Quantitative Credit Portfolio Management

An innovative approach to post-crash credit portfolio management

Credit portfolio managers traditionally rely on fundamental research for decisions on issuer selection and sector rotation. Quantitative researchers tend to use more mathematical techniques for pricing models and to quantify credit risk and relative value. The information found here bridges these two approaches. In an intuitive and readable style, this book illustrates how quantitative techniques can help address specific questions facing today's credit managers and risk analysts.

A targeted volume in the area of credit, this reliable resource contains some of the most recent and original research in this field, which addresses among other things important questions raised by the credit crisis of 2008-2009. Divided into two comprehensive parts, Quantitative Credit Portfolio Management offers essential insights into understanding the risks of corporate bonds--spread, liquidity, and Treasury yield curve risk--as well as managing corporate bond portfolios.
* Presents comprehensive coverage of everything from duration time spread and liquidity cost scores to capturing the credit spread premium
* Written by the number one ranked quantitative research group for four consecutive years by Institutional Investor
* Provides practical answers to difficult question, including: What diversification guidelines should you adopt to protect portfolios from issuer-specific risk? Are you well-advised to sell securities downgraded below investment grade?

Credit portfolio management continues to evolve, but with this book as your guide, you can gain a solid understanding of how to manage complex portfolios under dynamic events.

Foreword xvii
Introduction xix
Notes on Terminology xxvii
Part One Measuring the Market Risks of Corporate Bonds
Chapter 1 Measuring Spread Sensitivity of Corporate Bonds 3
Analysis of Corporate Bond Spread Behavior 5
A New Measure of Excess Return Volatility 20
Refinements and Further Tests 25
Summary and Implications for Portfolio Managers 30
Appendix: Data Description 34
Chapter 2 DTS for Credit Default Swaps 39
Estimation Methodology 40
Empirical Analysis of CDS Spreads 41
Appendix: Quasi-Maximum Likelihood Approach 51
Chapter 3 DTS for Sovereign Bonds 55
Spread Dynamics of Emerging Markets Debt 55
DTS for Developed Markets Sovereigns: The Case of Euro Treasuries 59
Managing Sovereign Risk Using DTS 66
Chapter 4 A Theoretical Basis for DTS 73
The Merton Model: A Zero-Coupon Bond 74
Dependence of Slope on Maturity 77
Chapter 5 Quantifying the Liquidity of Corporate Bonds 81
Liquidity Cost Scores (LCS) for U. S. Credit Bonds 82
Liquidity Cost Scores: Methodology 88
LCS for Trader-Quoted Bonds 92
LCS for Non-Quoted Bonds: The LCS Model 96
Testing the LCS Model: Out-of-Sample Tests 102
LCS for Pan-European Credit Bonds 113
Using LCS in Portfolio Construction 123
Trade Efficiency Scores (TES) 129
Chapter 6 Joint Dynamics of Default and Liquidity Risk 133
Spread Decomposition Methodology 138
What Drives OAS Differences across Bonds? 139
How Has the Composition of OAS Changed? 141
Spread Decomposition Using an Alternative Measure of Expected Default Losses 145
High-Yield Spread Decomposition 147
Applications of Spread Decomposition 147
Alternative Spread Decomposition Models 150
Appendix 152
Chapter 7 Empirical versus Nominal Durations of Corporate Bonds 157
Empirical Duration: Theory and Evidence 159
Segmentation in Credit Markets 173
Potential Stale Pricing and Its Effect on Hedge Ratios 173
Hedge Ratios Following Rating Changes: An Event Study Approach 179
Using Empirical Duration in Portfolio Management Applications 186
  Part Two Managing Corporate Bond Portfolios
Chapter 8 Hedging the Market Risk in Pairs Trades 197
Data and Hedging Simulation Methodology 199
Analysis of Hedging Results 200
Appendix: Hedging Pair-Wise Trades with Skill 208
Chapter 9 Positioning along the Credit Curve 213
Data and Methodology 214
Empirical Analysis 217
Chapter 10 The 2007-2009 Credit Crisis 229
Spread Behavior during the Credit Crisis 229
Applications of DTS 234
Advantages of DTS in Risk Model Construction 244
Chapter 11 A Framework for Diversification of Issuer Risk 249
Downgrade Risk before and after the Credit Crisis 250
Using DTS to Set Position-Size Ratios 257
Comparing and Combining the Two Approaches to Issuer Limits 260
Chapter 12 How Best to Capture the Spread Premium of Corporate Bonds? 265
The Credit Spread Premium 266
Measuring the Credit Spread Premium for the IG Corporate Index 266
Alternative Corporate Indexes 279
Capturing Spread Premium: Adopting an Alternative Corporate Benchmark 288
Chapter 13 Risk and Performance of Fallen Angels 295
Data and Methodology 298
Performance Dynamics around Rating Events 303
Fallen Angels as an Asset Class 319
Chapter 14 Obtaining Credit Exposure Using Cash and Synthetic Replication 337
Cash Credit Replication (TCX) 338
Synthetic Replication of Cash Indexes 351
Credit RBIs 358
References 367
Index 371