CHAPTER 26

CONSIDERATIONS IN CORPORATE BOND

PORTFOLIO MANAGEMENT

CHAPTER SUMMARY
Whereas earlier chapters in the book describe bond portfolio strategies and management in general,
this chapter covers issues associated specifically with the management of corporate bond
portfolios. Coverage includes the stability of the investment characteristics of bond market
indexes, credit relative value trades, constraint-tolerating investing, and how to quantify liquidity
risk for corporate bonds. This chapter also discusses special considerations in the management of
a portfolio of corporate bonds.

RISKRETURN FOR CORPORATE BONDS VERSUS EQUITIES

The riskreturn distribution faced by an equity investor is quite different from that of an investor
in the bonds issued by the same company. The upside for corporate bond investors is the coupon
payments, if the bond is purchased at par and held to maturity. For bonds purchased at a discount
and held to maturity, it is the capital gain realized plus the coupon payments.

An interesting exercise performed by Zan Li and Jing Zhang of Moodys Analytics highlights the
difference in the return distributions for investors in corporate bonds versus those of equity
investors. There are implications in their finding when establishing an investment philosophy for
managing corporate bond portfolios. First, avoiding losers is far more important for corporate
bond portfolio management than for equity portfolio management. Second, finding winners is
far more important for equity portfolio management than for bond portfolio management.

Moreover, it is particularly important to obtain diversification in managing a corporate bond

portfolio. If the benchmark is a corporate bond index with 3,000-plus bond issues, it will not be
practical to hold more than 150 or so issues. This means that there will be considerable
idiosyncratic risk that needs to be minimized.

CORPORATE BOND BENCHMARKS

The composition of the bond issues for a corporate bond index changes for the following reasons:
(1) issuance of new corporate bonds that qualify for inclusion in the index; (2) retirement of bonds
as a result of their maturing, being called by the issuer, being put by investors, or being converted
into common stock; (3) removal from the index due to failure to satisfy inclusion criteria (e.g.,
downgrades, shortening of maturity, and reduction in issuance size); and (4) inclusion in the index
due to bonds being upgraded in the case of an investment-grade corporate bond index.

As a result of the changing composition of a corporate bond index, the interest-rate risk exposure
(as measured by duration and convexity) and the credit risk exposure will change. The change may
be such that an investor who initially adopted a particular market-cap-weighted bond index as a

582
benchmark because the interest-rate risk and credit risk exposure were acceptable is no longer
acceptable as the composition of the index changes over time.

If a corporate bond index selected by a client is unstable, this means a portfolio manager must
monitor a clients portfolio dynamically to maintain the portfolios optimal investment. It is an
empirical question as to how stable the risk exposure of a market-cap-weighted corporate bond
index is. Goltz and Campani provide an extensive empirical analysis of the stability of the risk
characteristics of both U.S. and euro-denominated investment-grade corporate bond indexes to
address this issue.

Exhibits 26-4 and 26-5 plot the time series credit risk exposure for the U.S. and Eurozone corporate
bond indexes, respectively. In each exhibit there are two panels. Panel a shows the change in the
composition of an index using the S&P credit ratings; panel b shows the average credit rating. The
average credit rating is an attempt to place an index into one of the investment-grade classifications
based on the ratings of the corporate bonds comprising the portfolio.

The conclusion reached by Goltz and Campani is that cap-weighted investment-grade corporate
bond indexes are fairly unstable with respect to their exposure to interest-rate risk and credit risk,
and the fluctuations in risk exposures are incompatible with investors requirements that these
exposures be relatively stable so that allocation decisions are not compromised by such
fluctuations.

CREDIT RELATIVE VALUE STRATEGIES

Bond valuation methodologies involve the discounting of expected future cash flows. The goal of
the valuation is to identify mispriced bonds based on the portfolio managers or analysts
assumptions regarding the inputs used in the model. The underlying assumption is that the bond
market is inefficient in terms of pricing and therefore there are mispriced bonds that can be
identified with a good valuation model that will allow a portfolio to enhance returns.

In contrast to identifying mispriced bonds based solely on valuation models, relative value
methodologies seek to rank comparable bonds based on expected return over some specified
investment horizon. By comparable it is meant that the bonds might have the same credit rating
but different structures (i.e., callable versus non-callable or fixed versus floating coupon rate), with
the same maturity and in the same bond sector.

There are two underlying assumptions when using relative value methodologies. First, it is
extremely difficult because of their complex structure and market mechanics to identify mispriced
bonds using valuation models. Second, for bonds that are comparable, pricing errors can be
identified and those pricing errors will correct themselves over a specified investment horizon.

A good starting point for credit relative value analysis is the decomposition of historical bond
returns. In addition, the macroeconomic factors that have caused each source of return should be
analyzed. The technique of decomposing the historical total return into its different sources is
referred to as return attribution analysis.

583
Credit Relative Value Secondary Market Trades

Portfolio managers are continuously bombarded with macroeconomic data and industry and
company-specific information, causing them to constantly revise their expectations. As
expectations change, there is motivation for making trades in the secondary market. With respect
to credit trades, there are the following types of trades: yield spread pickup trades; credit-upside
trades; credit-defense trades; sector-rotation trades; curve-adjustment trades; and, structure trades.

