of indebtedness of the US nonfinancial corporate sector 34 xi

12 xii LIST OF FIGURES 3.8 Ratio of credit market instruments to internal funds for the US nonfinancial corporate sector Ratio of credit market instruments to pre-tax profits of the US nonfinancial corporate sector Percentage points of capital expenditures of the US nonfinancial corporate sector that are not covered by internal funds versus Baa corporate spread over treasuries Ratio of net interest payments to cash flow for the US nonfinancial corporate sector Ratio of profits before tax and interest of the US nonfinancial corporate sector to net interest payments versus Baa/Aa yield ratio US total industry capacity utilization versus Moody s Baa corporate spread over treasuries Annual change in US industrial production versus Moody s Baa corporate spread over treasuries Stylized leverage cycle and performance in credit and equity markets Baa corporate spread over treasuries versus trailing 12-month default rates Moody s ratings drift ([upgrades downgrades]/number of rated issuers) versus Moody s Baa corporate spread over treasuries Ratio of working capital to total assets for the US nonfinancial corporate sector Undistributed profits, earnings before tax and interest and internal funds versus total assets for the US nonfinancial corporate sector Market value of equity outstanding to total credit market instruments of the US nonfinancial corporate sector Nominal GDP of the US nonfinancial corporate sector to total assets Moody s Baa corporate bond spread versus Altman s z-score Moody s Baa corporate bond spread versus two fundamental models based on Altman s five indicators for the health of the corporate sector Euro corporate bond spreads versus equity-market performance Three-year rolling equity-market returns versus Baa corporate spread versus treasuries Euro corporate bond spreads versus Dow Jones Euro Stoxx 50 implied volatility of at-the-money call options 56

13 LIST OF FIGURES xiii 3.27 Moody s Baa Aa spread differential versus implied equity volatility for the S&P Ex ante equity risk premium for the US stock market and Moody s Baa corporate spreads versus treasuries Baa corporate bond spreads and CSFB global risk appetite index Spread versus government bonds for Euro and US$ investment grade corporate bonds Volume of announced mergers, acquisitions or divestitures involving either a European respectively US target or acquirer Net issuance of the US nonfinancial corporate sector Rolling 12-month net foreign purchases of US financial assets Net new sales and liquid assets ratio of US investment grade corporate bond funds Structure of the tactical asset allocation Sensitivity of different rating buckets to spread changes in the Merrill Lynch EMU corporate index in the period Dec Feb Spread history of different types of Euro bank debt Spread differential between senior and subordinated Euro insurance bonds versus risk appetite Retail sales around the 2001 recession in comparison to the last six recessions Spread history of different industry sectors of the Euro corporate bond market Structure of the industry analysis Life cycle of an industry Forces diagram Total and domestic corporate profits as a percentage of GDP US corporate bond spreads and corporate profits as a percentage of GDP Profit cycle of various industries Stylized profit cycle Profit cycle since the recession March until November Change in profits in recession and recovery for selected industries Global industries value chain Value chains for telecommunications wireless and electric utilities Value chain for the automobile sector 89

14 xiv LIST OF FIGURES 4.19 Amount of issuers on negative credit watch and US BBB corporate bond spread in basis points Relative value chart, spread volatility on x-axis and spreads on y-axis for different sectors Spread volatility and spread level for the European investment grade market The behavior of the treasury yield curve in the business cycle Slope of the 2s10s credit curve for A-rated US industrials versus spread levels in the period Jan until Nov Slope of the credit curve for A-rated US industrials versus slope of the yield curve during the early stages of the economic expansion after the 1990/91 recession Slope of the credit curve for A-rated US industrials versus slope of the yield curve during the 2001 recession France Telecom CDS spot and forward curves in 1-year on Mar. 17, Bottom-up approach for industrial companies Dimensions of corporate credit risk Major financial ratios Leverage and spread levels for selected European investment grade bonds (Merrill Lynch EMU Corporate Index ex financials) on February 13th Financing hierarchy Change in weighted average cost of capital with an increasing leverage The different life cycles of a plain convertible bond VNU 5-yr CDS versus stock price, Mar. 18, 2002 Sep. 04, Convertibles are a valuable asset class compared to stocks or bonds (Dec. 97 Jan 04) Convertibles in the Markowitz-framework Scenario analysis for a selected convertible bond issue SWOT analysis Multifactor Portfolio Matrix each quadrant represents a business unit Business strategy Ford equity price and bond spreads between Oct and Jan Ford bond spreads and Ford implied equity volatility between Oct and Feb Ahold bonds and equity reacted sharply to the announcement of accounting fraud Relationship between Worldcom stock and bonds 148

