Corporate bonds are the second oldest and, for most asset managers, the most demanding and fascinating subset of the global debt capital markets. The label, “corporate,” understates the scope of this burgeoning asset class. As commonly traded and administered within the context of an overall debt portfolio, the “corporate asset class” actually encompasses much more than pure corporate entities. Instead of the title, “corporate asset class,” this segment of the global bond market really should be classified as the “credit asset class,” including any nonagency mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS), asset-backed securities (ABS). Sovereigns and government-controlled entities with foreign currency debt issues thought to have more credit risk than the national government should also be included. In keeping with conventional practice in the fixed-income market however, the application of the term “credit asset class” in this chapter will pertain only to corporate bonds, sovereigns, and government-controlled entities.

Credit portfolio management represents a major subset of the multi-asset global portfolio management process illustrated in Exhibit 3. After setting the currency allocation (in this case, dollars were selected for illustration convenience) and distribution among fixed-income asset classes, bond managers are still left with a lengthy list of questions to construct an optimal credit portfolio. Some examples are:

Economists have long debated the concept and measurement of “value.” But fixed-income practitioners, perhaps because of the daily pragmatism enforced by the markets, have developed a consensus about the definition of value. In the bond market, relative value refers to the ranking of fixed-income investments by sectors, structures, issuers, and issues in terms of their expected performance during some future period of time.

There are two basic approaches to global credit bond portfolio management—top-down approach and bottom-up approach. The top-down approach focuses on high-level allocations among broadly defined credit asset classes. The goal of top-down research is to form views on large-scale economic and industry developments. These views then drive asset allocation decisions (overweight certain sectors, underweight others). The bottom-up approach focuses on individual issuers and issues that will outperform their peer groups. Managers follow this approach hoping to outperform their benchmark due to superior security selection, while maintaining neutral weightings to the various sectors in the benchmark.

EXHIBIT 4 Credit Sector Portfolio Management Process: Classic, Dialectical Relative Value Analysis

The main methodologies for credit relative-value maximization are:

In the sections that follow, we discuss each of these methodologies.

The goal of global credit portfolio management for most investors is to optimize the risk-adjusted total return of their credit portfolio. The best place to start is naturally total return analysis. Accordingly, credit relative-value analysis begins with a detailed dissection of past returns and a projection of expected returns. For the entire asset class and major contributing sub-sectors (such as banks, utilities, pipelines, Baa/BBB’s, etc.), how have returns been formed? How much is attributed to credit spread movements, sharp changes in the fundamental fortunes of key issuers, and yield curve dynamics? If there are macro determinants of credit returns (the total return of the credit asset class), then credit markets may display regular patterns. For instance, the macroeconomic cycle is the major determinant of overall credit spreads. During recessions, the escalation of default risk widens spreads (which are risk premiums over underlying, presumably default-free, government securities (or swaps)) and reduces credit returns relative to Treasuries. Conversely, economic prosperity reduces bankruptcies and enhances overall credit fundamentals of most issuers. Economic prosperity usually leads to tighter credit spreads and boosts credit returns relative to Treasuries. For brief intervals, noncyclical technical factors can offset fundamentals. For example, the inversion of the U.S. Treasury yield curve in 2000 actually led to wider credit spreads and credit underperformance despite solid global economic growth and corporate profitability.

The analysis of primary markets centers on new issue supply and demand. Supply is often a misunderstood factor in tactical relative-value analysis. Prospective new supply induces many traders, analysts, and investors to advocate a defensive stance toward the overall corporate market as well as toward individual sectors and issuers. Yet the premise, “supply will hurt spreads,” which may apply to an individual issuer, does not generally hold up for the entire credit market. Credit spreads are determined by many factors; supply, although important, represents one of many determinants. During most years, increases in issuance (most notably during the first quarter of each year) are associated with market-spread contraction and strong relative returns for credit debt. In contrast, sharp supply declines are accompanied frequently by spread expansion and a major fall in both relative and absolute returns for credit securities. For example, this counter-intuitive effect was most noticeable during the August-October 1998 interval when new issuance nearly disappeared in the face of the substantial increase in credit spreads. (This period is referred to as the “Great Spread-Sector Crash.”)

Given their immediate focus on the deals of the day and week, portfolio managers often overlook short-term and long-term market-structure dynamics in making portfolio decisions. Because the pace of change in market structure is often gradual, market dynamics have less effect on short-term tactical investment decision-making than on long-term strategy.

Partially offsetting this proliferation of issuers since the mid-1990s, the global credit market has become structurally more homogeneous. Specifically, bullet and intermediate-maturity structures have come to dominate the credit market. A bullet maturity means that the issue is not callable, putable, or sinkable prior to its scheduled final maturity. The trend toward bullet securities does not pertain to the high-yield market, where callables remain the structure of choice. With the hope of credit-quality improvement, many high-yield issuers expect to refinance prior to maturity at lower rates.

