managing portfolio credit risk/ structuring a credit ... portfolio credit r… · aaa: obligations...

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Managing Portfolio Credit Risk/ Structuring a Credit Analysis Process

October 12, 2017

PFM Asset Management LLC

One Keystone Plaza,Suite 300North Front & Market StHarrisburg, PA 17101

717.232.2723pfm.com

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Agenda

What are the Risks?

Policies and Procedures

What should we Look at?

Managing Risk

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What are the risks?

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Assessing Credit Risk

Likelihood of a default

Downgrade/Upgrade Risk

Spread tightening/narrowing

Generating excess return/yield

Liquidity impairment

Counterparty Failure

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Corporate Long-Term Ratings Definitions

Source: Moody’s Investor Services, Standards and Poor’s, Fitch Ratings.

S&P Moody’s Fitch Definitions (by Moody’s)

AAA Aaa AAA Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk.

AA Aa AA Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.

A A A Obligations rated A are considered upper-medium grade and are subject to low credit risk.

BBB Baa BBBObligations rated Baa are subject to moderate credit risk. They are considered medium grade and as such may possess certain speculative characteristics.

BB Ba BB Obligations rated Ba are judged to have speculative elements and are subject to substantial credit risk.

B B B Obligations rated B are considered speculative and are subject to high credit risk.

CCC Caa CCC Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk.

CC Ca CC Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest.

C C C Obligations rated C are the lowest rated class and are typically in default, with little prospect for recovery of principal or interest.

Inve

stm

ent G

rade

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Corporate Ratings Landscape Continues to Evolve

Composition of Merrill Lynch 1-5 Year Corporate Index

Source: BofA Merrill Lynch Indices composite ratings.

30%38% 40%

44%

47% 44%

20%

14% 15%

6% 1% 1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2008 2012 2016

By Face Value

276424 494

193

201 249

49 40 54

9 10 7

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2008 2012 2016

By Issuers

AAA

AA

A

BBB

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From\To: Aaa Aa A Baa Ba B Caa Ca-C Default WRAaa 87.6% 8.1% 0.6% 0.1% 0.0% 0.0% - - - 3.7%Aa 0.8% 85.2% 8.4% 0.4% 0.1% 0.0% 0.0% 0.0% 0.0% 5.0%A 0.1% 2.5% 86.7% 5.4% 0.5% 0.1% 0.0% 0.0% 0.1% 4.6%

Baa 0.0% 0.1% 4.2% 85.5% 3.9% 0.7% 0.2% 0.0% 0.2% 5.2%Ba 0.0% 0.0% 0.4% 6.1% 76.2% 7.2% 0.7% 0.1% 0.9% 0.8%B 0.0% 0.0% 0.1% 0.5% 4.8% 73.5% 6.6% 0.5% 3.4% 10.6%

Caa - 0.0% 0.0% 0.1% 0.4% 6.7% 67.4% 2.8% 8.4% 14.1%Ca-C - - 0.1% - 0.6% 2.5% 8.8% 39.5% 25.6% 22.9%

Legend: Upgrades Downgrades to Investment GradeDowngrades to Non-Investment Grade Defaults

Letter Rating Migration Rates

Source: Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2016.

From\To: Aaa Aa A Baa Ba B Caa Ca-C Default WRAaa 100.0% - - - - - - - - -Aa 0.3% 91.7% 5.6% - - - - - - 2.6%A - 0.7% 89.8% 5.7% 0.1% - - - - 3.8%

Baa - - 1.3% 87.1% 6.7% 0.8% 0.2% - - 3.8%Ba - - - 5.2% 77.6% 8.6% 1.0% 0.3% 0.1% 7.4%B - - - 0.2% 4.5% 71.9% 10.0% 0.2% 1.4% 11.8%

Caa - - - - - 5.5% 70.3% 4.4% 6.2% 13.6%Ca-C - - - - - 1.1% 1.1% 42.0% 44.3% 11.4%

2016 One-Year Letter Rating Migration Rates

Average One-Year Letter Rating Migration Rates, 1970-2016

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Default History

Source: Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2016.

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2016

Number of Investment Grade Corporate Issuer Defaults

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100

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1990

1991

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Number of Non-Investment Grade Corporate Issuer Defaults

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Policies and Procedures

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Develop polices that Achieve Risk Objectives

• Who has the authority to take certain actions?

