Web Manual of Loans Tips

The sensitivity of corporate bonds to the economic environment essentially depends on their time to maturity. In the short term, default risk for investment grade corporate issuers is primarily due to nonsystematic factors, for example, cases of fraud or litigation. Over longer term horizons, conversely, systematic factors tend to have a higher impact on the default probability of corporate issuers. Changes in the economic environment and business risks in the sense of adverse industry trends or increasing competition are major drivers of credit risk and hence for spreads in the longer term. Therefore, one would expect the spreads of long and intermediate investment grade corporate bonds to be more sensitive to indicators of economic activity than short-term bonds. This implies that credit curves should flatten when the economic outlook improves. Rising confidence in the corporate sector additionally spurs investors’ willingness to take on more spread duration. Consequently, in periods of spread tightening investors should expect credit curves to flatten. In other words, the slope of the credit curve and the level of credit spreads are positively correlated for investment grade issuers.

Technical factors have to be considered in the decision process regarding the weighting of various sectors in a corporate bond portfolio. First of all, projections about the expected net new issuance volume have to be made. All redemptions in an industry are known and the projected financing needs of all companies within an industry add to the total expected issuance from a specific sector. In the past, the largest issuance volume has been concentrated in the automobile, telecommunications and utility sectors.

It has to be evaluated whether the new issuance volume can be absorbed by the market or whether it will put pressure on spreads. The general risk appetite/aversion of market participants and the prevailing sentiment towards the various sectors will give a hint about the demand for certain sectors. Another important factor is liquidity because it will vary substantially between sectors. Furthermore if investors want to express a certain view on different maturity buckets within a portfolio the choice might be limited to a few frequent borrowers who have bonds in all maturity buckets outstanding. Those companies are usually concentrated in the automobile, telecommunications and utility sectors.

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.