Transcript Setting Credit Risk Limits

Credit Risk, Diversification
and Setting Limits
Mark C. Abbott, Managing Director, Guardian Life
Saturday, November 23, 2002 - Columbia University
Practitioners Conference in Mathematics of Finance
Outline
• Overview
• Market Concerns
•
•
•
•
Credit Risk Limits
Credit Risk Models
Credit Risk Diversification
Credit Risk Management Process
2
Overview:
Current State of the Credit Market
• Although Fixed Income has recently outperformed equity, the Corporate
•
Bond market has severely underperformed Treasuries
The market has experienced rising defaults, downgrades, and an
unprecedented number of Investment Grade credits falling into High Yield
(a.k.a. “Fallen Angels”)
– “Fallen Angels” are overwhelming the High Yield market as they number 14 of the top 25
issuers and comprise 20% of the total amount outstanding in High Yield
• Telecom/Energy have been at the core of the fundamental deterioration in
•
credit with outsized spending to meet unrealistic demand expectations and
aggressive expansions into energy trading in utilities
Extreme market volatility and limited liquidity best characterizes the current
state of the corporate bond market
– Banks are restricting access to liquidity and the resulting illiquidity is contributing to the
credit market’s volatility
• Portfolio diversification is difficult to achieve given that 33% of amount
•
outstanding and 42% of new issue volume are in the the top 25 names
Survival depends on minimizing the occurrence and magnitude of
distressed credits
3
Market Concerns
• What is contributing to the current credit
volatility?
–Bear equity market and corporate scandals
–Credit recession (stressed credit market)
–Liquidity crisis
–Historically low rates
–Economic recovery unclear
4
A Bear Market in Equity
•
Volatility at historic highs since 1997
– 3+ years upside of technology bubble
– 2.5 years of bubble bursting and corporate scandals
– Volatility measure of “% days per year S&P 500 Index
moved greater than +/- 1%” in August 2002 was 43%
versus 22% historic average since 1925
•
Current downturn deepest since 1973-74 and longest
since 1929-32 or 1946-49
– At its July 2002 low, the S&P 500 was 48% below its March
2000 peak and the decline has endured for 29 months.
This makes it the longest bear market since 1946/49 and
together with the 1973/74 cycle, the steepest of the postWWII period.(1)
(1)
The Bank Credit Analyst, August 2002
5
A Bear Market in Equity
• Valuations are still above historic
norms on almost every measure
(Price/Earnings, DividendYield, Price/Book,
Price/Sales), except for
EarningsYield/BondYield (which is near fair
value, as bond yields are at historic lows)
• Earnings remain under pressure
• Outflows from domestic equity mutual funds
and foreign sales of US stocks has intensified
since June 2002(2)
(2)
Ned Davis Research Inc., September 2002
6
Recent Equity and Fixed Income Returns
(For Periods Ended 10/31/2002)
5 Yr Cumulative Returns
(Since End of October 1997)
Average Annual Returns
80
15
70
10
60
5
10.37
41.45
40
Return %
50
Return %
9.34
7.52
7.07
6.34
0.75
0
-5
-3.96
30
-10
20
-15
10
3.82
0
-12.21
-15.10
-20
-20.14
-25
-10
ct
-0
2
2
2 Years
S&P 500
3 Years
4 Years
5 Years
Lehman Aggregate
O
pr
-0
A
1
ct
-0
1
O
pr
-0
A
0
ct
-0
0
S&P 500
O