Yield-Spread Pickup Trades

Despite the warning about the limitations of yield measures, a major reason for secondary market
trades in credit markets appears to be to swap one corporate bond for another with a higher credit
spread. These are called yield-spread pickup trades. When a yield-spread pickup trade is
undertaken, the portfolio manager must be sure that it is a dollar-duration-neutral trade so that the
portfolio is not impacted by changes in the level of Treasury rates. The success of such trades is
measured by their realized returns, which will depend on factors other than the magnitude of the
current credit spread for the two corporate bonds that are candidates for a swap.

Credit-Upside Trades

Suppose that a credit analyst covering a particular sector within the corporate bond market believes
a particular issuer will have a credit upgrade and is currently trading at a wider spread than what
it would if the credit rating were upgraded. The action that might be taken by the portfolio manager
to whom the credit analyst reports is to acquire the issue that is expected to be upgraded. Such a
trade is referred to as credit-upside trade.

Credit-upside trades are often done for high-yield corporate bonds expected to be upgraded to an
investment-grade credit rating. The benefits of such a trade would be twofold. First, if the upgrade
to investment grade does occur, the expected return would be better than that of other investment-
grade corporate bonds with the same credit rating because of the narrowing of its credit spread.
Second, because the issue will be removed from a high-yield corporate bond index to an
investment-grade corporate bond index, its liquidity would be expected to improve.

Credit-Defense Trades

In contrast to a credit-upside trade, a credit-defense trade occurs when there is uncertainty about
the impact of macroeconomic or industry events that may adversely impact credit spreads. The
question that is faced by a manager when there is a downgrade is whether or not to sell the
downgraded issue.

There are three factors that the portfolio manager must consider: (1) a downgrade to a credit rating
below that permitted by the clients investment guidelines may require that the downgraded issue
be removed from the portfolio; an analysis of the potential expected return by retaining the issue
versus that of replacing the issue must be performed; and, (3) in the decision to dispose of a
downgraded issue the portfolio manager may be slow to remove an issue if a loss must be realized.

584
New-Issue Swap Trades

Trades from seasoned issues to new issues, referred to new-issue swap trades, occur for two
reasons. First, new issues are viewed as having better liquidity than seasoned issues. Evidence
confirms the better liquidity provided by new issues. The second reason for acquiring new issues
beyond liquidity enhancement potential are to gain exposure to a new issuer or to a new type of
corporate bond structure.

Sector-Rotation Trades

The three broad sectors within the corporate sector are financials, industrials, and utilities. Within
each of these sectors there are further classifications by industry. The purpose of sector-rotation
trades is to overweight the sectors within the corporate market that are expected to perform better
than other sectors, which are then underweighted.

Curve-Adjustment Trades

Trades are undertaken to adjust a portfolios duration relative to that of the benchmark. The
portfolio duration can be adjusted to maintain its equality with the duration of the benchmark, an
interest-rate position taken when the portfolio manager wants to be neutral to the benchmark.
Trades for the purpose of adjusting portfolio duration are referred to as curve-adjustment trades.
Typically, curve-adjustment trades are done in the more liquid Treasury market (cash or
derivatives) rather than in the corporate bond market.

Structure Trades

Structure trades involve one of the following: (1) swaps from one structure, such as bullet, callable
or putable bonds, to a different structure; (2) swaps into different coupon types (fixed to floating
or floating to fixed); and (3) swaps from less restrictive covenants to more restrictive covenants or
vice versa. The decision to do a structure trade is based on expectations about changes in yields,
spreads, and interest-rate volatility.

CONSTRAINT-TOLERANT INVESTING

An investment strategy of just buying and holding todays index components will lead to tracking
error over time as the index evolves. Investment-grade issuers downgraded to a noninvestment-
grade rating are called fallen angels. For most corporate bond indexes, the minimum maturity
requirement is one year. For the investment-grade corporate index that will be used in our
discussion, the Barclays Capital Corporate Investment-Grade Index, the minimum liquidity is $250
million. Constraint-tolerant investing refers to how a portfolio manager would have performed if
clients allowed the portfolio manager to use discretion and continue holding bonds that are
removed from an investment-grade corporate index.

For portfolio managers whose clients specify in their investment guidelines that the issue must be
sold if it falls below investment grade, the portfolio manager has no choice. If the portfolio
manager is not forced to sell the position in a fallen angel, there are two adverse consequences.

585
First, the fallen angel becomes an out-of-index holding and this will adversely impact the
portfolios tracking error. Second, for insurance companies, regulations mandate that capital
reserves be increased because there are higher capital reserves required for noninvestment-grade
bonds than for investment-grade bonds.

Ng and Phelps construct different tolerant portfolios, which they refer to as alternative
corporate indices. The five tolerant portfolios are as follows:
1. Downgrade tolerant: Downgraded bonds are retained in the portfolio as long as they meet
the maturity and liquidity requirements.
2. Remaining maturity tolerant: Permits the holding of issues with a maturity of one year or
less but not if they are downgraded to noninvestment grade or if they fall below the liquidity
requirement.
3. Liquidity constraint tolerant: Permits the holding of an issue if it falls below the minimum
liquidity requirement ($250 million) but not if it is downgraded to noninvestment grade or
has a maturity of less than one year.
4. Investment-grade only full tolerant: Any issue that is investment grade may be included
even if it violates the maturity and liquidity requirement. That is, downgraded issues to
noninvestment grade are not permitted.
5. Fully tolerant: No issue is removed due to downgrade, maturity, or liquidity violations.

