the credit conundrum- credit manager selection – an essential guide
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26th March 2009
The Credit Conundrum
Session 4: Credit Manager Selection – An Essential Guide
Credit Manager Selection
Contents
2
Page
Introduction 3
Why it Matters 4
Current Environment Consideration 7
Designing a Mandate 10
Choosing a Manager 16
Summary 21
Contents
• Popular market views on Credit is “new equity”, “free lunch”, “once in a life time opportunity”.
• But there are Risks: • When consensus say one thing, market often does the opposite; • We have seen significant credit deterioration already with more to come; • Defaults will increase and recovery rates are likely to collapse; • Refinancing will be difficult as little credit liquidity is available to corporates.
• Nevertheless, there are outstanding opportunities in the credit universe……
3
Credit Manager Selection
Introduction
Credit Manager Selection
Why it Matters
4
• This chart shows the monthly return dispersion between Oct 2005 and June 2007.
• This chart shows the monthly return dispersion between Oct 2005 and Jan 2009. (Note that only 14 managers
reported their January return.)
• Monthly return dispersion between managers has widened significantly since July 2007.
5
Credit Manager Selection
Why Manager Selection Is So Important?
Why Manager Selection Is So Important?
• In the past, all that mattered was getting asset allocation correct, equities, bonds, properties, etc.
• Now manager selection is vital.
Source: CAMRADATA/iBoxx
6
Credit Manager Selection
Executive Summary
• There are a few terms that need clarification.
Executive Summary
Like any other asset class – Does the manager have the necessary skill set to produce attractive returns in the sector in which he or she operates in the current environment?
• These are needed for mandate design
• This is needed for manager selection. What is the necessary skill set?
What is the current environment?
What is an attractive return?
What is the sector?
• We will discuss the pitfalls in manager selection.
7
Credit Manager Selection
Current Environment Consideration
0
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400
500
600
700
800
02/01/2003 02/01/2004 02/01/2005 02/01/2006 02/01/2007 02/01/2008 02/01/2009
Spre
ad
Benchmark Spread
iBoxx Sterling Non-Gilts iBoxx Sterling Non-Gilts A iBoxx Sterling Non-Gilts BBB
8
Credit Manager Selection
Current Environment Consideration
• In stable environments with no defaults (2003-2007) the skills required will be different from the skills needed now. i.e. now managers need a deep understanding of every issuer and every bond
• The spreads now are extremely wide on a historic basis but expected defaults are expected to increase significantly.
• The rating agencies have not proved to be particularly helpful.
Choosing a Manager – The Current Environment Matters……
Source: Barclays Capital
9
Credit Manager Selection
Current Environment Consideration
• Downgrade/transition risk: • Note: the implied “cost” of downgrade is
substantial, and prices may anticipate downgrade
Choosing a Manager – The Current Environment Matters……
The ongoing banking crisis and global economic downturn make it almost certain that default rates will continue to climb sharply during 2009. Because the impact of the current economic downturn on corporate debt issuers is likely to be more severe than for the two most recent credit cycles of the early 1990s and 2000s, Moody’s expects that the speculative-grade default rate will exceed the peaks of 11.9% and 10.4% reached in those cycles, respectively.
(Source: Corporate default and recovery rates, 1920-2008, Moody’s Global Credit Policy, Feb 2009)
Source: Barclays Capital
Credit Manager Selection
Designing a Mandate
10
11
Credit Manager Selection
Designing a Mandate
• Opportunity • We feel that the current environment makes credit look attractive. • Target return: We would be happy with LIBOR + 250 • Achievable by investing in a diversified portfolio of Investment Grade Credit.
• Clarity needed around the sector:
Designing a Mandate – The Sector
High grade credit?
Sterling high grade credit?
Should it include any
Gilts?
Should it include Quasi-
government EIB, KFW
etc.?
High yield? Currency
considerations?
• PITFALL NUMBER 1: Not being specific around the sector will give you unwanted risks.
12
Credit Manager Selection
Designing a Mandate
• We think that the iBoxx 10 year sterling corporate index is a good proxy for credit.
• Tracking error • We will allow a reasonable tracking error. • This has been the traditional method used for investing in credit
• But is it right for March 2009? • There is a bias in credit that one should be aware of (unlike Government benchmarks?) • The more a borrower issues the larger a percentage they are in the index. • The index may not contain the right amount of risk (either too much or too little).
Designing a Mandate – The Benchmark
• PITFALL NUMBER 2: Using an index that does not contain the appropriate securities is unlikely to lead to a portfolio you thought you would get.
13
Credit Manager Selection
Designing a Mandate
• Behavioural finance • How will the manager behave if we give him this benchmark? • How will the benchmark affect his decision making?