pr
-0
A
ct
-9
9
9
O
pr
-9
A
8
ct
-9
8
O
pr
-9
A
O
ct
-9
7
1 Year
Lehman Aggregate
Source: Lehman, Standard & Poors
7
Credit Market Under Stress
•
Unprecedented numbers of distressed credits
(“Fallen Angels” are investment grade credits that have been downgraded to high yield)
– $115 billion Fallen Angels YTD through October 2002
– Since 2001 default rates have exceeded 1991 highs
– "Default rates have been rising continuously since 1999. It has been like a
–
•
•
•
credit recession for several years and I expect it to continue until default
rates clearly have peaked.” Edward Altman, Ph.D. NYU Stern School of
Business
2001 experienced the most ever Chapter 11 filings with 170 and pre-petition
liabilities of $230 billion
• First half of 2002 had 74 filings totaling $130 billion
Since June 1997 a series of financial crises have resulted in huge
volatility in and widening of credit spreads; this has produced
sustained negative excess returns in corporate issues
Moody’s downgrade/upgrade ratio rose from 1.4 in 1998 to 4.1
Moody’s year-to-year defaults rose from 1.3% in 1998 to 10.53% in
June 2002 and are at 9.2% for September 2002
Source: Lehman, Moody’s, Edward Altman
8
Liquidity Crisis
•
•
Credit contraction in bank lending and commercial
paper is causing a “liquidity crisis”, reversing trend for
last 5 years of 20% annual expansion
– Bank lending is currently 15% lower than last July
– Non-financial CP has contracted 47.7% to a low of
$179.5 billion in June 2002 from high of $343.3 billion
in December 2000
Financial leverage (ratio of current debt to total market
capitalization) of corporations increased in 2002 to
26.6% (on $4.5 trillion), the highest level since the 199091 recession
Source: Lehman
9
Historical Lows For
Interest Rates
•
•
•
•
UPDATE
Aggressive Fed easing with Fed Funds at 1.25% since November
6, 2002 cut of 50 bps
– The resulting yield curve is the steepest since Fall 1992
Rates at 4-decade lows
– 10-year Treasury Note yield of 3.57% on October 9th was at a
44-year low
– As of November 11, 2002 the 10-year has risen 58 bps from
this low
Historically low rates led to another mortgage refinancing wave
which is supporting consumer spending
Expectation is for interest rates to stay low this year, rising next
year as the yield curve to flatten from the short end
Source: Bloomberg
10
Uncertainty of Economic
Recovery
•
•
•
Blue Chip consensus GDP growth is forecast at 1.6% in
Q4-2002 and 3.3% in 2003.
Concerns that declines in equity markets and financial
wealth could reduce consumer spending and economic
growth
Continued concern: Geopolitical risk may disrupt
recovery
Source: Blue Chip Consensus Forecast
11
Investment Grade Corporate
Cumulative Excess Returns
6.00
Period of Narrowing
Corporate Spreads
4.00
3.00
Asia
Crisis
2.00
1.00
0.55
0.00
-0.24
-1.00
Enron
Russia
Collapse,
LTCM
Worldcom
Technology
Bubble Collapses
Lehman Credit Index Cumulative Excess ROR
02
1
Ju
n-
c-0
De
01
Ju
n-
0
c-0
De
00
9
Ju
n-
c-9
De
99
8
Ju
n-
c-9
De
98
Ju
n-
7
c-9
De
97
6
Ju
n-
c-9
De
96
5
Ju
n-
c-9
De
95
4
Ju
n-
c-9
De
94
3
Ju
n-
c-9
De
93
Ju
n-
c-9
2
-2.00
De
Curve Adjusted Excess ROR
5.00
A Series of
Financial Crises
Lehman Credit Index Ex Communications Cumulative Excess ROR
12
Corporate Bond Valuations
Anything But Telecom and Pipelines!
