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Quantitative Credit Portfolio Management: Practical Innovations for Measuring and Controlling Liquidity, Spread, and Issuer Concentration Risk



Quantitative Credit Portfolio Management: Practical Innovations for Measuring and Controlling Liquidity, Spread, and Issuer Concentration Risk

Arik Ben Dor, Lev Dynkin, Jay Hyman, Bruce D. Phelps

ISBN: 978-1-118-11769-9 December 2011 416 Pages


An innovative approach to post-crash credit portfolio management

Credit portfolio managers traditionally rely on fundamental research for decisions on issuer selection and sector rotation. Quantitative researchers tend to use more mathematical techniques for pricing models and to quantify credit risk and relative value. The information found here bridges these two approaches. In an intuitive and readable style, this book illustrates how quantitative techniques can help address specific questions facing today's credit managers and risk analysts.

A targeted volume in the area of credit, this reliable resource contains some of the most recent and original research in this field, which addresses among other things important questions raised by the credit crisis of 2008-2009. Divided into two comprehensive parts, Quantitative Credit Portfolio Management offers essential insights into understanding the risks of corporate bonds—spread, liquidity, and Treasury yield curve risk—as well as managing corporate bond portfolios.

  • Presents comprehensive coverage of everything from duration time spread and liquidity cost scores to capturing the credit spread premium
  • Written by the number one ranked quantitative research group for four consecutive years by Institutional Investor
  • Provides practical answers to difficult question, including: What diversification guidelines should you adopt to protect portfolios from issuer-specific risk? Are you well-advised to sell securities downgraded below investment grade?

Credit portfolio management continues to evolve, but with this book as your guide, you can gain a solid understanding of how to manage complex portfolios under dynamic events.

Foreword xvii

Introduction xix

Notes on Terminology xxvii

PART ONE Measuring the Market Risks of Corporate Bonds

CHAPTER 1 Measuring Spread Sensitivity of Corporate Bonds 3

Analysis of Corporate Bond Spread Behavior 5

A New Measure of Excess Return Volatility 20

Refinements and Further Tests 25

Summary and Implications for Portfolio Managers 30

Appendix: Data Description 34

CHAPTER 2 DTS for Credit Default Swaps 39

Estimation Methodology 40

Empirical Analysis of CDS Spreads 41

Appendix: Quasi-Maximum Likelihood Approach 51

CHAPTER 3 DTS for Sovereign Bonds 55

Spread Dynamics of Emerging Markets Debt 55

DTS for Developed Markets Sovereigns: The Case of Euro Treasuries 59

Managing Sovereign Risk Using DTS 66

CHAPTER 4 A Theoretical Basis for DTS 73

The Merton Model: A Zero-Coupon Bond 74

Dependence of Slope on Maturity 77

CHAPTER 5 Quantifying the Liquidity of Corporate Bonds 81

Liquidity Cost Scores (LCS) for U.S. Credit Bonds 82

Liquidity Cost Scores: Methodology 88

LCS for Trader-Quoted Bonds 92

LCS for Non-Quoted Bonds: The LCS Model 96

Testing the LCS Model: Out-of-Sample Tests 102

LCS for Pan-European Credit Bonds 113

Using LCS in Portfolio Construction 123

Trade Efficiency Scores (TES) 129

CHAPTER 6 Joint Dynamics of Default and Liquidity Risk 133

Spread Decomposition Methodology 138

What Drives OAS Differences across Bonds? 139

How Has the Composition of OAS Changed? 141

Spread Decomposition Using an Alternative Measure of Expected Default Losses 145

High-Yield Spread Decomposition 147

Applications of Spread Decomposition 147

Alternative Spread Decomposition Models 150

Appendix 152

CHAPTER 7 Empirical versus Nominal Durations of Corporate Bonds 157

Empirical Duration: Theory and Evidence 159

Segmentation in Credit Markets 173

Potential Stale Pricing and Its Effect on Hedge Ratios 173

Hedge Ratios Following Rating Changes: An Event Study Approach 179

Using Empirical Duration in Portfolio Management Applications 186

PART TWO Managing Corporate Bond Portfolios

CHAPTER 8 Hedging the Market Risk in Pairs Trades 197

Data and Hedging Simulation Methodology 199

Analysis of Hedging Results 200

Appendix: Hedging Pair-Wise Trades with Skill 208

CHAPTER 9 Positioning along the Credit Curve 213

Data and Methodology 214

Empirical Analysis 217

CHAPTER 10 The 2007–2009 Credit Crisis 229

Spread Behavior during the Credit Crisis 229

Applications of DTS 234

Advantages of DTS in Risk Model Construction 244

CHAPTER 11 A Framework for Diversification of Issuer Risk 249

Downgrade Risk before and after the Credit Crisis 250

Using DTS to Set Position-Size Ratios 257

Comparing and Combining the Two Approaches to Issuer Limits 260

CHAPTER 12 How Best to Capture the Spread Premium of Corporate Bonds? 265

The Credit Spread Premium 266

Measuring the Credit Spread Premium for the IG Corporate Index 266

Alternative Corporate Indexes 279

Capturing Spread Premium: Adopting an Alternative Corporate Benchmark 288

CHAPTER 13 Risk and Performance of Fallen Angels 295

Data and Methodology 298

Performance Dynamics around Rating Events 303

Fallen Angels as an Asset Class 319

CHAPTER 14 Obtaining Credit Exposure Using Cash and Synthetic Replication 337

Cash Credit Replication (TCX) 338

Synthetic Replication of Cash Indexes 351

Credit RBIs 358

References 367

Index 371