Short-term and long-term liquidity needs influence portfolio management decisions. Citing lower expected liquidity, some investors are reluctant to purchase certain types of issues such as small-sized issues (less than $1.0 billion), private placements, MTNs, and non-local corporate issuers. Other investors gladly exchange a potential liquidity disadvantage for incremental yield. For investment-grade issuers, these liquidity concerns often are exaggerated.

Capital market expectations constantly change. Recessions may arrive sooner rather than later. The yield curve may steepen rather than flatten. The auto and paper cycles may be moving down from their peaks. Higher oil and natural gas prices may benefit the credit quality of the energy sector. An industrial may have announced a large debt-financed acquisition, earning an immediate ratings rebuke from the rating agencies. A major bank may plan to repurchase 15% of its outstanding common stock (great for shareholders but leading to higher financial leverage for debtholders). In response to such daily information flows, portfolio managers amend their holdings. To understand trading flows and the real dynamics of the credit market, investors should consider the most common rationales of whether to trade and not to trade.

There are dozens of rationales to execute secondary trades when pursuing portfolio optimization. Several of the most popular are discussed below. The framework for assessing secondary trades is the total return framework explained in Chapter 18.

Portfolio managers also should review their main rationales for not trading. Some of the best investment decisions are not to trade. Conversely, some of the worst investment decisions emanate from stale views based on dated and anachronistic constraints (e.g., avoid investing in bonds rated below Aa/AA). The best portfolio managers retain very open minds, constantly self-critiquing both their successful and unsuccessful methodologies.

By custom, some segments of the high-yield and emerging (EMG) debt markets still prefer to measure value by bond price or bond yield rather than spread. But for the rest of the global credit market, nominal spread (the yield difference between corporate and government bonds of similar maturities) has been the basic unit of both price and relative-value analysis for more than two centuries.

Many U.S. practitioners prefer to value investment-grade credit securities in terms of option-adjusted spreads (OAS) so they can be more easily compared to the volatility (“vol”) sectors (mortgage-backed securities and U.S. agencies).³¹⁶ But given the rapid reduction of credit structures with embedded options since 1990 (see structural discussion above), the use of OAS in primary and secondary pricing has diminished within the investment-grade credit asset class. Moreover, the standard one-factor binomial models³¹⁷ do not account for credit spread volatility. Given the exclusion of default risk in OAS option-valuation models, OAS valuation has seen only limited extension into the higher-risk markets of the quasi-equity, high-yield corporate, and EMG-debt asset classes.

Swap spreads became a popular valuation yardstick for credit debt in Europe during the 1990s. This practice was enhanced by the unique nature of the European credit asset class. Unlike its American counterpart, the European credit market has been consistently homogeneous. Most issuance was of high quality (rated Aa3/AA-and above) and intermediate maturity (10 years and less). Consequently, swap spreads are a good proxy for credit spreads in such a uniform market. Most issuers were financial institutions, natural swappers between fixed-rate and floating-rate obligations. And European credit investors, often residing in financial institutions like commercial banks, have been much more willing to use the swap methodology to capture value discrepancies between the fixed- and floating-rate markets.

Treasury yield of 6.43%. This equates to a yield-to-maturity of 7.56% (6.43% + 113 bp). On that date, 5-year swap spreads were 83 bp (to the 5-year U.S. Treasury). Recall that swaps are quoted where the fixed-rate payer pays the yield on a Treasury with a maturity equal to the initial term of the swap plus the swap spread. The fixed-rate payer receives LIBOR flat—that is, no increment over LIBOR. So, if the bond manager invests in the Ford Motor Credit issue and simultaneously enters into this 5-year swap, the following would result:

Thus, a bond manager could exchange this Ford Motor Credit bond’s fixed coupon flow for LIBOR + 30 bp. On the trade date, LIBOR was 6.24%, so that the asset swapper would earn 6.54% (= 6.24% + 30 bp) until the first reset date of the swap. A total return manager would want to take advantage of this swap by paying fixed and receiving floating if he expects interest rates to increase in the future.

Investors should also understand how best to evaluate spread levels in their decision-making. Spread valuation includes mean-reversion analysis, quality-spread analysis, and percent yield spread analysis.