• Incentives
• Should we ask him to beat the benchmark and if so, by how much? • Target: iBoxx Corporate index + 50bp. • Environment: 2005/2006 with low default rates and low volatility • Strategies to achieve return without additional interest rate risk
• Trade the portfolio like a banshee and generate alpha by small bets • Very difficult: very few managers achieved this.
• Or perhaps simply underweight the lower yielding securities and overweight the higher yielding securities (e.g. tier 1 and upper tier 2).
Designing a Mandate – Other Benchmark Considerations
2004 2006 2009
14
Credit Manager Selection
Designing a Mandate
Designing a Mandate – Other Benchmark Considerations • Suppose the manager underweight the lower yielding securities and overweight the higher yielding
securities. • Under current environment, value of high-yield securities shrink massively. • Overweighting high-yield securities results in significant underperformance of credit portfolio.
• PITFALL NUMBER 3: Beware of unintended consequences of setting inappropriate incentives.
Source: Redington Partners
15
Credit Manager Selection
Designing a Mandate
• Last point on benchmarks • Can it ever be good to underperform the benchmark?
• Yes, if it leads to a better risk-adjusted return • Benchmark
Designing a Mandate – The Benchmark
Pro: provides framework for measuring performance
Con: may unnecessarily constrain the manager’s ability to act on his views or lead to the manager taking asymmetric risk
16
Credit Manager Selection
Choosing a Manager
17
Credit Manager Selection
Choosing a Manager
Choosing a Manager
Like any other asset class – Does the manager have the necessary skill set to produce attractive returns in the sector in which he or she operates in the current environment?
• If we have answered the first three questions we are more than half way there
• Let’s make some assumptions and then look at some pitfalls.
18
Credit Manager Selection
Choosing a Manager
• Process • Define the criteria on which the
managers will be assessed (just a few examples):
Choosing a Manager
• What defines a good philosophy? • We need a framework
• If we have answered the first three questions we are more than half way there
• Let’s make some assumptions and then look at some pitfalls.
Assessing Managers
Size of the Firm
Client Quality
People
Philosophy
USP
Investment Process
Client Products
Risk Control
Performance
Street Relationship
Fantasy Football Meets Investment Management People
10/10
Criteria • Structure which covers Top-down
and bottom-up. • Balanced roles and geographical
distribution. • Significant experience in the
industry and the firm. • Senior new-joiner recently is also a
benefit.
John Maynard Keynes, 94 yrs experience.
Strategist
Sunzi, 2500 yrs experience.
Portfolio Managers
W. Buffet, 74 yrs experience.
Analysts
Meredith Whitney, 20 yrs experience.
Traders
Derek Trotter, 47 yrs experience.
Client Relationship
Macro
Credit Manager Selection
Choosing a Manager
19
• Define the standard of perfection e.g. what would a manager scoring 10 for People look like?
Brangelina
20
Credit Manager Selection
Choosing a Manager
• Is it different from 2006-2008? • Could the best performing manager in this period be the best
performing manager in 2009 or do you need to look for something else?
• Example • In the previous period a manager could have got one bet
right – being long EIB and KFW. • Macroeconomic Team
• They have an excellent Macroeconomic team and accurately forecast the downturn in the economy.
• Strategists • Furthermore, the strategists could see what impact this would
have on spreads.
• Historical Performance • They will have outperformed both the index and the peer
group in 2008. • The skills needed for 2009 may well be different. What are you
trying to achieve? The index will give you LIBOR + 400 – more than you need.
Choosing a Manager – Skill Set needed in 2009
• Dispersion between the best and the worst credit managers have increased dramatically in 2008:
• Manager returns in 2008 range from 0% and -17%;
• While the difference was around 4-5% in 2007 and <3% in 2006.
• PITFALL NUMBER 4: Relying too heavily on performance when choosing a manager may ignore the skill set needed in the current environment
Source: CAMRADATA/iBoxx
21
Credit Manager Selection
Summary
22
Credit Manager Selection
Summary
Summary
Recapping a few pitfalls: • PITFALL 1: Not being specific around the sector will give you unwanted risks. • PITFALL 2: Using an index that does not contain the appropriate securities is unlikely to lead to a
portfolio you thought you would get. • PITFALL 3: Beware of unintended consequences of setting inappropriate incentives. • PITFALL 4: Relying too heavily on performance when choosing a manager may ignore the skill set
needed in the current environment.
• Selecting the right manager really matters.
Like any other asset class – Does the manager have the necessary skill set to produce attractive returns in the sector in which he or she operates in the current environment?
• Understand your objectives, and then determine the appropriate sector:
Consider the current environment – what
matters now
Design the mandate avoiding unintended risks
Now need a deep understanding of the managers in this area
Select the credit manger that best fits your risk return profile
and is most likely to deliver
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