Frank Fabozzi - The Handbook of Fixed Income Securities, Chapter 46 - Global Credit Bond Portfolio Management

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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), and asset-backed securities (ABS). Sovereigns and government-controlled entities with foreign currency debt issues thought to have more credit risk than the national government also should 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.

From six continents, thousands of organizations (corporations, government agencies, projects, and structured pools of debt securities) with different credit stories have sold debt to sustain their operations and to finance their expansion. These borrowers use dozens of different types of debt instruments (first mortgage bonds, debentures, equipment trust certificates, subordinated debentures, medium-term notes, floating-rate notes, private placements, preferred stock) and in multiple currencies (dollars, yen, euros, Swiss francs, pounds) from maturities ranging from one year to even a thousand years. Sometimes these debt structures carry embedded options, which may allow for full or partial redemption prior to maturity at the option of either the borrower or the investor. Sometimes the coupon payment floats with short-term interest rates or resets to a higher rate after a fixed interval or a credit-rating change.

This chapter is adapted from Relative-Value Methodologies for Global Credit Bond Portfolio Management, Chapter 5 in Frank J. Fabozzi (ed.), Fixed Income Readings for the Chartered Financial Analyst Program (New Hope, PA: Frank J. Fabozzi Associates, 2004).

further underscores the oscillations in relative credit performance.

Global credit portfolio management presents a complex challenge. Each day hundreds of credit portfolio managers face thousands of choices in the primary (new issue) and secondary markets. In addition to tracking primary and secondary flows, investors have to keep tabs on ever-varying issuer fundamentals, creditworthiness, acquisitions, earnings, ratings, etc. The task of global credit portfolio management is to process all this rapidly changing information about the credit markets (issuers, issues, dealers, and competing managers) and to construct the portfolio with the best return for a given risk tolerance. This discipline combines the qualitative tools of equity analysis with the quantitative precision of fixed income analysis.

illustrates the magnitude of this information-processing challenge. From a set of 5,000 different issuers, investors can assemble 4 10 (55) different combinations of 20-bond portfolios. The number of potential portfolio combinations of 20 bonds expands to the infinity neighborhood with the inclusion of additional variables such as rating (20 choices), issues (100,000), and currencies (at least 20). Incredibly, the number of potential combinations of this 20-bond credit portfolio exceeds the neutrons in the known universe. In turn, this begs the question of whether credit portfolio optimization is truly achievable given the current state of technology. Although perfect optimization may prove elusive, the optimization goal remains a worthy pursuit for asset managers.

Despite this apparent limitation on the perfection of corporate portfolio optimization, broad demand exists for corporate debt. Investors in corporate debt consist of individuals in the pursuit of high yields, central banks aiming to extract a higher yield and return on their considerable holdings of fixed income assets, commercial banks arbitraging the difference between the higher yields on floating-rate notes and their lower cost of funding, mutual funds attempting to maximize both yield and total return, insurers and state pension funds seeking to fund their projected long-term liabilities, pure Total-return maximizers competing against each other on a monthly, quarterly, and annual basis to satisfy their clients (public or private pension fund plan sponsors) or risk their loss, and hedge funds staking out leveraged long or short positions in credits with short-term potential for major spread movements. Portfolio investment choices are driven also by the existing security population of the corporate market (sector, issuer, structure, and currency), by the psychology of the portfolio managers (overall risk tolerance, shortfall risk aversion, and internal politics of the investment-management institution), and the state of market liquidity.