Fallen Angels and Bond Risk Management
Yannis Sardis, 28 September 2020
For a full account of this article, please see: “Fallen Angels and Bond Risk Management”.
“In the long run we shall have to pay our debts at a time that may be very inconvenient for our survival.”
Norbert Wiener, American Mathematician and Philosopher (1894-1964)
Bond portfolios face various risks that could drastically affect the price of their underlying holdings, the most prominent of which is the interest rate policy of the Central Bank. A more idiosyncratic factor that could adversely affect a bond price is its credit rating. Given the current market conditions and unprecedented levels of corporate borrowing, proactively stress-testing potential credit rating movements is vital to a sound portfolio management process for the fixed income manager.
Post the credit rating that a bond is assigned when initially issued, ratings are frequently reviewed and they may change, due to macro-economic events or sector and firm-specific conditions. Considering that credit ratings affect the interest rate that a firm-issuer needs to pay in order to attract buyers, bonds with higher quality credit ratings have lower yields, the bond yield reflecting the bond’s creditworthiness. If a bond is downgraded, the bond price declines and the bond yield increases, and vice versa.
To protect the value of their portfolios but also attempt to enhance the yield return of their bonds, investors select securities from a combination of higher credit quality, known as Investment Grade (IG), and of lower credit quality, known as High Yield (HY) or Junk.
Having had a decade of mounting corporate leverage and in a COVID19-hit global economy, certain corporate sectors have experienced a sharper decline in their business activity and revenues, in particular cyclical industries such as energy, airlines, tourism, hospitality and the off-line retail, a fact that makes the affected companies less able to meet their debt obligations, hence their credit rating status.
Considering that bond prices may change even in anticipation of a credit rating upgrade or downgrade, bond investors may want to systematically assess how potential credit rating fluctuations would affect the valuation of a bond portfolio and stress-test their holdings through changes in credit rating, to gauge a portfolio’s behaviour in different scenarios, like ones with rating downgrades or upgrades.
The impact of the ‘stressed’ credit rating scenarios can be viewed though a number of output risk analytics, such as:
• The change of the expected shortfall of the portfolio and
• The expected new stressed market value (post the credit rating changes),
thus helping one to decide if an imminent portfolio rebalancing is needed.
Even in cases where, to diversify the portfolio’s credit risk, an investor holds bonds of different issuers and different maturities, a risk model should be measuring the risks emanating from potential credit quality changes, determine the overall portfolio risks and set relevant selling or hedging strategies to mitigate potential losses.
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