(From December 31, 2001 through September 30, 2002)
650
Option Adjusted Spread (bp)
600
550
500
450
400
350
300
250
200
150
31
-D
ec
14 -01
-J
an
28 -02
-J
a
11 n-0
-F 2
eb
25 -02
-F
e
11 b-0
-M 2
a
25 r-0
-M 2
ar
8- 02
Ap
22 r-0
-A 2
pr
6- -02
M
a
20 y-0
-M 2
ay
3- 02
Ju
n
17 -02
-J
un
1- 02
Ju
l
15 -02
-J
ul
29 -02
-J
u
12 l-0
-A 2
u
26 g-0
-A 2
ug
9- 02
Se
p
23 -02
-S
ep
-0
2
100
Date
Lehman Credit Index
Lehman Wirelines Index
Lehman Pipelines Index
Lehman Credit Index ex Wirelines & Pipelines
Source: Lehman
13
Avoiding Credit Disasters and
Defaults is Essential
The first ten months of 2002 saw the largest number of Fallen Angels (Investment
grade credits that have been downgraded to High Yield) in history (245 totaling
$115.4 Billion).
Fallen Angels
115.4
120
Enron, Calpine,
JCPenney, PG&E,
Lucent, Mirant,
S.Cal Edison,
Delta Airlines,
Worldcom,
KMart
Qwest, Tyco,
64
Williams Co.,
Georgia Pacific,
Xerox,
Waste
USWest
Conseco,
US West Capital, Management, Finova
Comm., AT&T
Columbia/HCA
Rite Aid
Canada,
25
Dynegy, Nortel,
22
21
Gap, Goodyear
100
$ Billions
80
60
40
20
Telecommunications,
Niagara TCI Comm, ITT
Mohawk
10
11
1995
1996
4
0
1997
Source: Lehman (2002 YTD through October 31, 2002)
1998
1999
2000
2001
2002 YTD
14
Top 50 Fallen Angels from 1995-2002 YTD
*
Credit Risk Management is Critical to Performance
Ranking
Fallen Angel
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
WORLDCOM
QWEST
TYCO
WILLIAMS COMPANY
CALPINE CANADA ENERGY FIN
ENRON CORP
GEORGIA-PACIFIC
U.S. WEST COMMUNICATIONS
PENNEY J C
US WEST CAPITAL FDING
PACIFIC GAS + ELECTRIC
XEROX CORPORATION
TELE-COMMUNICATIONS
CONSECO INC
WASTE MANAGEMENT, INC.
TELLUS CORPORATION
MIRANT AMERICAN GENERATION
EDISON INTERNATIONAL INC
LUCENT TECHNOLOGIES INC
AT&T CANADA INC
DYNEGY INC
FINOVA CAPITAL CORP
DELTA AIR LINES
SERVICE CORP INTL
TCI COMM INC
NIAGARA MOHAWK POWER
COLUMBIA/HCA HEALTHCARE
NRG ENERGY
RITE AID CORP
INTERMEDIA COMMUNICATION
USA WASTE SERVICES INC
TENNECO INC
CROWN CORK & SEAL
MGM GRAND INC
NORTEL NETWORKS LTD-GLOBAL
K MART
LAIDLAW INC.
DANA CORP
MARCONI CORPORATION PLC
HILTON HOTELS
ITT CORP
GAP INC
SAKS INCORPORATED
UNITED AIR LINES INC
ROYAL CARIBBEAN
KANSAS GAS + ELECTRIC
PETROLEUM GEO-SERVICES
BROWNING FERRIS IND INC
ROGERS CANTEL INC.
GOODYEAR TIRE & RUBBER
Total
Downgrade Date
# of issues
May 2002
May 2002
Jun 2002
Jul 2002
Dec 2001
Nov 2001
May 2002
Jul 2002
Mar 2001
May 1998
Jan 2001
Dec 2000
Apr 1996
Apr 2000
Aug 1999
Jul 2002
Dec 2001
Jan 2001
Jun 2001
Feb 2002
Jun 2002
Aug 2000
Sep 2001
Jan 2000
Apr 1996
Oct 1995
Feb 1998
Jul 2002
Oct 1999
Apr 2002
Aug 1999
Jul 1999
Nov 2000
Jan 2002
Apr 2002
Dec 2001
Feb 2000
May 2001
Sep 2001
Dec 2001
Mar 1998
Feb 2002
Jan 2001
May 2001
Feb 2001
Mar 2000
Jul 2002
Jul 1999
Jul 2002
Jun 2002
18
14
12
21
10
21
18
12
18
8
12
12
13
9
13
2
7
7
4
6
9
8
6
11
6
13
11
7
10
6
6
9
9
7
5
6
10
7
2
6
4
4
5
6
7
8
5
6
4
4
Moody's Quality
Before Downgrade
After Downgrade
444
Source: Lehman (2002 YTD through October 31, 2002)
* Index Exposure -- Actual balance sheet exposure may be higher.
