The last column in this series asked the rhetorical question: “Credit Risk—is it time to panic?”(Have you ever noticed that investment columnists rarely answer their own questions?)The header was challenged by a couple of readers, who wondered what would constitute an appropriate level of panic and what, in fact, a plan sponsor who was currently reviewing a fixed-income portfolio should actually do.
There’s an expression that’s popular on trading floors—“when the suits tell you it’s time to sell, you know it’s time to buy.” Certainly selling a fixed income holding after spreads have shot out by a few hundred basis points is rarely a good idea(noting that the exception proves the rule). More often, portfolio managers are forced to sell due to policy constraints on ratings exposures or in a mad dash for the exits triggered by those who suddenly find that they were not aware of the level of risks being assumed. As has often been observed, fear is a powerful motivator.
As mentioned in the previous column, the key question is whether the holding will mature its principal and, if not, whether the recovery value will exceed the current market value. In the absence of fraud or gross negligence, recovery values usually have an upward bias in the long-term, particularly for financial institutions or for any entity with hard assets. This is why these assets are often picked over by vulture funds, who have the patience and perseverance to pursue the residual value, and profit handsomely from their efforts.(Of course, vulture fund managers rarely receive awards for their humanitarian tendencies.)
However, in some cases, the market value may still exceed the ultimate recovery value and an early dash for the exits makes sense. Credit default swap(CDS)spreads may provide a leading indicator of this. Unfortunately, the only recourse may be to buy the derivative protection if the physical asset has lost its liquidity, thus adding counterparty risk to the exposure. One theory holds that the only reason the CDS market provides leading indicators is the lack of liquidity in the physical debt market.(As an aside, one of the ironies of the CDS market is that it uses simplifying assumptions for recovery values, thus inadvertently creating the very market inefficiencies that CDS products were created to exploit.)
The time for credit analysis and the review of SEDAR filings is long before any turbulence appears on the credit horizon. Likewise the time to review credit documentation is before you buy, not before you sell. Those who rely solely on rating agencies do so at their peril.(While agencies are viewed as being more proactive now than they used to be, they still wish to avoid biting the hand that pays their fees, or being accused of causing the market disruption themselves.)
A pension fund, or any fixed-income manager, should be as thorough in their credit analysis as in their equity analysis if they are assuming credit risk in their portfolios. The good news is that as the credit cycle runs its course, there will be great opportunities to invest in securities that are out of favour, allowing sponsors to diversify away from equity risk and interest rate risk, should they be inclined to do so.