15 LIST OF FIGURES xv 5.19 Selected Euro telecom bonds with 1 10 year maturity on Feb. 11, Selected Euro automobile bonds with 1 10 year maturity on February 11, Deutsche telekom cash bonds and CDS on Feb. 11, Ford motor credit cash bonds and CDS on Feb. 11th Single corporate bonds versus sectors and market index Monthly spread change for selected Euro automobile bonds (February 2004) Contractual and Structural subordination of high-yield bonds Coupon step-up Regulatory capital of a bank according to the Basel Capital Accord Asset swap spreads of Euro Tier 1 issues as of Jan Asset swap spreads of Euro Lower Tier 2 issues as of Jan Risk-reward profile of different types of bank capital as of Dec Asset swap spreads of Euro denominated bank issues Spread differentials between different types of Euro denominated subordinated bank issues High-yield bonds as a percentage of outstanding corporate bonds by principal amount High-yield spread classes 02/99 02/ Investment grade and high-yield average path to default, Aug Relationship between GDP growth and US high-yield spreads Jun. 85 Sep Default rate peaks between 1920 and Default rates cycle by issuers and the amount outstanding Correlation between high-yield spreads and Moody s default rate Jan Jan Average 1-year credit loss rates (in percent) New issuance being used to refinance 1986 Nov (in percent) Distress ratio 1992 Feb Moody s default rate and the distress ratio (in percent) Correlation between US capacity utilization and high-yield spreads Jan Jan

16 xvi LIST OF FIGURES 6.13 Relationship between IP and default rates Relationship between high-yield spreads and ISM index Correlation between high-yield spreads and the tightening standards for commercial and industrial loans Relationship between high-yield spreads and the demand for Commercial and Industrial Loans Relationship between equity (here: S&P 500) and high-yield markets Dec. 96 Nov Correlation between high-yield spreads and equity market volatility Jan Dec Relationship between mutual fund flows and high-yield spreads Relationship between mutual fund flows and high-yield total returns High-yield mutual fund liquidity ratio Jan Oct Coverage (EBITDA/Interest) and spread levels for selected high-yield companies (Merrill Lynch BBs and Bs in Euro and US$, Nov. 2003) Leverage (Total Debt/EBITDA) and spread levels for selected high-yield companies (Merrill Lynch BBs and Bs in Euro and US$, Nov. 2003) Leverage (Total Debt/(Total Debt MarketCap) and spread levels for selected high-yield companies (Merrill Lynch BBs and Bs in Euro and US$, Nov. 2003) Correlation between treasury returns and high-yield market returns Average spread for selected companies 200 days before and after being downgraded to high yield by either Moody s or S&P during , The vertical line marks day Disciplined stop loss marks for a high-yield Portfolio, in percent The evolution of bond prices for Ericsson, Tyco and ABB during phases of distress Parmalat bond prices Sep. 03 Dec Spread differential between investment grade and high-yield indices in Euro and US$ Apr Nov Spread differential between BBB and BB spread in Euro Mar Nov Spread diferential between BBs and B, US issuers Relative value of CCC-C rated bonds Spread differential between US and Euro high-yield markets Dec. 97 Nov

17 LIST OF FIGURES xvii 6.35 Value of $100 invested in high yield and S&P 500 Jan Dec Two-year rolling volatilities of returns for high yield and equities, Jan Dec Yields in high-yield market to BBBs and the 10-year Treasury Jan. 88 Dec A typical credit default swap Physical settlement (credit event) CDS isolates the credit risk component Deutsche Telecom CDS basis CDS spread is highly correlated to implied equity volatility Spread trade: Vodafone CDS versus France Telecom CDS Munich Re senior versus subordinated CDS spreads CDS basis for PHILIPS ELECTRONICS Widening in the Fiat basis because of convertible bond issuance (hedging) Funded cash flow CDO BB/BBB-Leveraged loan spreads CDO Capital structure Synthetic CDO Static versus managed CDO BBB CDO note versus a BBB-corporate bond fund over 5 years Inflection point of a AAA-note (annualized 5-year cumulative credit loss rates), around 10 the historical multiple loss Inflection point of a BBB-note (annualized 5-year cumulative credit loss rates), around 4.5 times the historical multiple loss Inflection points assuming different recovery rates (5-year cumulative default rates) for AAA-notes Inflection points assuming different recovery rates (5-year cumulative default rates) for BBB-notes Expected loss of a mezzanine class (equity 4 percent) in relation to the size Risk leverage as a function of subordination compared to the portfolio expected loss Different annualized default risk measurements Default rates of speculative issuers regressed to their recovery rates Breakeven point of an equity-note (annualized 5-year cumulative credit loss rates), 2.5 the historical multiple loss 248