Downgrade-Tolerant Investing: Case of Fallen Angels

The Ng and Phelps study provides preliminary evidence for holding issues that have been removed
from the Barclays Capital Investment Grade Corporate Index. For portfolio managers granted the
flexibility of retaining a fallen angel, the question is whether there will be better long-term
performance by disposing of the bond shortly after the announcement of the downgrade or
retaining it in the portfolio.

Dor and Xu suggest how, by understanding the characteristics and price dynamics of fallen angels,
a portfolio manager of a corporate bond portfolio can formulate rules-based strategies to exploit
price behavior so as to generate alpha. They investigate whether there is price pressure after an
investment-grade issue is downgraded to noninvestment grade as portfolio managers collectively
divest themselves of the downgraded issue. The findings provide strong support for such price
pressure, resulting shortly after downgrading in a market price below fundamental value.

USING CREDIT RISK MODELING TO CONSTRUCT

CORPORATE BOND PORTFOLIOS

A key credit risk measure provided by Moodys Analytics is the expected default frequency (EDF).
Using the EDF measure for credit risk, Moodys Analytics provides a framework that takes into
account factors that drive the credit spread to determine the credit spread. The framework it
proposes, referred to as its fair-value spread (FVS) framework, can be used to construct portfolios
based on the relative value of the observed credit spread versus the modeled credit spread (i.e., the

586
FVS). The FVS framework is not an investment strategy but a tool that can be used in constructing
portfolios for any strategy pursued by a credit portfolio manager.

Portfolio construction involves two steps. The first step is to define two strategies: risk-based
strategy and valuation-based strategy. For its risk-based strategy, Moodys Analytics defines
attractiveness in terms of a bonds spread per unit of expected loss, referred to as gamma and
measured as follows:

OAS
Risk@based strategy gamma =
EDF LGD

where OAS = option-adjusted spread; EDF = expected default frequency; and, LGD = loss given
default.

Gamma in the risk-based strategy is a measure of a bonds spread per unit of loss because the
numerator is a spread measure that adjusts for a bonds optionality and the denominator is the
expected loss.

For its valuation-based strategy, Moodys Analytics calculates the FVS, which is the difference
between the market OAS minus its modeled spread. The difference is then put on a per unit loss
basis by dividing by the bonds expected loss. That valuation-based measure, also referred to as
gamma, is then

OAS FVS
Valuation@based strategy gamma =
EDF LGD

The higher the gamma value as computed for either strategy, the more attractive the bond. Notice
that if a bond is fairly valued based on Moodys Analytics estimated FVS model, then gamma is
zero.

The second step is to construct the portfolio based on the gamma values. To do so, each candidate
bond is ranked by its gamma value starting from the lowest value to the highest value. Moodys
Analytics divide all the candidate bonds into 10 buckets using percentiles of 1% up to 99%. Each
of these 10 buckets is denoted by n, starting with n = 0 and the last bucket n = 9. The higher the n,
the more attractive the bonds are in that bucket. In general, the more weight placed on buckets
with higher gamma values, the more concentrated the portfolio will be (i.e., less diversified), with
the expectation that there will be more volatility compared to less concentrated portfolios in
higher-gamma-value bonds. Moodys Analytics uses a weight parameter that it denotes by c, with
c varying from 1 to 19. The higher the c, the greater the concentration in bonds with high gamma
values.

Li and Zhang report results of the cumulative returns for investment-grade bonds for different
values of the weight control parameter c for the original Merrill Lynch Index, the risk-based
strategy, and the valuation-based strategy. We summarize the annualized excess return over the
period (i.e., excess over the original Merrill Lynch Index) for the figures that appeared in the study
as follows:

587
 Weight Control c Risk-Based Strategy Valuation-Based Strategy
1 113 bps 117 bps
13 239 bps 274 bps
19 265 bps 309 bps

The two panels in Exhibit 26-8 provide the results for high-yield bonds. The findings are the same
as for the investment-grade bonds: outperformance of both the risk-based and valuation-based
strategies relative to the Pseudo Index and with lower standard deviation of returns. A summary
of the annualized excess return over the period (i.e., excess over the original Merrill Lynch Index)
is:

Weight Control c Risk-Based Strategy Valuation-Based Strategy

12 675 bps 765 bps
19 665 bps 752 bps

LIQUIDITY MANAGEMENT FOR CORPORATE BOND PORTFOLIOS

Basically, liquidity is the flexibility afforded a portfolio manager in rebalancing a portfolio based
on expectations. Although market participants have long recognized the importance of liquidity,
the question is how to measure it. Once measured, a portfolio manager and/or clients use the
measure in the implementation and designing of portfolio strategies.

Portfolio managers can use a liquidity measure in several ways. First, several studies have
suggested that historically observed credit spreads (even after adjusting for any embedded option)
are greater than can be justified by historical default and recovery rates. A liquidity measure can
be used to decompose the observed spread for a credit-risky issue. This decomposition allows a
portfolio manager to potentially enhance return by having a better measure of the true credit risk
of an issue and to take an appropriate position in issues whose liquidity is expected to increase or
decrease. Second, in executing trades during a period of illiquidity, monitoring the behavior of a
liquidity measure over time can be used to determine what action should be taken at the beginning
of a liquidity crisis.

