Managing Credit Risk in Corporate Bond Portfolios : A Practitioner
New Technology for Managing Credit Risk
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Transcript of New Technology for Managing Credit Risk
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1© 2003 Barra, Inc. All rights reserved.
JEAN-MARTIN AUSSANTDIRECTOR
FIXED INCOME PRODUCT STRATEGY
PRMIALONDON
18 MAY 2004
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2© 2003 Barra, Inc. All rights reserved.
Recent market environment
New market-implied techniques to manage credit risk
Introduction to the BDP (Barra Default Probability)
Practical Examples
Questions and answers (assuming I have the answers)
Discussion OutlineDiscussion Outline
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3© 2003 Barra, Inc. All rights reserved.
Recent market environment
New market-implied techniques to manage credit risk
Introduction to the BDP (Barra Default Probability)
Practical Examples
Questions and answers
Discussion OutlineDiscussion Outline
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4© 2003 Barra, Inc. All rights reserved.
Equity declines drove re-allocations to fixed income
Simultaneously government yieldsdecreased to all time lows
Credit default rates neared all time highs
Pension fund shortfalls (Focus on ALM)
Credit markets are increasingly complex
Universe of assets is expanding rapidly
Spread products are becoming more complicated
Limited headcount to cover expandingnumber of issues
Market Forces Change the Rules of Credit InvestingMarket Forces Change the Rules of Credit Investing
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Currently Very Few Easy OpportunitiesCurrently Very Few Easy Opportunities
End of the bear credit market in 2003
Spreads have tightened to extreme levels
Lowest since 1998
Demand still high
Non-traditional investors
Source: S&P
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6© 2003 Barra, Inc. All rights reserved.
Outperformance Is More Demanding Than Ever Outperformance Is More Demanding Than Ever
Are we being correctly compensated? Risk premium close to zero
How does a long-only investor win/outperform? Spreads have nowhere to go
Move to Lower-quality / higher-yielding Find names with value still
Asset selection is key
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7© 2003 Barra, Inc. All rights reserved.
One Default Can Negate Entire Portfolio’s ReturnOne Default Can Negate Entire Portfolio’s Return
Credit market is strongly asymmetric
Earning the spread has become extremely difficult over the past few years
Unprecedented market conditions with record downgrades and defaults Source: Lehman Brothers, 2002
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8© 2003 Barra, Inc. All rights reserved.
Fundamental Analysis Alone Is Not EnoughFundamental Analysis Alone Is Not Enough
Judgment of experienced analysts remains essential
However, judgment often impaired by questionable data
Nearly 1000 accounting re-statementsin the last three years (source: SEC)
Creative accounting
What’s required is a more efficient process to monitor, screen, and select credit-risky investments
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Gaining the Advantage in Credit InvestingGaining the Advantage in Credit Investing
To successfully manage credit, you need
Earlier, more accurate prediction of potential default risk
Models that allow for the real-world uncertainty of financial statements
Tools to make your credit analysis process more efficient
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10© 2003 Barra, Inc. All rights reserved.
Recent market environment
New market-implied techniques to manage credit risk
Introduction to the BDP (Barra Default Probability)
Practical Examples
Questions and answers
Discussion OutlineDiscussion Outline
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11© 2003 Barra, Inc. All rights reserved.
Market-Implied Measures Provide Additional InsightMarket-Implied Measures Provide Additional Insight
Market-implied measures from the:
Equity Market – Barra Default Probabilities (BDP)
Bond Market – Barra Implied Ratings (BIR)
Derivatives Market – Credit Default Swaps (CDS)
Coming soon…
Crossover – Empirical Credit Risk (ECR)Equity Risk Implied Spreads (ERIS)
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Equity Market – BDPs Go Beyond Traditional ModelsEquity Market – BDPs Go Beyond Traditional Models
BDP advantages
Incomplete Information framework assumes fundamental data may be flawed
Use of Barra’s industry standard equity volatility forecast
Empirical study of
historical leverage
Barra’s model signals significant uptrend in default risk months earlier
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Bond Market – BIRs Lead Agency RatingsBond Market – BIRs Lead Agency Ratings
Barra Implied Ratings take the bond market’s perspective on credit and match it to a best fit distribution ofactual ratings
Barra ImpliedRatings typicallycan lead agency ratings by as much as three months
Barra’s measures provide earlier warning to possible downgrade
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Derivatives Market – CDS Market a Leading IndicatorDerivatives Market – CDS Market a Leading Indicator
Credit Default Swap (CDS) rates often provide leading indication of risk and value
CDS market is exploding: more than $4 trillion notional outstanding andmost big names actively traded(source: BBA)
-80
-60
-40
-20
0
20
40
60
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2-Jan-02 13-Mar-02 23-May-02 1-Aug-02 17-Oct-02 6-Jan-03 20-Mar-03 2-Jun-03 11-Aug-03 22-Oct-03
Time
Sp
read
(b
p)
Cash-CDS basis 5 Year CDS rate 5 Year CM Asset Swap Spread
Cash-CDS Basis HistoryMerrill Lynch (5 Year USD)
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15© 2003 Barra, Inc. All rights reserved.