As explained earlier in this chapter, there are bullet, callable, putable, and sinking fund structures. Structural analysis is simply analyzing the performance of the different structures discussed throughout this chapter. While evaluating bond structures was extremely important in the 1980s, it became less influential in credit bond market since the mid-1990s for several reasons. First, the European credit bond market almost exclusively features intermediate bullets. Second, as can be seen in Exhibit 5, the U.S. credit and the global bond markets have moved to embrace this structurally homogeneous European bullet standard. Plenty of structural diversity still resides within the U.S. high yield and EMG debt markets, but portfolio decisions in these speculative-grade sectors understandably hinge more on pure credit differentiation than the structural diversity of the issue-choice set.

EXHIBIT 5 Changing Composition of the U.S. Investment-Grade Credit Markets*

Source: Lehman Brothers U.S. Investment-Grade Credit Index

Here is a review of how different types of investors are using bullet structures with different maturities.

Typically after a 5-year or 10-year wait (longer for some rare issues), credit structures are callable at the option of the issuer at any time. Call prices usually are set at a premium above par (par + the initial coupon) and decline linearly on an annual basis to par by 5-10 years prior to final scheduled maturity. The ability to refinance debt in a potentially lower-interest rate environment is extremely valuable to issuers. Conversely, the risk of earlier-than-expected retirement of an above-current market coupon is bothersome to investors.

A sinking fund structure allows an issuer to execute a series of partial calls (annually or semiannually) prior to maturity. Issuers also usually have an option to retire an additional portion of the issue on the sinking fund date, typically ranging from 1 to 2 times the mandatory sinking fund obligation. Historically, especially during the early 1980s, total return investors favored the collection of sinking fund structures at sub-par prices. These discounted sinking funds retained price upside during interest rate rallies (provided the indicated bond price remained below par), and, given the issuers’ requirement to retire at least annually some portion of the issue at par, the price of these sinking fund structures did not fall as much compared to callables and bullets when interest rates rose. It should be noted that astute issuers with strong liability management skills can sometimes satisfy such annual sinking fund obligations in whole or in part through prior open market purchases at prices below par. Nonetheless, this annual sinking fund purchase obligation by issuers does limit bond price depreciation during periods of rising rates.

Conventional put structures are simpler than callables. Yet in trading circles, put bond valuations often are the subject of debate. American-option callables grant issuers the right to call an issue at any time at the designated call price after expiration of the non-callable or non-redemption period. Put bonds typically provide investors with a one-time, one-date put option (European option) to demand full repayment at par. Less frequently, put bonds include a second or third put option date. A very limited number of put issues afford investors the privilege to put such structures back to the issuers at par in the case of rating downgrades (typically to below investment-grade status).

The rapid growth of credit derivatives³¹⁹ since the mid-1990s has inspired a groundswell of academic and practitioner interest in the development of more rigorous techniques to analyze the term structure (1-100 years) and credit structure (Aaa/AAA through B2/B’s) of credit spread curves (higher risk higher-yield securities trade on a price rather than a spread basis).

In the continuous quest to seek credit upgrades and contraction in issuer/issue spread resulting from possible upgrades and, more importantly, to avoid credit downgrades resulting in an increase in issuer/issue spread, superior credit analysis has been and will remain the most important determinant of credit bond portfolio relative performance. Credit screening tools tied to equity valuations, relative spread movements, and the Internet (information available tracking all related news on portfolio holdings) can provide helpful supplements to classic credit research and rating agency opinions. But self-characterized credit models, relying exclusively on variables like interest-rate volatility and binomial processes imported from option-valuation techniques, are not especially helpful in ranking the expected credit performance of individual credits like IBM, British Gas, Texas Utilities, Pohang Iron & Steel, Sumitomo, and Brazil.

EXHIBIT 6 Illustration of Two Typical U.S. Investment-Grade Curves

Source: Lehman Brothers U.S. Investment-Grade Credit Index, based on average corporate curves 1990-2003

Sector rotation strategies have long played a key role in equity portfolio management. In the credit bond market, “macro” sector rotations among industrials, utilities, financial institutions, sovereigns, and supranationals also have a long history. During the last quarter of the 20th Century, there were major variations in investor sentiment toward these major credit sectors. Utilities endured market wariness about heavy supply and nuclear exposure in the early-to-mid 1980s. U.S. and European financial institutions coped with investor concern about asset quality in the late 1980s and early 1990s. Similar investor skittishness affected demand for Asian financial institution debt in the late 1990s. Industrials embodied severe “event risk” in the mid-to-late 1980s, recession vulnerability during 1990-1992, a return of event risk in the late 1990s amid a general boom in corporate mergers and acquisitions, and a devastating series of accounting and corporate governance blows during 2001-2002. Sovereigns were exposed to periodic market reservations about the implications of independence for Quebec, political risk for various countries (i.e., Russia), the effects of the “Asian Contagion” during 1997-1998, and outright defaults like Argentina (2001).

EXHIBIT 7 Some Outperformance Methodologies