There have been several proposals for measuring liquidity. Our focus here is on the measure used
by Barclays Capital, the Liquidity Cost Score (LCS), which it defines as the cost of a roundtrip
institutional-size transaction in a bond. For bonds that are quoted in terms of their bid-ask spread,
the LCS is defined as

(Bid Ask spread in basis points) Spread duration

For example, if a credit-risky bond has a spread duration of 4 and a bid-ask spread of 40 basis
points, the LCS is 4 times 40 basis points, which is equal to 160 basis points or 1.6%.

The interpretation of the LCS is as follows: it is the roundtrip cost as percent of the bonds value
of immediately executing a standard institutional transaction. Roundtrip cost refers to the cost
of buying and then selling a bond. A higher LCS value means worse liquidity.

588
For bonds quoted in terms of price rather than bid-ask spread (referred to as price-quoted bonds),
LCS is computed as

(Ask price Bid price)/Bid price

Both measures are computed based on simultaneous bid-ask spreads quoted by Barclays Capitals
credit traders (both investment-grade and high-yield traders) to clients.

Not all of the bonds comprising a credit index have quotes from the Barclays Capital traders. An
adjustment to the LCS for such bonds is made. To do so, Barclays Capital partitions bonds into
two groups: trader-quoted bonds (those bonds that during the month had at least two bid-ask
indications) and non-quoted bonds (those bonds with no indications or only one bid-ask
indication).

Barclays Capital developed a methodology for adjusting the LCS of trader-quoted bonds to obtain
an LCS for non-quoted bonds. A statistical methodology is employed using the attributes found to
impact bid-ask spreads to obtain an attribute-based LCS. The methodology allows Barclays Capital
to cover sectors other than investment-grade and high-yield corporate credits in the U.S. and Pan-
Euro credits.

A potential application of a liquidity measure is that it can help decompose the spread that a credit-
risky bond is trading over a comparable Treasury, typically defined as the credit spread, into a true
credit-related component and a liquidity component. Barclays Capital has a model that does
precisely that. The Barclays Capital model decomposes the OAS into three components as follows:

OAS of a bond = Risk premium + Expected default losses + Expected liquidity costs

KEY POINTS

The riskreturn profile for an investor in the common stock of a company versus the
corporate bonds of the same company is substantially different and has implications for the
investment philosophy of the management of a corporate bond portfolio.
The implication for the management of corporate bond portfolios is to avoid losers, and
this is far more important than for equity portfolios. Equity portfolio management for long-
only investors involves identifying winners.
For corporate bond portfolios it is particularly important to obtain diversification in
managing a corporate bond portfolio given that a corporate bond index may have far more
issues than a manager may be able to purchase for a typical portfolio.
One problem associated with using a market-cap-weighted corporate bond index is that
over time, due to additions and removals of bond issues, the interest-rate risk exposure and
the credit risk exposure of the benchmark will change.
The change in the risk attributes over time of a market-cap-weighted corporate bond index
may be such that an investor who initially adopted a particular index as a benchmark may
find the new level of risk exposure unacceptable.

589
 Empirical evidence for both U.S. and Eurozone investment-grade corporate bond indexes
suggests that their risk exposure fluctuates considerably over time.
Corporate bond trades based on relative value methodologies seek to rank comparable
corporate bonds based on expected return over some specified investment horizon.
Relative value methodologies provide a portfolio manager with some guidance about how
similar bonds are currently priced in the market on a relative basis.
Two assumptions when employing relative value methodologies are (1) because of the
complexity of certain sectors of the bond market there will be mispriced securities and (2)
pricing errors can be identified and those pricing errors will correct themselves over a
specified investment horizon.
Credit relative value secondary market trades include yield-spread pickup trades, credit-
upside trades, credit-defense trades, sector-rotation trades, curve-adjustment trades, and
structure trades.
When bond issues held in a portfolio are removed from an index used as a benchmark, a
portfolio manager may be forced to dispose of those issues within a specified period of
time. Constraint-tolerant investing is a strategy whereby a portfolio manager is permitted
to continue to invest in bond issues removed from an index.
Constraint-tolerant investing involves tolerances with respect to credit downgrade,
remaining maturity, and liquidity (as measured by the size of an issue).
Studies of the performance of downgrade tolerance, remaining maturity tolerance, liquidity
constraint tolerance, investment-grade only full tolerance, and full tolerance indicate that
tolerant-constraint investing leads to superior performance in comparison to the index
itself.
Downgrade-tolerant investing, which involves fallen angels, is one of the constraints that
has been of particular interest to corporate bond portfolio managers. The empirical
evidence suggests that price pressure shortly after the downgrading of an issue from
investment grade to noninvestment grade results in a market price below fundamental value
and that after two years there is a reversal that results in superior performance of fallen
angels.
Credit risk models can be used to construct corporate bond portfolios.
A corporate bonds liquidity is the flexibility that it provides a manager in rebalancing a
portfolio based on expectations.
The most commonly used quantitative measure of liquidity that institutional investors use
is the Barclays Capitals Liquidity Cost Score, defined as a bonds roundtrip cost (i.e., cost
of buying and selling) on an institutional-size transaction.
By measuring liquidity, the portion of what is typically referred to as credit spread can be
adjusted to remove the liquidity component.