Baa2
Baa3
Baa2
Baa3
Baa3
Baa2
Baa3
Baa3
Baa3
Baa1
A1
Baa2
Baa3
Baa3
Baa2
Baa2
Baa3
A2
Baa3
Baa3
Baa3
Baa2
Baa3
Baa3
Baa3
Baa3
Baa2
Baa3
Baa1
Baa2
Baa3
Baa1
Baa3
Baa3
Baa3
Baa3
Baa3
Baa2
Baa2
Baa3
Baa2
Baa3
Baa3
Baa3
Baa3
Baa1
Baa3
Baa1
Baa3
Baa3
Ba2
Ba2
Ba2
B1
Ba1
B3
Ba1
Ba3
Ba2
Ba1
B3
Ba1
Ba1
Ba1
Ba1
Ba1
Ba1
Caa2
Ba1
Ba3
Ba1
Ba1
Ba2
Ba1
Ba1
Ba2
Ba1
B1
Ba2
Ba1
Ba1
Ba1
B2
Ba1
Ba3
Ba2
Ba1
Ba1
Ba1
Ba1
Ba1
Ba3
Ba1
Ba1
Ba2
Ba2
Ba1
Ba3
Ba3
Ba1
Amount Outstanding
($ million)
21,790.0
14,385.6
8,389.6
8,003.9
6,938.7
6,767.0
5,670.0
5,521.5
5,450.0
4,650.0
4,162.5
3,944.2
3,850.0
3,545.0
3,350.0
3,300.0
3,200.0
2,931.1
2,910.0
2,864.6
2,800.4
2,800.0
2,726.6
2,650.0
2,600.0
2,385.2
2,331.2
2,330.0
2,300.0
2,292.9
2,250.0
2,213.0
2,200.0
2,200.0
2,200.0
1,829.0
1,825.0
1,800.0
1,800.0
1,800.0
1,750.0
1,700.0
1,650.0
1,641.2
1,625.0
1,524.1
1,460.0
1,450.0
1,375.4
1,350.0
87,634
182,482.6
•
•
•
•
•
•
•
•
•
WorldCom’s $22.8 Billion
total public debt ranks as
largest fallen angel
Qwest’s $14.4 Billion is
second
Tyco’s $8.4 Billion is third
Williams’ $8.0 Billion is
fourth
Enron’s $6.8 Billion is sixth
Georgia-Pacific’s $5.7
Billion is in the top 10
May 2002 will be recalled for
a record $42.8 Billion of
fallen angel debt moving
into high yield
July 2002 was next largest
at $22.8 Billion
Cumulative $115 Billion in
principal of fallen angels in
2002 YTD is record high
15
High Yield Corporates: Index Returns and Default Rates
(From 1980 through September 30, 2002)
12%
40.0%
10%
Return
30.0%
8%
20.0%
6%
10.0%
4%
0.0%
-10.0%
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
Default Rate
2002 YTD*
High Yield Index
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
-20.0%
-7.63%
Default Rate
50.0%
2%
0%
Most years of peak default rates or following year are also years of high returns: 1982, 1986, 1991 and 1995
Source: Lehman High Yield Index 1983-2002, * -7.63% Return is YTD through September 30, 2002, Credit Suisse First Boston (CSFB)
Returns for 1980-1982, Moody’s Default Rates 1983-2002, *9.2% Default Rate is for annual period from October 2001- September 2002
16
1/3
1
7/3 /199
1/ 0
1/3 199
1 0
7/3 /199
1/ 1
1/3 199
1 1
7/3 /199
1/ 2
1/3 199
1 2
7/3 /199
1 3
1/3 /199
1/1 3
7/3 99
1/1 4
1/3 99
1 4
7/3 /199
1/ 5
1/3 199
1 5
7/3 /199
1/ 6
1/3 199
1 6
7/3 /199
1/ 7
1/3 199
1 7
7/3 /199
1 8
1/3 /199
1/ 8
7/3 199
1 9
1/3 /199
1/ 9
7/3 200
1 0
1/3 /200
1 0
7/3 /200
1/ 1
1/3 200
1 1
7/3 /200
