Investing in Corporate Bonds and Credit Risk

355 Pages·2004·2.83 MB·English

by  Frank Hagenstein, Alexander Mertz, Jan Seifert (auth.)

Investing in Corporate
Bonds and Credit Risk
Frank Hagenstein, Alexander Mertz
and Jan Seifert
INVESTING IN CORPORATE BONDS
AND CREDIT RISK
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Investing in
Corporate Bonds
and Credit Risk
FRANK HAGENSTEIN,
ALEXANDER MERTZ AND JAN SEIFERT
© Frank Hagenstein,Alexander Mertz and Jan Seifert 2004
Softcover reprint of the hardcover 1st edition 2004 978-1-4039-3469-7
All rights reserved.No reproduction,copy or transmission of this
publication may be made without written permission.
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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
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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 1988.
First published in 2004 by
PALGRAVE MACMILLAN
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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 978-1-349-51730-5 ISBN 978-0-230-52329-6 (eBook)
DOI 10.1057/9780230523296
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.H23 2004
332.63(cid:2)234—dc22 2004048937
10 9 8 7 6 5 4 3 2 1
13 12 11 10 09 08 07 06 05 04
Contents
List of Tables viii
List of Figures xi
Preface xx
Foreword xxi
1 Introduction 1
1.1 Background 1
1.2 Organization of the Book 2
1.3 Setting for Credit Management 4
2 Investment Process 6
2.1 Basic Structure of an Investment Process for
Credit Portfolios 6
2.2 Diversification of Ideas 9
2.3 Quantitative Analyses 13
3 Strategic Asset Allocation 23
3.1 Overview of the Top-down Research Process 23
3.2 Macroeconomic Environment 25
3.3 Valuation 46
3.4 Market Technicals 63
v
vi CONTENTS
4 Tactical Asset Allocation 69
4.1 Overview 69
4.2 Spread Class Selection 70
4.3 Sector Allocation 76
4.4 Credit Curve Positioning 98
5 Credit Research 109
5.1 Introduction 109
5.2 The Bottom-up Approach for Industrial Companies 109
5.3 Financial Institutions 163
6 High-Yield Investing 181
6.1 Introduction 181
6.2 Description of the High-yield Market 182
6.3 Drivers of the High-yield Market 190
6.4 Crossover Credits/ Fallen Angels 213
6.5 Risk Management in High Yield 217
6.6 Relative Value 221
7 Credit Derivatives 229
7.1 Introduction 229
7.2 Credit Default Swaps 229
7.3 Collateralized Debt Obligations 237
8 Credit Indices 249
8.1 Index Selection 249
8.2 Exchange Traded Funds 253
9 The Role of Ratings 257
9.1 Reducing Information Asymmetry 257
9.2 Ratings and Credit Spreads 260
9.3 The Perspective of Buy-and-hold Investors 262
9.4 The Perspective of an Active Manager 266
9.5 Ratings and Risk Management 268
10 Portfolio Construction 269
10.1 Introduction 269
10.2 Statistical Properties of Bond Returns 272
10.3 Portfolio Optimization with Skewness and Kurtosis 273
10.4 Illiquidity and Portfolio Construction 278
10.5 Out-of-sample Performance of Optimized Portfolios 281
10.6 Long-term Characteristics of Corporate Bond
Portfolios 285
CONTENTS vii
11 Total and Absolute Return Strategies with Credits 288
11.1 Multicurrency Investing 288
11.2 Asymmetric Risk Management for Corporate
Bond Portfolios 292
12 Risk Management 307
12.1 Management of Systematic Risk in Credit Portfolios 307
12.2 Reducing Nonsystematic Risk Through
Diversification 310
12.3 Modeling Default Risk in Credit Baskets 314
References 321
Index 329
List of Tables
2.1 Stylized balance sheet 14
3.1 Factors of the Altman z-score model 47
3.2 Structure of the markets for Euro and US Dollar denominated
investment grade corporate bonds as of October 2003
(in percent) 64
4.1 Selected industries and their main event risks 94
4.2 Index characteristics of the Merrill Lynch EMU Corporate
Index and the subsector automotive per Feb. 29, 2004 106
4.3 Alternative strategies to change the portfolio exposure to a
certain sector 107
5.1 Income statement according to US–GAAP 113
5.2 Balance sheet positions according to US–GAAP 115
5.3 Main working capital ratios 115
5.4 Cash flow statement according to US–GAAP 118
5.5 A classification of cash in- and outflows from operating,
investing and financing activities 118
5.6 Cash flows from operating activities (direct method) 120
5.7 Cash flows from operating activities (indirect method) 120
5.8 Computation of free cash flow from operations using the
indirect method 121
5.9 Behavior of convertible bonds in different life cycles 135
5.10 Correlation matrix among different asset classes
(Dec. 97– Jan. 04) 136
5.11 Qualitative and quantitative factors applied in the company
selection process 148
viii
LIST OF TABLES ix
5.12 Major event risks for companies 156
5.13 Average principal loss rate and recovery rate according to
seniority as of Dec. 2003 158
5.14 Risk-weighting scheme for banking book items 166
5.15 Trading book capital requirements 167
5.16 Banking book capital requirements 167
5.17 Risks of bank capital to investors 170
5.18 Notching methodology of the three major rating agencies
for bank capital 170
5.19 Comparison between the cost of common equity and the
cost of Tier 1 preferred 178
6.1 Definitions of Moody’s corporate bond ratings 183
6.2 Monthly total return correlation between various asset
classes Jul. 83–1 Dec. 2003 186
6.3 Correlation of monthly returns of corporate bonds by
rating classes 1989–2003 187
6.4 Corporate average rating transition matrix in percent,
1985–2002 187
6.5 Rating transitions for high-yield corporates 1997–2003 188
6.6 The change in bond prices over a 12-month horizon 190
6.7 Cumulative average default rates 1983–2002 194
6.8 Recovery rates by security and priority in Europe and the
United States (in percent) (1982–2002) 196
6.9 Distribution of years to default from original issue date
1989–Sep. 2003 199
6.10 15 bonds from companies which were downgraded from
investment grade into high yield by either Moody’s or S&P
during 2002–2003 215
6.11 Analysis approach for “Fallen Angels” and other troubled credits 216
6.12 Categories of troubled companies (December 2003) 218
6.13 Average ratings for selected US high-yield industries in
Feb. 2004 226
8.1 Criteria for the selection of benchmark indices 251
9.1 Cumulative default probabilities of corporate bonds for
the period 1970–2002 263
9.2 Recovery rates for defaulted US corporate bonds for the
period 1982–2002 263
9.3 One-year rating migration probabilities for US investment
grade corporate bonds 266
9.4 Example for the calculation of expected excess return for
a 1-year investment horizon 267
10.1 Descriptive statistics of Merrill Lynch US bond indices
during the sample period Jan. 1987–Sep. 2003 272