In the years leading up to the 2008 financial crisis, a slack lending environment led to unprecedented levels of credit volatility. After 2008, however, volatility was driven by concerns over European credit and its spillover effects on global recovery. Central Bank intervention eventually helped, but it has also led to concerns over its eventual withdrawal and the potential for risk-on/risk-off markets as a result. At the same time, reduced dealer positions will eventually lead to increased secondary-market liquidity premiums.
Without a doubt, managing credit-spread volatility in this environment will continue to be challenging. To help, this article outlines six basic principles to help investors mitigate volatility in these difficult times.
1) Independent and forward-looking credit research is the best way to avoid problems.
Know what you’re buying. Emphasize and foster a credit-research culture in your organization. Put in place a framework where credit metrics and opinions are reported. In outsourcing portfolio management, good research teams should be a primary criterion.
2) Portfolio-management teams should be responsible for identifying, measuring, monitoring and controlling credit risk.
Portfolio management owns risk. Institutionalize a periodic formal meeting where management solely focuses on factors driving performance and what can go wrong.
3) There should be processes and systems in place to monitor credits.
Ensure that when a research opinion deteriorates, there is a mechanism to quickly communicate and act on it. Leverage technology such as email groups and discussion forums to communicate changes in research opinions.
4) Portfolio-management teams need to assess the impact of likely future changes in economic conditions on a portfolio.
Historical scenario analysis is limited when economic conditions are unprecedented. In addition, scenario analysis is only useful if it identifies economic environments that will most impact the portfolio’s value. Specify those scenarios and try to quantify how portfolio assets will perform. Use history as a guide, but lean most on management insight.
5) A system must be in place for early remedial action on deteriorating credits or underperforming asset classes linked to similar risk factors.
Underperformance limits should be considered to trigger a formal review when individual credits or correlated assets underperform. These underperformance limits should be based on sensible risk-return expectations.
6) Limits should be considered to restrict exposures to similar risk factors.
When management acknowledges that a portfolio has concentrated exposures to correlated assets, consider putting sensible limits to those exposures. Use historical simulation for guidance on correlations and risk-return profiles of different assets.
Brad Crombie is global head of fixed income and global head of high yield, Aberdeen Asset Management Inc.