1/2 2
00
2
Nominal Spread (in bps)
High Yield Spreads By Credit Quality
(From January 31, 1990 Through September 30, 2002)
4,000
3,000
2,000
2,376
1,000
968
680
0
BB
B
CCC
Source: Credit Suisse First Boston (CSFB)
17
Paradigm Shift in Fallen
Angels
• Over 20% of the Lehman High Yield Index is now
comprised of former investment grade credits.
• Returns fell more rapidly than ever in 2001-2002,
so the punishment for owning a distressed credit
was severe.
• Good credit defense and index-like performance
made for great performance
18
Losses in Investment Grade Bonds Occur
in Months Prior to Downgrades
•
Loss of value due to a downgrade occurs
over a few prior months. Depending on
the initial credit quality losses could
stretch over 2 months for AAA-AA and
up to 8 months for BAA
•
The variability of the magnitude of the
loss (i.e., Standard deviation) is very
significant
Average Monthly Underperformance Due to Downgrade
8/88 – 12/01
Source: Lehman
19
Since 2001 Long Term Relative* Performance
Subsequent to Distress was Negative for
Investment Grade Bonds
Subsequent Excess Returns (vs. UST) of investment-grade bonds after distress**
# distressed
24-month
“Vintage Year”
issues
excess return vs. UST
Consistently positive
excess returns
subsequent to
distress before 2001
--------------------Since 2001 long
horizon excess
returns for distressed
bonds have been
negative because of
the credit recession
resulting from a
liquidity crisis
Source: Lehman
1990
1991
...
1998
1999
2000
Years prior 2001
50
14
28.28%
40.94%
29
10
139
250
19.33%
10.69%
8.35%
16.56%
-------------------------------------------------------2001
YTD Jun 2002
Years since 2001
54
68
122
-23.08%
-24.21%
-23.71%
All Years
372
3.35%
* Relative to Treasuries
** Lehman defines a distressed investment-grade bond as…
Rated Baa3 or higher; Fixed coupon; OAS to US Treasuries of 400bp or
more; and Dollar price <80% of par.
20
Absolute vs. Relative Risk:
A Debate
• A desire to limit absolute risk has led to increased
tracking error for credit defensive players that have
limited issuer exposures.
• Index issuer considerations
– Should indices represent the active investable universe of the few active
–
–
issues available?
Or should index providers keep large numbers of illiquid issues?
Should indices caps the max percentage for an individual issuer?
• Should limits be placed on the amount outstanding for
currently dominant credits?