590
 ANSWERS TO QUESTIONS FOR CHAPTER 26
(Questions are in bold print followed by answers.)

1. How does the investment risk profile of a corporate bond and that of the common stock of
the same company affect the investment philosophy in managing a corporate bond portfolio?

The riskreturn profile for an investor in the common stock of a company versus the corporate
bonds of the same company is substantially different and has implications for the investment
philosophy of the management of a corporate bond portfolio. The implication for the management
of corporate bond portfolios is to avoid losers, and this is far more important than for equity
portfolios. Equity portfolio management for long-only investors involves identifying winners.
For corporate bond portfolios it is particularly important to obtain diversification in managing a
corporate bond portfolio given that a corporate bond index may have far more issues than a
manager may be able to purchase for a typical portfolio. More details are given below.

The riskreturn distribution faced by an equity investor is quite different from that of an investor
in the bonds issued by the same company. The upside for corporate bond investors is the coupon
payments, if the bond is purchased at par and held to maturity. For bonds purchased at a discount
and held to maturity, it is the capital gain realized plus the coupon payments. For a corporate bond
sold prior to maturity and that is not a distressed bond selling at extremely low prices, there is
market price appreciation. However, the price appreciation is limited. For an equity investor, the
upside is potentially unlimited. The doubling, tripling, or even greater increase over a short period
of time is not unusual. As for the downside, for a corporate bond investor both the principal and
the interest payments can be lost, partially offset by some possible recovery value. For an equity
investor, the entire investment can be lost.

An interesting exercise performed by Zan Li and Jing Zhang of Moodys Analytics highlights the
difference in the return distributions for investors in corporate bonds versus those of equity
investors. The exercise has important implications for investing in corporate bonds. Using the
Merrill Lynch Investment Grade Index, Li and Zhang eliminated the 10% best-performing and
10% worst-performing issues over the period from July 1999 to July 2009. Panel A of Exhibit 26-
1 shows the cumulative total return over the period for both the original index and for the truncated
index (i.e., the index after removing the 10% best and 10% worst performers). As can be seen, the
truncated index outperforms that of the original index. When the same analysis was done for the
Merrill Lynch High-Yield Index, the truncated indexs outperformance was far greater (see panel
B of Exhibit 26-1). Finally, Li and Zhang did the same exercise using the Dow Jones 30 equity
index. The result, is different from what was found for the two corporate bond indices. The
cumulated return for the truncated stock index is considerably less than the original index.

What are the implications of this exercise in establishing an investment philosophy for managing
corporate bond portfolios? We can see that for credit portfolios, avoiding losers is far more
important for credit portfolios of corporate bonds than for equity portfolios. Equity portfolio
management for long-only investors involves identifying winners. Moreover, it is particularly
important to obtain diversification in managing a corporate bond portfolio. If the benchmark is a
corporate bond index with 3,000-plus bond issues, it will not be practical to hold more than 150 or

591
so issues. This means that there will be considerable idiosyncratic risk. This risk cannot be avoided
but it can be minimized using traditional credit analysis and/or credit risk models.

2. You have been retained by a wealth management firm to advise on the selection of a
benchmark for its client who has made the decision to invest in only U.S. investment-grade
corporate bonds. One of the firms managers recommended that a market-capitalization-
weighted investment-grade corporate bond index be selected. The manager argued that by
doing so the client would know the investment characteristics of the benchmark and
determine if they are within the clients risk tolerance.

Answer the below questions.

(a) What is meant by the investment characteristics of the benchmark?

Benchmarks are used to determine relative performance of portfolios and securities. When a manager
recommends a benchmark, the manager must first review the characteristics associated with good
benchmarks. According to industry experts, a valid and effective benchmark must exhibit the
following investment characteristics. First, it must be investable. The option should exist to invest in
the benchmark as a replacement to the portfolio being considered. For example, it is not possible to
invest in the bond fund that will produce top results come year-end, but it is possible to invest in the
two-year treasury. Second, it must be suitable. The benchmarks main characteristics are in harmony
with those of the portfolio being measured against it. For example, a mortgage-backed securities
portfolio is compared to a mortgage-backed bond index. Third, it must operate under an informed
opinion. The investments in the benchmark and how they behave are understood, so the performance
of the portfolio against the benchmark can be explained. Fourth, it must be clear-cut. To avoid
vagueness for a benchmark, a manager should make sure the name and weight of the index or peer
group are clearly defined. Fifth, it must be specified in advance. This means the benchmark is
selected/constructed before comparing portfolio accomplishments. Altering the benchmark after the
fact can exaggerate or play down performance comparisons.

(b) How would you respond to the managers suggestion about a suitable benchmark?

First, it is very difficult to find a suitable benchmark. For example, if the benchmark is a
corporate bond index with 3,000-plus bond issues, it will not be practical to hold more than 150 or
so issues. This means that there will be considerable idiosyncratic risk. This risk cannot be avoided
but it can be minimized using traditional credit analysis and/or credit risk models. Furthermore,
the composition of the bond issues for a corporate bond index can be altered by a variety of factors
including the addition of new bond and the retire of maturing bonds. As a result of the changing
composition of a corporate bond index, the interest-rate risk exposure (as measured by duration
and convexity) and the credit risk exposure will change. The change may be such that an investor
who initially adopted a particular market-cap-weighted bond index as a benchmark because the
interest-rate risk and credit risk exposure were acceptable is no longer acceptable as the
composition of the index changes over time.

