Web Manual of Loans Tips

Many government bond investors believe that deviations of treasury yield curve steepness from the traditional range or a fair value obtained by regression analysis are only temporary. That is, they expect yield curve steepness to be mean reverting. From a theoretical point of view there is strong support for this hypothesis. In the early stages of the business cycle, that is at the beginning of an expansion, monetary policy is easy and shortterm interest rates are still low. But an improving outlook for future economic growth leads to rising long-term interest rates and a steeper yield curve. The later stages of the expansion are characterized by rising inflationary pressures and consequently central bank tightening. The most  impressive example for this experience were the seven interest rate hikes by the Fed between January 1994 and January 1995, that led to a sell-off in the treasury market and were accompanied by a massive flattening of the yield curve. When the tighter monetary policy begins to unfold its influence on price growth, this is usually followed by weakening economic growth. In this economic environment yield curves steepen again, because short-term interest rates tend to price in room for central banks to cut interest rates.

The rating outlook of both rating agencies (S&P and Moody’s) can be another criterion to choose between industries. If companies with a positive rating outlook outweigh the companies with a stable or negative rating outlook within an industry, it can be a good indicator for favorable industry dynamics, even if we have to recognize that ratings are sometimes lagging indicators for credit quality. A diversified portfolio should overweight the industries with a positive rating outlook and underweight industries with a negative rating outlook if the whole credit market experiences a “Flight-to-Quality.” During a market phase with a higher risk appetite, fundamental factors like the rating trend in a specific industry might not be the primary decision criterion for a sector positioning and other factors like valuation
will play a bigger role.

The occurrence of event risks is almost unpredictable hence they are hard to quantify. Most of the event risks can be associated with the creation of shareholder value. This can be share buyback programs, an aggressive acquisition strategy, or isolated, risky projects which change the capital structure of a company in favor of shareholders. A wealth transfer takes place from bondholders to shareholders of a company. This kind of event risk can be reduced by regular meetings with management. Unfortunately many event risks are out of control for management and sometimes the effects are not isolated for a specific company but have an effect on the entire industry. In the past good examples can be found for various industries.

Many capital goods companies are facing asbestos claims which weigh heavily on their financial profiles. Especially in a market phase with increased risk aversion these topics are brought up and heighten the negative sentiment of market participants against sectors with increased asbestos liabilities. The telecommunications sector faces new challenges through wireless technologies. European state regulators set license fees for wireless spectrum which reached billions. This changed the financial profile of the incumbent telecommunications companies. The utilities sector goes through a liberalization process accompanied by increasingly riskier business models. The tobacco sector is always a litigation target and the healthcare and pharma sectors face a lot of regulatory risks.