The Credit Conundrum- Warning - Holding Credit is not Without Risk
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The Credit Conundrum- Warning - Holding Credit is not Without Risk
- 1. 26th March 2009 The Credit Conundrum Session 5: Warning - Holding credit is not without risk
- 2. 2 Global Equity 47% Alternatives 3% UK Property 4% Cash 6%Corporate Credit 6% Gilts 34% Current Asset Allocation (estimate) Q4 2008 Asset Allocation End 2009? Warning: Holding credit is not without risk Asset Allocation Source: Goldman Sachs Asset Management - 2008 Source: Redington Partners Note: Includes 50%-70% duration overlay using swaps ,Gilts, and / or synthetic equity replication using futures over Gilts. Global Equity 25% Alternatives 3% UK Property 4%Cash 6% Corporate Credit 27% Gilts 25% Supranationals 10%
- 3. 3 However timing is important: Excess return over Libor – 2008 Warning: Holding credit is not without risk Credit, Fixed Income and Equity Returns for 2008 Source: Redington Partners
- 4. 4 Credit – A Long term investment Warning: Holding credit is not without risk Credit – A long term investment? Price volatility • Liquidity worsens • Risk aversion increases (market panics on worsening economic news) • Default probabilities seen as rising • VaR increases, valuations decrease, deficits rise Downgrade risk • Downgrades to High Yield • Can you hold them? • No buyers – prices falling off a cliff • Mandate design crucial • How long can your Portfolio Manager hold downgraded bonds? • Fire sale prices to be avoided
- 5. 5 Year on Year European GDP vs. 12-month Trailing Upgrade/Downgrade Ratio Source: Deutsche Bank Warning: Holding credit is not without risk Credit – A long term investment?
- 6. 6 5 year cumulative implied default rates based on spreads v Govt for IG and HY bonds (£) Source: Deutsche bank ~Default study 17th March 2009 Warning: Holding credit is not without risk Default rates – Sterling Corporate Bonds Spread Implied Default rate Actual Default Rate (since 1970) Source Sector Average 5 yr spread (bps) Average Recovery Zero Recovery Worst Average iBoxx Corporate 769 51% 33% 2.4% 0.9% Non-Financial 397 30% 18% N/A N/A Financial 986 60% 40% N/A N/A AA 522 38% 23% 1.8% 0.2% A 747 48% 31% 2.6% 0.6% BBB 1,035 58% 39% 5.8% 1.8% High Yield Euro HY 1,592 69% 53% 31.0% 19.3%
- 7. 7 Type of RMBS No. of Upgrades/Downgrades Barclays Capital rating outlook RMBS: UK Prime 13/0 Stable RMBS: UK NC (Subprime) 90/462 Negative RMBS: Spanish 16/104 Negative RMBS: Dutch 31/13 Stable to positive RMBS: Portuguese 3/8 Stable to negative RMBS: Irish 4/0 Stable to positive RMBS: Greek 10/0 Stable to positive CMBS: UK 10/91 Negative Auto ABS: German 5/2 Stable Auto ABS: French 0/0 Stable to positive Auto ABS: Spanish 1/5 Negative Auto ABS: Italian 0/0 Negative Total 183/685 2008: Upgrades/Downgrades European ABS plus outlooks Source: Barclays Capital 2009 Global Securitisation Annual “Globally, given the negative fundamental trends and the possibility of rating methodology revisions by the rating agencies, we expect even more downgrades in 2009” Global 2009 ABS outlook - Barclays Capital Warning: Holding credit is not without risk Upgrades/Downgrades on European ABS
- 8. 8 Warning: Holding credit is not without risk Estimated equities returns 1998 - 2018 Source: Redington Partners Projected levels required from FTSE All TR based on approx. 3% risk premium over gilts
- 9. Warning: Holding credit is not without risk Credit vs. Equities 9 10-year Rolling Rate of Return on FTSE 100 versus 10 yr swaps (10 yr to date) Source: Redington Partners
- 10. Warning: Holding credit is not without risk Credit vs. Equities 10 Annual 20-Year returns for the UK stock market Source: Global Financial Data, Datastream
- 11. •Shares plummeted against falling property valuations •March 16th 2009 Brixton axed final dividend and announced new rights issue 11 In 2008 Dividends axed or slashed across the board – Losses of USD 903bn worldwide Capital raising of USD 906bn worldwide Property companies Main stream blue chip corporates Financials •General Electric announced a 68% cut in dividend for the first time since 1938 •Dow Chemicals cut theirs by 64% for the first time since 1912 •L&G slashed final dividend by 50% on 25th March 2009 Equities - Dividends Slashed/Share dilution through Rights Issuance •S& P predicts that dividends in US could fall by 25% in 2009. •From 1931 – 35 American dividends fell 45%. 2008 2009 Warning: Holding credit is not without risk Equities Outlook
- 12. Capital Structure – Order of Seniority 12 Secured •Regular coupon •Bond /Loan redeemed at par on maturity • Secured against named assets •Losses only when, in event of default, the value of secured assets drops below initial valuation levels Senior unsecured •Regular coupon •Redeemed at par •Losses only in event of default •Usually some recovery rate (historically 40% for investment grade, 15% for high yield) Lower Tier 2 Upper Tier 2 Tier 1 •Enhanced fixed rate coupon •Coupon may be cancelled or suspended at the discretion of the issuer •Issues are long dated or open-ended. Callable by nature with step-up coupons •Lower recovery rates, as lower down the capital structure Equity •Dividend – not guaranteed in either magnitude or existence •Price of share – not limited to 100 redemption •Equities take the first losses Warning: Holding credit is not without risk Credit vs. Equities
- 13. Minimum Funding Level Cone of Uncertainty Cone of Uncertainty FRS 17/IAS 19 BUYOUT S75 13 Warning: Holding credit is not without risk Credit and the Flight Plan Using Credit in your Strategic Asset Allocation – Matching, Return or Both?
- 14. 14 Credit – on the path to Buy-in/Buy-out
- 15. 15 Buyout - “Preferred” Assets Bonds Gilts Sterling investment grade bonds Overseas investment grade credit Credit Derivatives Structured Credit Cash Bank deposits Swaps Interest Rate Inflation Subject to counterparty agreement Equities Exchange traded Private Warning: Holding credit is not without risk Credit – preferred assets
- 16. 16 Buyout – Risk Profile of investment Strategies 60 / 30 / 10 – Traditional Allocation Interest rate and inflation hedging Transition Growth Assets to Matching/Eligible assets Buy-in hedge portfolio/longevity swaps Buy-in/Buyout High Risk Medium Risk Low Risk Least Risk Warning: Holding credit is not without risk Getting your ducks in a row
- 17. 17 Warning: Holding credit is not without risk