3. How does a yield-spread pickup trade differ from a credit-upside trade?

592
A yield-spread pickup trade is characterized as a trade of an asset (such as a bond) for another like asset
but with a higher credit spread whereas a credit-upside trade is characterized as a trade of an asset (such
as a bond) for another like asset that is expected to have a credit upgrade. This upgrade will cause the
asset to trade at a lower spread as opposed to a yield-spread pickup trade that is undertaken to increase
the spread. Hence, for a credit-upside trade, profit can be realized without additional risk whereas the
yield-spread pickup takes on additional risk to increase its yield. More details are found below.

A yield-spread pickup trade refers to the additional interest-rate spread an investor receives when
selling a lower interest-rate spread in exchange for a higher interest-rate spread. The bond with the
lower spread generally has a shorter maturity, while the bond with the higher spread will typically
have a longer maturity. A certain amount of risk is involved since the bond with a higher spread
is often of a lower credit quality. Additionally, the investor can be exposed to interest rate risk with
the longer maturity bond. The trade to pick up yield will not necessarily mean a superior expected
return for the bond simply because of the higher spread. When the trade is undertaken, the portfolio
manager must be sure that it is a dollar-duration-neutral trade so that the portfolio is not impacted
by changes in the level of Treasury rates. Moreover, corporate bonds with different credit ratings
will be impacted by changes in credit spreads and credit spread volatility as Treasury rates change.

A credit-upside trade refers to the potential dollar or percentage amount by which the asset could
rise. We can illustrate a credit-upside trade as follows. Suppose that a credit analyst covering a
particular sector within the corporate bond market believes a particular issuer will have a credit
upgrade and is currently trading at a wider spread than what it would if the credit rating were
upgraded. The action that might be taken by the portfolio manager to whom the credit analyst
reports is to acquire the issue that is expected to be upgraded, assuming that the market has not
reflected the anticipated action by the rating agency into the issues price. Such a trade is referred
to as credit-upside trade.

4. What is the motivation for a new-issue swap trade?

Trades from seasoned issues to new issues, referred to new-issue swap trades, are based on two
motives. First, new issues are viewed as having better liquidity than seasoned issues. Evidence
confirms that new issues provide better liquidity. The second motive for acquiring new issues are
to gain exposure to a new issuer or to a new type of corporate bond structure.

5. Give two examples of a structure trade.

The decision to do a structure trade is based on expectations about changes in yields, spreads, and
interest-rate volatility using total return analysis to assess potential performance. Several examples
of structure trades can be described. First, we have swaps from one structure, such a callable bond
structure to a putable bond structure. Second, we can have a swap from a fixed rate structure to a
floating-rate structure. Another example would be a swap from a less restrictive covenants to a
more restrictive covenant.

6. What is meant by constraint-tolerant investing?

593
Constraint-tolerant investing refers to how a portfolio manager would have performed if clients
allowed the portfolio manager to use discretion and continue holding bonds that are removed from
an investment-grade corporate index. Reasons for removal include downgrade to noninvestment
grade, violation of maturity requirement, or violation of liquidity requirement.

7. What are the implications of findings regarding various types of constraint-tolerating

investing for setting an investment policy for corporate bond portfolios?

The major study providing implications is by Ng and Phelps. Their findings gives guidance as to
whether portfolio managers should be tolerant of any violation in the inclusion requirements and
continue to hold an issue that has been removed from the index. They look at the credit spread
premium (i.e., the return in excess of a Treasury portfolio with similar duration) of a portfolio that
permits an issue removed from the index to be retained and compares that to the index itself.
Specifically, Ng and Phelps construct different tolerant portfolios, which they refer to as
alternative corporate indices. The five tolerant portfolios that has implications for setting an
investment policy for corporate bond portfolios are as follows:

1. Downgrade tolerant: Downgraded bonds are retained in the portfolio as long as they meet the
maturity and liquidity requirements.
2. Remaining maturity tolerant: Permits the holding of issues with a maturity of one year or less
but not if they are downgraded to noninvestment grade or if they fall below the liquidity
requirement.
3. Liquidity constraint tolerant: Permits the holding of an issue if it falls below the minimum
liquidity requirement ($250 million) but not if it is downgraded to noninvestment grade or has a
maturity of less than one year.
4. Investment-grade only full tolerant: Any issue that is investment grade may be included even
if it violates the maturity and liquidity requirement. That is, downgraded issues to noninvestment
grade are not permitted.

In conclusion, the Ng and Phelps study provides preliminary evidence for bond portfolio managers
to hold issues that have been removed from the Barclays Capital Investment Grade Corporate
Index. The implications are that managers should consider a variety of tolerant strategies.

8. What are the risks associated with the disposing of a bond issue in an investment-grade
corporate bond index after it is downgraded to noninvestment grade?

The question that is faced by a manager when there is a downgrade is whether or not to sell the
downgraded issue. Either action has its own risk. For example, in the decision to dispose of a
downgraded issue the portfolio manager may be giving up characteristics of the bond that has a
positive influences (such as adding to the overall average maturity of the portfolio). For some
institutions (such as insurance companies) keeping the downgraded bond has a risk associated with
removing an issue that will cause it to realize a loss it may not be able to afford. The Ng and Phelps
study provides preliminary evidence for holding issues that have been removed from the Barclays
Capital Investment Grade Corporate Index. This evidence suggests a number of implicit risks
associated with the disposing of a bond issue in an investment-grade corporate bond index after it

594
is downgraded to noninvestment grade. The risks are associated with losing desirable portfolio
features such as liquidity, maturity, duration and so forth.