• Who has an oversight role?

• How will decisions be made?

• Set standards for due diligence and review.

• What is the risk appetite and what do I hope to achieve?

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An Approved List can be an Important Risk Management Tool

• An approved list restricts purchases made by those authorized.

• Helps to strengthen the oversight process.

• Aware of potential risk at all times.

• Focus resources on areas of potential exposure.

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Broker/Dealer Approved List Manages Counterparty Risk

• Manage the risk that a counterparty will not be able to meet its obligations.

• Financial strength of company.

• Availability of product.

• Competitiveness of pricing.

• Quality of sales coverage.

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What are we looking at?

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Narrowing The Universe of Potential Issuers?

• Does an issuer’s ratings meet policy requirements?

• Does an issuer have value?

• Is a company in a risky or volatile business?

• What is its competitive position and fundamental condition relative to peers?

• Narrowing the list produces candidates for further review.

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AAA/AA Rated Representative Issuer List

Representative list for informational purposes only; not an investment recommendation.Source: BofA Merrill Lynch 1-5 Year U.S. Corporate Index, as of 12/31/2016.

Top 10 Issuers # of Issues

AmountOutstanding

(millions)

% of Corp Index Moody’s S&P Fitch

Apple 10 $18,400 0.77% Aa1 AA+ -

Westpac Banking 14 $16,450 0.69% Aa2 AA- -

Chevron 11 $15,950 0.67% Aa2 A WD

Shell International 11 $15,750 0.66% Aa2 A AA-

Toronto-Dom. Bank 12 $15,750 0.65% Aa1 AA- AA-

Microsoft 10 $14,950 0.62% Aaa AAA AA+

Royal Bank of Canada 11 $13,700 0.57% Aa3 AA- AA

General Electric 11 $12,375 0.55% A1 AA- AA-

Bank of Nova Scotia 11 $12,350 0.52% Aa3 A+ AA-

Coca Cola 9 $10,324 0.43% Aa3 AA- A+

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A Rated Representative Issuer List

Representative list for informational purposes only; not an investment recommendation.Source: BofA Merrill Lynch 1-5 Year U.S. Corporate Index, as of 12/31/2016.

Top 10 Issuers # of Issues

AmountOutstanding

(millions)

% of Corp Index Moody’s S&P Fitch

J.P. Morgan Chase 19 $44,850 1.93% A3 A- A+

Morgan Stanley 19 $42,485 1.86% A3 BBB+ A

Goldman Sachs 17 $38,750 1.69% A3 BBB+ A

Bank of America 14 $33,964 1.48% Baa1 BBB+ A

Citigroup 16 $27,350 1.15% Baa1 BBB+ A

Wells Fargo 11 $24,950 1.05% A2 A AA-

Cisco Systems 11 $18,100 0.77% A1 AA- -

Toyota 16 $16,850 0.71% Aa3 AA- A

Daimler Finance 16 $15,950 0.66% A2 A A-

Sumitomo Mitsui 14 $14,500 0.60% A1 A A

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Fundamental Condition

• A consistent and repeatable framework to monitor the fundamental condition of a company should exist.

• Tools like Bloomberg can greatly assist with the gathering and analysis of data.

• Data can be compared to peers, historically or to rating agency targets to review the fundamental condition of a company

• Select metrics for each important category and develop a framework to gather and review data.

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Measures of Fundamental Condition Vary

• Depending on the industry the measure of fundamental condition will vary.

• In the industrial sector the analysis will focus on profitability, cash flow generation and leverage.

• When assessing the banking sector the focus may be on capital and asset quality in addition to profitability.

• Comparison across industries will vary, some operate at higher levels of leverage for example.

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• Debt/EBITDA

• EBIT/Interest Expense

• Residual Free Cash Flow/Debt

Examples of Measure of Leverage

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• EBITDA Margin

• Operating Margin

Measures of Profitability

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Second Quarter Corporate Earnings Remains Strong

• The S&P 500 posted another strong quarter of corporate earnings, as earnings per share grew 16% in Q2, based on 99% of

companies that have reported so far.

• Over 75% of the companies have reported earnings that beat analysts’ expectations

Source: Bloomberg, as of 09/01/17, with 496 of the S&P 500 companies reporting so far for Q2.