Recent market environment
New market-implied techniques to manage credit risk
Introduction to the BDP (Barra Default Probability)
Practical Examples
Questions and answers
Discussion OutlineDiscussion Outline
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16© 2003 Barra, Inc. All rights reserved.
Current Quantitative Default ModelsCurrent Quantitative Default Models
Structural or Cause-and-Effect approach (Merton)
Default happens for a reason
Firm-specific information canbe used advantageously
Reduced form approach
Default rates can be analysed statistically
Ad hoc, exogenously-given, default rate
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Merton’s Structural Model of DefaultMerton’s Structural Model of Default
Default occurs at debt maturity if the firm valueis below the liabilities value
We thus need
A model of firm value process
Estimate of default point
Merton identified equity as being long a call option on the firm value
Merton identified a bond as being short a put option on the firm value
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Payoff at maturity of the bond
Value of the Equity at maturity time T
Value of the Bond at maturity time T
i.e. default free bond + short European put on V @ K
Merton’s Structural Model of DefaultMerton’s Structural Model of Default
i.e. European call on V @ K
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Merton’s Structural Model of DefaultMerton’s Structural Model of Default
0
D
V0
No Default
Probability of Default
Default
T
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Reduced Form ModelsReduced Form Models
Assume that default is totally unpredictable
Default comes unannounced
Based on a conditional default rate or intensity
Exogenously given
Fit well to market data including short credit spreads
Ad hoc, lack intuitive appeal
The picture: ?
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Model ComparisonModel Comparison
Based on a model definition of default
Intuitive, appealing
The default time is often (implicitly) predictable
Hard to fit to empirical data
Based on an exogenously given default rate
Ad hoc
The default time is always totally unpredictable
Easy to fit to empirical data
Structural / Cause and Effect
What we want: a hybrid model
Incorporate the best features of structural and reduced form
Avoid their pitfalls
Reduced Form
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22© 2003 Barra, Inc. All rights reserved.
The Barra Default Probability (BDP) ModelThe Barra Default Probability (BDP) Model
A genuine hybrid of cause-and-effect (structural) and reduced-form models (compensator approach)
Based on a default time that is not predictable
Makes use of all publicly available liabilitystatements and equity market data
Assumes investors have incomplete information
Calibrates easily to short credit spreads
Intuitive and appealing
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Barra Default Probability Model – IntuitionBarra Default Probability Model – Intuition
0
V0
T
Distribution of possible default boundary levels
Paths of Asset Value Process
Expected level of default barrier
Width represents ‘uncertainty’ in the default barrier level
Time
Ass
et V
alu
e
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Default Barrier – Scaled Beta DistributionDefault Barrier – Scaled Beta Distribution
Mean = current debt
Standard deviation, calibrated or user-configured
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BDP Model – Uncertainty Can Be VariedBDP Model – Uncertainty Can Be Varied
IBM One Year Default Probabilities
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
4/19/2001 9/16/2001 2/13/2002 7/13/2002 12/10/2002 5/9/2003
Pe
rce
nt
Barra Default Probability Model
Variant 1
Variant 2
Variant 3
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BDP Model – A Firm Becomes DistressedBDP Model – A Firm Becomes Distressed
United Airlines Term Structures of Credit Spreads
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350
400
0 0.2 0.4 0.6 0.8 1 1.2
Maturity (years)
Ba
sis
Po
ints 9/17/2001
9/10/2001
Credit term structure steepens and short-term spreads increase
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BDP Model Subtlety – Healthy FirmBDP Model Subtlety – Healthy Firm
General Electric Term Structures of Spreads
0
5
10
15
20
25
30
0 0.2 0.4 0.6 0.8 1 1.2
Maturity (years)
Sp
rea
d (
ba
sis
po
ints
)
4/15/2002
4/10/2002
15% drop in equityCredit term structure steepens but short-term spreads barely move
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28© 2003 Barra, Inc. All rights reserved.
