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.

An innovative approach to post-crash credit portfoliomanagementCredit portfolio managers traditionally rely on fundamentalresearch for decisions on issuer selection and sector rotation.Quantitative researchers tend to use more mathematical techniquesfor pricing models and to quantify credit risk and relative value.The information found here bridges these two approaches. In anintuitive and readable style, this book illustrates howquantitative techniques can help address specific questions facingtoday's credit managers and risk analysts.A targeted volume in the area of credit, this reliable resourcecontains some of the most recent and original research in thisfield, which addresses among other things important questionsraised by the credit crisis of 2008-2009. Divided into twocomprehensive parts, Quantitative Credit PortfolioManagement offers essential insights into understanding therisks of corporate bonds--spread, liquidity, and Treasuryyield curve risk--as well as managing corporate bondportfolios.* Presents comprehensive coverage of everything from durationtime spread and liquidity cost scores to capturing the creditspread premium* Written by the number one ranked quantitative research groupfor four consecutive years by Institutional Investor* Provides practical answers to difficult question, including:What diversification guidelines should you adopt to protectportfolios from issuer-specific risk? Are you well-advised to sellsecurities downgraded below investment grade?Credit portfolio management continues to evolve, but with thisbook as your guide, you can gain a solid understanding of how tomanage complex portfolios under dynamic events.

Foreword xviiIntroduction xixNotes on Terminology xxviiPART ONE Measuring the Market Risks of CorporateBondsCHAPTER 1 Measuring Spread Sensitivity of Corporate Bonds3Analysis of Corporate Bond Spread Behavior 5A New Measure of Excess Return Volatility 20Refinements and Further Tests 25Summary and Implications for Portfolio Managers 30Appendix: Data Description 34CHAPTER 2 DTS for Credit Default Swaps 39Estimation Methodology 40Empirical Analysis of CDS Spreads 41Appendix: Quasi-Maximum Likelihood Approach 51CHAPTER 3 DTS for Sovereign Bonds 55Spread Dynamics of Emerging Markets Debt 55DTS for Developed Markets Sovereigns: The Case of EuroTreasuries 59Managing Sovereign Risk Using DTS 66CHAPTER 4 A Theoretical Basis for DTS 73The Merton Model: A Zero-Coupon Bond 74Dependence of Slope on Maturity 77CHAPTER 5 Quantifying the Liquidity of Corporate Bonds81Liquidity Cost Scores (LCS) for U.S. Credit Bonds 82Liquidity Cost Scores: Methodology 88LCS for Trader-Quoted Bonds 92LCS for Non-Quoted Bonds: The LCS Model 96Testing the LCS Model: Out-of-Sample Tests 102LCS for Pan-European Credit Bonds 113Using LCS in Portfolio Construction 123Trade Efficiency Scores (TES) 129CHAPTER 6 Joint Dynamics of Default and Liquidity Risk133Spread Decomposition Methodology 138What Drives OAS Differences across Bonds? 139How Has the Composition of OAS Changed? 141Spread Decomposition Using an Alternative Measure of ExpectedDefault Losses 145High-Yield Spread Decomposition 147Applications of Spread Decomposition 147Alternative Spread Decomposition Models 150Appendix 152CHAPTER 7 Empirical versus Nominal Durations of CorporateBonds 157Empirical Duration: Theory and Evidence 159Segmentation in Credit Markets 173Potential Stale Pricing and Its Effect on Hedge Ratios 173Hedge Ratios Following Rating Changes: An Event Study Approach179Using Empirical Duration in Portfolio Management Applications186PART TWO Managing Corporate Bond PortfoliosCHAPTER 8 Hedging the Market Risk in Pairs Trades 197Data and Hedging Simulation Methodology 199Analysis of Hedging Results 200Appendix: Hedging Pair-Wise Trades with Skill 208CHAPTER 9 Positioning along the Credit Curve 213Data and Methodology 214Empirical Analysis 217CHAPTER 10 The 2007-2009 Credit Crisis 229Spread Behavior during the Credit Crisis 229Applications of DTS 234Advantages of DTS in Risk Model Construction 244CHAPTER 11 A Framework for Diversification of Issuer Risk249Downgrade Risk before and after the Credit Crisis 250Using DTS to Set Position-Size Ratios 257Comparing and Combining the Two Approaches to Issuer Limits260CHAPTER 12 How Best to Capture the Spread Premium ofCorporate Bonds? 265The Credit Spread Premium 266Measuring the Credit Spread Premium for the IG Corporate Index266Alternative Corporate Indexes 279Capturing Spread Premium: Adopting an Alternative CorporateBenchmark 288CHAPTER 13 Risk and Performance of Fallen Angels 295Data and Methodology 298Performance Dynamics around Rating Events 303Fallen Angels as an Asset Class 319CHAPTER 14 Obtaining Credit Exposure Using Cash and SyntheticReplication 337Cash Credit Replication (TCX) 338Synthetic Replication of Cash Indexes 351Credit RBIs 358References 367Index 371