18%

16%

-10%

0%

10%

20%

Q2

'11

Q4

'11

Q2

'12

Q4

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Q2

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Q4

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Q2

'14

Q4

'14

Q2

'15

Q4

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Q2

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Q4

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Q2

'17

S&P 500 EPS Growth(YoY)

0%

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100%

IT

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% of S&P 500 CompaniesReporting Better/Worse Earnings in Q2 ‘17

Positive Surprise Inline Negative Surprise

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What is the Role of the Rating Agencies?

• Rating agencies determine if an issuers debt meets policy requirements.

• Rating agencies have very good access to companies and as a result important insights.

• Historical data on individual issuers and sectors is valuable to investors.

• A good place to start when thinking about an issuer, but we need to be sure their assessment matches our risk tolerance.

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Understanding Market Sentiment is Important

• Often an indicator of problems, stress or concern.

• We can judge market sentiment based on changes in stock, bond and derivative prices.

• Changes in prices can be compared to the broader market to judge if price movements are out of the ordinary.

• Traders should understand the relative value of issuers and be conditioned to spot outliers or significant changes.

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Credit Spreads Narrowing Requiring Careful Issue Selection

Source: Bloomberg, Bank of America Merrill Lynch Indices, as of 08/31/17. OAS is Option Adjusted Spread.

40

60

80

100

120

140

160

Aug '12 Feb '13 Aug '13 Feb '14 Aug '14 Feb '15 Aug '15 Feb '16 Aug '16 Feb '17 Aug '17

1-5 Yr. A-AAA Corporate Yield Spreads (OAS)

20

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40

50

60

70

80

Aug '12 Feb '13 Aug '13 Feb '14 Aug '14 Feb '15 Aug '15 Feb '16 Aug '16 Feb '17 Aug '17

0-5 Yr. AAA ABS Yield Spreads (OAS)

Strong investor demand has resulted in corporate spreads narrowing, which now warrants more careful selection

of industry, issuer, and maturity.

Yields spreads on ABS have also contracted, but still offer decent incremental value for AAA-rated structures.

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Corporates Continue to Outperform

Source: BofA Merrill Lynch Indices. MBS and ABS indices are 0-3 and 0-5 year, based on Weighted Average Life.

0%

1%

2%

3%

4%

U.S

. Tre

asur

y

Age

ncy

Cor

p (A

-AA

A)

MB

S

ABS

(AA

A)

U.S

. Tre

asur

y

Age

ncy

Cor

p (A

-AA

A)

MB

S

ABS

(AA

A)

U.S

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Age

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Cor

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-AA

A)

MB

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5-Year Average Annualized Returns(Period ended 08/31/17)

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1%

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3%

4%

U.S

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asur

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Age

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Cor

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A)

MB

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(AA

A)

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Age

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-AA

A)

MB

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ABS

(AA

A)

U.S

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Age

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Cor

p (A

-AA

A)

MB

S

Trailing 3-Month Return(05/31/17 – 08/31/17)

1-3 Year 1-5 Year Master 1-3 Year 1-5 Year Master

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Diversity can Help Mange Risk

• Two theories, put all your eggs in one basket and watch the basket closely, diversify to guard against unknown circumstances.

• Not all adverse events can be predicted, how do we protect against this?

• Diversity limits can reduce the loss if there is a credit event, but might require additional work to maintain a larger approved list.

• Concentration limits can be based on maturity or credit quality or a combination of both.

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Maturity Restrictions can Effectively Manage Risk

• Maturity limits can be used to manage risk.

• Limits can be set by the credit quality of an individual issuers, sector or issuers from a common geographical region

• Maturity limits can be used to mange around events that might happen in the near future.

• Limits can be changed to reflect the changing circumstances of an issuer.

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Understanding Market Values

• Traders should understand the market for securities being transacted.

• Helps to ensures that prices paid for securities are fair, three quality bids.

• As discussed earlier, market sentiment is an important part of the process, traders are the first line of defense.

• Ensure proper trading procedures, comparative shopping and execution.

• Available tools include, Trace, BVAL and news flow from broker/dealers.

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Disclaimer

This material is based on information obtained from sources generally believed to be reliable and available to the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities.

The information provided in this presentation related to representative issuers is general in nature only and has not been prepared taking into consideration your particular needs, circumstances or objectives. Issuers depicted in this presentation are for illustrative purposes only.

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