For portfolio managers granted the flexibility of retaining a fallen angel, the question is whether
there will be better long-term performance by disposing of the bond shortly after the announcement
of the downgrade or retaining it in the portfolio. The disadvantage of disposing of the fallen angel
is that given the limited liquidity in the corporate high-yield market, a liquidation that occurs at
the same time as other portfolio managers who are either forced to liquidate or elect to do so can
result in a sale price of a fallen angel that is below its fundamental value. Thus, we have the risk
of selling an underrated bond. There is empirical evidence to support this. For example, Dor and
Xu investigate whether there is price pressure after an investment-grade issue is downgraded to
noninvestment grade as portfolio managers collectively divest themselves of the downgraded
issue. The findings provide strong support for such price pressure, resulting shortly after
downgrading in a market price below fundamental value.

9. What has been the observed price performance of fallen angels after they have been
downgraded?

A fallen angel is bond that was once investment grade but has since been reduced to junk bond
status due to downgrades. Studies have observed that fallen angels outperform peer high-yield
bonds two years after the downgrade announcement. The amount of outperformance after two
years was found by Dor and Xu to be a total of 6.63%.

NOTE: There can be negative consequences that may offset the superior price performance. For
example, if the portfolio manager is not forced to sell the position in a fallen angel, there are two
adverse consequences. First, the fallen angel becomes an out-of-index holding and this will
adversely impact the portfolios tracking error. Second, for insurance companies, regulations
mandate that capital reserves be increased because there are higher capital reserves required for
noninvestment-grade bonds than for investment-grade bonds.

10. What metric from Moodys Analytics can be used to assess the attractiveness of a bonds
spread per unit of expected loss?

Moodys Analytics uses its R8isk@based strategy gamma to assess the attractiveness of a bonds
spread per unit of expected loss. Gamma in the risk-based strategy is a measure of a bonds spread
per unit of loss because the numerator is a spread measure that adjusts for a bonds optionality and
the denominator is the expected loss. In equation form, we have:
OAS
Risk@based strategy gamma =
EDF LGD
where
OAS = option-adjusted spread
EDF = expected default frequency
LGD = loss given default

595
For its valuation-based strategy, Moodys Analytics calculates the FVS, which is the difference
between the market OAS minus its modeled spread. The difference is then put on a per unit loss
basis by dividing by the bonds expected loss. That valuation-based measure, also referred to as
gamma, is then
OAS FVS
Valuation@based strategy gamma =
EDF LGD
The higher the gamma value as computed for either strategy, the more attractive the bond. Notice
that if a bond is fairly valued based on Moodys Analytics estimated FVS model, then gamma is
zero.

11. Studies have suggested that credit spreads in the market have been observed to be greater
than what can be justified by default and recovery rates. Explain how by quantifying
liquidity spreads, one can obtain a truer measure of credit spreads.

To begin, let us note that liquidity is the flexibility afforded a portfolio manager in rebalancing a
portfolio based on expectations. A liquidity measure can be used by a client seeking to create a
customized liquid benchmark for credit portfolio managers that it has engaged. The credit issues
included in such a customized credit benchmark would be the result of screening all the credit
bonds in a broader benchmark so as to include only liquid issues as determined by the liquidity
measures. Portfolio managers can use a liquidity measure in several ways.

First, several studies have suggested that historically observed credit spreads (even after adjusting
for any embedded option) are greater than can be justified by historical default and recovery rates.
A liquidity measure can be used to decompose the observed spread for a credit-risky issue, which
is simply referred to as the credit spread, into a liquidity-adjusted credit spread and liquidity spread.
This decomposition allows a portfolio manager to potentially enhance return by having a better
measure of the true credit risk of an issue and to take an appropriate position in issues whose
liquidity is expected to increase or decrease.

Second, in executing trades during a period of illiquidity, monitoring the behavior of a liquidity
measure over time can be used to determine what action should be taken at the beginning of a
liquidity crisis. Understanding the performance of bonds identified as illiquid over time can
provide guidance to portfolio managers as to whether to sell highly liquid bonds (as determined
by the liquidity measure) or illiquid bonds.

There have been several proposals for measuring liquidity. One measure is Barclays Capital, the
Liquidity Cost Score (LCS), which it defines as the cost of a roundtrip institutional-size
transaction in a bond. For bonds that are quoted in terms of their bid-ask spread (referred to as
spread-quoted bonds), the LCS is defined as
LCS = (Bid Ask spread in basis points) Spread duration
For example, if a credit-risky bond has a spread duration of 4 and a bid-ask spread of 40 basis
points, the LCS is 4 times 40 basis points, which is equal to 160 basis points or 1.6%.

The interpretation of the LCS is as follows: it is the roundtrip cost as percent of the bonds value
of immediately executing a standard institutional transaction. Roundtrip cost refers to the cost

596
of buying and then selling a bond. A standard institutional transaction is for $3 to $5 million of par
value. An LCS for a bond of 1.6% trading at a bid price of 85 means that the current immediate
roundtrip cost would be 1.6% of the bonds price. A higher LCS value means worse liquidity.