MODEL FORECAST
Event (+)
Non-Event (-)
REAL WORLDEvent Non-Event
True Positive False Positive
False Negative True Negative
Testing the Model – ROC CurvesTesting the Model – ROC Curves
Radar Operators in WWII: Plane (or flock of birds)?
Medical Diagnosis: Is this person’s Thyroid OK?
Astronomy: Is this a Planet?
Marketing Analysis: Will this household buy insurance?
Credit Risk: Will this name default?
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ROC Curves – Merton ComparisonROC Curves – Merton Comparison
ROC Curves for 1999-2002
0.00.10.20.30.40.50.60.70.80.91.0
0.0 0.2 0.4 0.6 0.8 1.0
False positives
Tru
e p
os
itiv
es
Merton
BDP
Random Method
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ROC Curves – First Passage ComparisonROC Curves – First Passage Comparison
ROC Curves for 1999-2002
0.00.10.20.30.40.50.60.70.80.91.0
0.0 0.2 0.4 0.6 0.8 1.0
False positives
Tru
e p
os
itiv
es First Pass
BDP
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ROC Curves – Moody’s Rating ComparisonROC Curves – Moody’s Rating Comparison
ROC Curves for 1999-2002
0.00.10.20.30.40.50.60.70.80.91.0
0.0 0.2 0.4 0.6 0.8 1.0False positives
Tru
e p
os
itiv
es
BDP
Moody’s Rating
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32© 2003 Barra, Inc. All rights reserved.
Recent market environment
New market-implied techniques to manage credit risk
Introduction to the BDP (Barra Default Probability)
Practical Examples
Questions and answers
Discussion OutlineDiscussion Outline
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33© 2003 Barra, Inc. All rights reserved.
BIR – Good Complement to Agency RatingsBIR – Good Complement to Agency Ratings
ZOOM
ZOOM
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34© 2003 Barra, Inc. All rights reserved.
BDP – Outlier IdentificationBDP – Outlier Identification
Inspecting ‘like-credits’ in a new way can sometimes turn up opportunities or threats
USD BBB Consumer Cyclicals Average BDP = 0.20%Toys ‘R’ Us BDP = 4.97%
Source: Barra Credit
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BDP – Warning of Toys R Us’ Downgrade?BDP – Warning of Toys R Us’ Downgrade?
Bond implied ratings moved in October as well
A few days later spreads widened, and months later Toys R Uswas downgraded to below investment grade (junk)
Source: Barra Credit
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BIR – Mandate RestrictionsBIR – Mandate Restrictions
Early warnings of Potential Downgrades can allowmanagers to exit worrying names before the flood
The Bond Market was pricing in concerns back in Septemberwhen the Barra Implied Rating for Parmalat dropped to Sub-IG
Source: Barra Credit
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BDP – Early WarningBDP – Early Warning
The equity market was also signalling concerns for Parmalat
The BDP moved well into HY levels before December
Parmalat - 1-Year Barra Default Probabilities
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2
4
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8
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9/1/03 10/1/03 11/1/03 12/1/03Time
1-Y
ea
r B
DP
€ 0
€ 500,000,000
€ 1,000,000,000
€ 1,500,000,000
€ 2,000,000,000
€ 2,500,000,000
€ 3,000,000,000
Eq
uit
y M
ark
et
Ca
p
Barra Default Probability - 1 Year Equity Market Cap
Source: Barra Credit
Investment Grade (approximately)..
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Capital Structure ArbitrageCapital Structure Arbitrage
Differing views from two markets on the capitalstructure point out interesting opportunities
FedEx’s announcement of its planned acquisitionof Kinko’s triggered concern implied by the equity
market but not reflected in bond spreads
Source: Barra Credit
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Market-Implied Measures Offer More InsightMarket-Implied Measures Offer More Insight
Parmalat - 1-Year Barra Default Probabilities
0
2
4
6
8
10
9/1/03 10/1/03 11/1/03 12/1/03Time
1-Y
ea
r B
DP
€ 0
€ 500,000,000
€ 1,000,000,000
€ 1,500,000,000
€ 2,000,000,000
€ 2,500,000,000
€ 3,000,000,000
Eq
uit
y M
ark
et
Ca
p
Barra Default Probability - 1 Year Equity Market Cap
Source: Barra Credit
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