18 xviii LIST OF FIGURES 9.1 Reaction of Fiat bond and stock prices on rating actions Spread dispersion of Euro investment grade corporate bonds by rating class as of February 27th, Spread history of Ford and Renault issues with similar characteristics Spreads required to compensate investors for taking on default risk under the assumption that future default probabilities and recovery rates equal historical ones Spread history of US corporate bonds by rating class Portfolio optimization objectives Efficient frontier with minimum risk portfolio (MRP), tangency portfolio (TP) and equal risk portfolio (ERP) Return distributions and cumulative return distributions of two investment alternatives F and G Effect of desmoothing (serial correlation adjustment) of index time series on the risk/return profiles of the considered asset classes Resampled efficient frontiers. Light grey lines show the expected risk-return profile of the optimized portfolios, thin lines the actual risk-return profiles under the assumption that in the out-of-sample period the true means, variances and correlations are realized Membership in the second-order stochastic dominance efficient set under the assumption of autocorrelated returns Option adjusted spreads (OAS) of Ford bonds with identical maturity and similar coupon, but in differing currencies Changes in option adjusted spreads for GE bonds with similar maturity and identical coupon, but in differing currencies Classification of investment styles Spread changes of the constituents of the Merrill Lynch EMU Corporate Index as of Dec. 31, 2001 over the course of the year Agency ratings and implied ratings as alternative indicators of credit risk US corporate bond spreads during the Russia/LTCM crisis Expected tracking error of equally weighted Euro corporate bond portfolios versus Merrill Lynch EMU Corporate Index Realized tracking error of equally weighted Euro corporate bond portfolios versus Merrill Lynch EMU Corporate Index Expected tracking error of ex ante optimal Euro corporate bond portfolios versus Merrill Lynch EMU Corporate Index Realized tracking error of ex ante optimal Euro corporate bond portfolios versus Merrill Lynch EMU Corporate Index 313

19 LIST OF FIGURES xix 12.5 Schematic stop loss approach for investment grade corporate bonds Default distribution for a portfolio of 100 issuers with a default probability of 10 percent and pairwise default correlations of 1 percent Default distribution for a portfolio of 100 issuers with a default probability of 10 percent and pairwise default correlations of 4 percent Default distribution for a portfolio of 100 issuers with a default probability of 10 percent and pairwise default correlations of 8 percent 317

20 Preface This book covers various topics related to credit risks. The last couple of years was driven by a volatile and changing world of corporate bonds. Strategic asset allocation for corporate bonds in general and the use of quantitative techniques (in particular) has become more and more important. Therefore credit managers have to use structured credit products and derivatives for positioning and hedging. Looking forward the challenge for being successful in managing credit portfolios will be a split between top-down and bottom-up analysis. A permanent overlay of risk management tools is needed for generating an attractive risk-adjusted performance. Special thanks are due to Viktor Hjort (Credit Strategist from Morgan Stanley) for his input in Chapter 7. Thanks are also due to colleagues at Union Investment: Anja Mikus (MD of Fixed Income Portfolio Management) and Martin Marinov (Macro Strategist) for their helpful comments in Chapter 3 and Peter Varga (Credit Fund Manager) for his input on convertibles in Chapter 5. We gratefully acknowledge significant support by Thomas Bossert (MD of institutional portfolio management) who provided us with the description of an asymmetric risk management for corporate bond portfolios in Chapter 11. Finally we are very grateful to Matt King (Head of European Quantitative Credit Strategy) from Citigroup for the foreword and his careful pre-reading of various chapters. xx

21 Foreword Investing successfully in credit represents a considerable challenge. Over the past few years, the asset class has grown enormously. So too has the range of derivative instruments and modelling techniques which ought to aid portfolio management. Yet coping with the day-to-day realities of portfolio management the fear that another undetected accounting scandal might undermine a whole year s returns, the difficulty of making up for losses with gains elsewhere, the illiquidity of the asset class remains as difficult as ever. Somehow much of the literature on credit portfolio management remains too academic to be easily applicable in practice. In this book, Hagenstein, Mertz and Seifert steer a careful path between the best of theory and practice. Drawing upon years of buy-side experience of running corporate bond portfolios in both high grade and high yield, and illustrating with numerous examples, they provide a practical guide to successful portfolio management in cash, and to the workings of the myriad of derivative instruments (single name and tranched) now widespread in the market. I have personally not seen any single volume elsewhere which provides such a comprehensive guide to successful investing in credit. Matt King Director, Head of European Quantitative Credit Strategy Citigroup Global Markets Limited xxi