For bonds quoted in terms of price rather than bid-ask spread (referred to as price-quoted bonds),
LCS is computed as
LCS = (Ask price Bid price)/Bid price

12. What does a Barclays Capital Liquidity Cost Score of 1.2 mean?

The interpretation of the meaning of Barclays Capital Liquidity Cost Score (LCS) of 1.2 is as
follows. An LCS of 1.2 is the roundtrip cost as percent of the bonds value of immediately
executing a standard institutional transaction. (Thus, as a percent, 1.2 means 1.2%.) Roundtrip
cost refers to the cost of buying and then selling a bond. A standard institutional transaction is for
$3 to $5 million of par value. An LCS for a bond of 1.2% trading at a bid price of 95 means that
the current immediate roundtrip cost would be 1.2% of the bonds price or 0.012 95 = 1.14. A
higher LCS value means worse liquidity.

13. Answer the below questions.

(a) For the Barclays Capital Liquidity Cost Scores, how are the bid-ask spreads obtained?

For the Barclays Capital Liquidity Cost Scores (LCSs), its LCS measures are computed based on
simultaneous bid-ask spreads quoted by Barclays Capitals credit traders (both investment-grade
and high-yield traders) to clients. The database is built from the hundreds of messages sent by its
credit traders for standard institutional transactions bond-level bid-ask spread indications.

(b) What are the limitations of the bid-ask spreads used by Barclays Capital to compute the
Liquidity Cost Score?

Barclays Capital concedes that the LCS is not a perfect measure of liquidity. The problems
associated with this measure identified by Barclays Capital are threefold
1) The quotes may not be the best market quote at the time. For example, if the spread-quote
from the Barclays Capital trader is 140165, there may be a 135-155 quote by a trader at
another firm. Consequently, the effective bid-ask spread for a client would be 140155.
2) The quote may be influenced by the inventory held by the trader or the outlook the trader
has about the bond.
3) The quotes are indications, not necessarily two-way prices at which investors can transact.

Not all of the bonds comprising a credit index have quotes from the Barclays Capital traders. Nor
are there bonds in the index that are followed closely by its traders. As a result, an adjustment to
the LCS for such bonds is made. To do so, Barclays Capital partitions bonds into two groups:
trader-quoted bonds (those bonds that during the month had at least two bid-ask indications) and
non-quoted bonds (those bonds with no indications or only one bid-ask indication). Within each
group, bonds are then further classified as benchmark bonds and non-benchmark bonds. The
former are defined as high-profile bonds that are closely monitored by traders and whose bid-ask
597
indication is likely to be close to the markets actual bid-ask spread. High-profile bonds are defined
as on-the-run bond issues and bonds with high trading volume. Non-benchmark bonds are then
off-the-run issues that experience low trading volume.

Barclays Capital developed a methodology for adjusting the LCS of trader-quoted bonds to obtain
an LCS for non-quoted bonds. A statistical methodology is employed using the attributes found to
impact bid-ask spreads to obtain an attribute-based LCS. The attributes include the sector, the
option-adjusted spread, the trading volume, the amount outstanding, the seasoning or age of the
bond (i.e., amount of time since issuance), and the bonds benchmark status. Once the attribute-
based LCS for non-quoted bonds is obtained using the statistical methodology, it is further adjusted
based on the frequency with which the particular bond was quoted in recent months.

The methodology allows Barclays Capital to cover sectors other than investment-grade and high-
yield corporate credits in the U.S. and Pan-Euro credits. For example, an LCS can be obtained for
U.S. Treasuries, TIPS, and fixed-rate agency mortgage-backed securities (MBS). Moreover, the
methodology has been extended to include bonds not included in an index (i.e., non-index bonds).

14. Answer the below questions.

(a) How is the Barclays Capital Liquidity Cost Score calculated for a spread-quoted bonds?

For bonds that are quoted in terms of their bid-ask spread (referred to as spread-quoted bonds), the
LCS is defined as
(Bid Ask spread in basis points) Spread duration
For example, if a credit-risky bond has a spread duration of 4 and a bid-ask spread of 40 basis
points, the LCS is 4 times 40 basis points, which is equal to 160 basis points or 1.6%.

The interpretation of the LCS is as follows: it is the roundtrip cost as percent of the bonds value
of immediately executing a standard institutional transaction. Roundtrip cost refers to the cost
of buying and then selling a bond. A standard institutional transaction is for $3 to $5 million of par
value. An LCS for a bond of 1.6% trading at a bid price of 85 means that the current immediate
roundtrip cost would be 1.6% of the bonds price. A higher LCS value means worse liquidity.

(b) How is the Barclays Capital Liquidity Cost Score calculated for a price-quoted bonds?

For bonds quoted in terms of price rather than bid-ask spread (referred to as price-quoted bonds),
LCS is computed as
(Ask price Bid price)/Bid price
Both LCS measures are computed based on simultaneous bid-ask spreads quoted by Barclays Capitals
credit traders (both investment-grade and high-yield traders) to clients. The database is built from the
hundreds of messages sent by its credit traders for standard institutional transactions bond-level bid-ask
spread indications. Barclays Capital concedes that the LCS is not a perfect measure of liquidity.

598