– Fallen Angels comprise over 20% of Lehman High Yield Index
21
Risk Limits
• Divide investment grade corporates into groups by
quality (AAA, AA, A, BBB), by sectors (or even
subsectors), and by duration (0–2, 3-5, 6–10, 10+)
• High yield: diversify, diversify, diversify
• Classic: Establish limits by groups and by specific
issuers overall
• Contemporary: Use a combination of tracking error and
absolute limits
22
Quantitative Credit Risk
Metrics
Spread
Default
• OAS
• OAS volatility
• Spread duration
• Swap spread duration
• Return
• Excess return
• Variance/Covariance of
• CDS
• CDS volatility
• Default Probability
• Loss Frequency
• Loss Given Default
• Transition Probability Matrix
• Variance/Covariance of
•
•
•
•
Spreads or Excess Returns
Integrates well with Market Risk
Spreads can be difficult to
measure during periods of
illiquidity
Spreads
Credit VaR
Difficult to estimate during
periods of sparse defaults
23
Quantititative Credit
Measures
• Moody’s KMV EDFs
• Moody’s RiskCalc PDs
• CreditSights’ BondScore CREs
• CSFB CreditRisk+
• McKinsey CrPortView
• RiskMetrics CreditMetrics/CreditGrades
• Standard & Poor’s
24
Model Comparison
25
Model Comparison
26
Quantititative Diversification
Products
Default related
• Moody’s KMV
• CreditGrades
• Gifford Fong Associates
Spread/Return based
• Lehman POINT
• Barra TotalRisk
27
Credit Risk Diversification by
Sector and Rating
•
•
•
•
•
Credit diversification across sectors can reduce portfolio volatility
from concentration risk for credits that have a higher probability
of becoming distressed or can experience higher volatility - thus
reducing the standard deviation of returns
Systematic vs. Idiosyncratic Risk
Contagion risk has hammered certain sectors where there have
been considerable bankruptcy filings and “fallen angels”; these
sectors are slowly becoming more attractive
Historically fixed income has a low probability of loss of principal
Credit differences result in diversification benefits
– Financial
– Industrial
– Telecom
– Energy
28
Credit Diversification
Downgrade Risk vs.
Other Non-Systematic Risk
From Observed
Performance of
Downgraded Bonds
Aaa – Aa
A
Baa
Position Size Ratio
Downgrade
Risk
Other NonSystematic Risk
Total NonSystematic Risk
73
168
622
9:4:1
141
165
231
159
236
664
4:3:1
• Downgrade only idiosyncratic size ratio for different ratings: Aa-Aaa:A:Baa = 9:4:1
– Downgrade diversify requires 9 times more low grade Baa to high grade Aaa
• Idiosyncratic risk as stable-rated bonds experience “natural” spread volatility
• Total idiosyncratic risk less differentiated by quality than downgrade risk alone
as indicated by size ratio for different quality ratings: Aa-Aaa:A:Baa = 4:3:1
– Diversification of total idiosyncratic risk requires only 4 times as many Baa
credit to Aaa credits
Source: Lehman, Lev Dynkin Aug 14, 2002, PRMIA New Frontiers in Credit Risk)
29
Diversification Balance
• Balance minimizing tracking error vs. maximizing return
or risk adjusted return
• Too much diversification costs performance
– Decreases security selection return from purchase of
cheaper bonds
30
Sufficient Diversification:
Conclusions
•
•
•
•
Optimal size ratio to minimize risk of underperformance due to
downgrades for Aaa/Aa, A and Baa portfolio is 9:4:1 (was 7:3:1
prior to 2001)
Optimal size ratio to minimize risk of underperformance due to
natural spread volatility for Aaa/Aa, A and Baa portfolio is 4:3:1
The change since 2000 was not due to change in transition
probabilities, but due to return severity of 2001 downgrades.
Minimize the impact through diversification in addition to using
fundamental analysis to avoid selecting future fallen angels and
defaults
Source: Lehman
31
Conclusions: Risk Management
Oriented Portfolio Construction
Process
• Balance fundamental credit analysis with quantitative
measures, relative and defensive credit alerts
• Monitor absolute and relative issuer exposure,
duration, convexity, spread duration and yield curve
exposure
• Identify many small selective risks via security level
spread, portfolio scenario and tracking error analyses
• Credit defense: Monitor changes using leading
indicators like CDS data and Credit Risk default
models like Ed Altman’s Z-score, Merton/Moody’s
KMV or hybrids like CreditSights’ BondScore
32