In recent months it has become popular to equate monetary union and the introduction of a credit term in government bond yields with a bottom-up” approach to fixed income fund management.

This is, at best, rather naive.

It is true that the independence of the European Central Bank and the mutual denial of access to the printing presses for debt service will introduce default risk into government bond yields but this does not imply that ratings should be lower or yields higher. It is also true that the rigours of the “Growth and Stability” pact will leave governments with little option but to encourage their agencies and municipalities to self-finance.

Thus we may expect a broader market, a greater diversity of bond issuers and government markets distinguished by credit spreads but also by other idiosyncratic differences.

Some analysts are suggesting that these credit spreads could be the motor mechanism for active management of bond portfolios. However, credit spreads are the expectation of default and in themselves offer no excess return. Regrettably, there is no free lunch. A manager is faced with the same problems of market relative performance as today. Credit spreads are, if you wish, a zero sum game.

It is true that corporate and provincial spreads are inexplicably volatile (standard deviations are of the order of 30-50%) but the absolute values of these changes are small. An active manager of global bonds might currently suggest an expected outperformance of a global benchmark by 200 basis points, which does not appear outrageous given the variance of returns between markets of 400-500 basis points. A credit manager is likely to be faced, at least in Euro-government bonds, with a variance of less than 100 basis points. Transaction expenses increase significance dramatically in this world. What outperformance might a manager suggest now - 30 basis points? Will there be a client base for this government credit management style? Many of us will buy lottery tickets but few of us will gamble for small rewards.

Perhaps the more relevant question is whether we might be better rewarded by deploying our macro-analytic skills in search of opportunities among the less central markets. Our clients already understand the benefits of global diversification along these lines.

Numerous studies of low-grade bonds, from Drexel Burnham on, suggest a systematic mispricing of the credit spread in favour of investors. The introduction of JP Morgan’s CreditMetrics seems timely in this context. The prospect of “bottom-up” security analysis and selection combined with quantitative portfolio management techniques is appealing.

There are, however, a few practical difficulties. Credit diversification requires the use of very many more securities than equity or global bond diversification. Hundreds or thousands of securities versus tens or hundreds. Our analytic capabilities may be strained by the volume of work necessary to avoid the risks of credit concentrations.

Robert Merton first suggested an option approach to credit in the early 1970s and this is the structural basis of credit portfolio techniques. Bonds are seen as containing an embedded option on the value of the firm. The extension of this to municipal or agency debt is somewhat problematic. What is the value of a municipality and how does it vary with capital market prices?

A further difficulty exists in that under this model of credit the value of the firm and the default risk move in the same direction. As a firm’s value declines, its credit spread increases. However, in the field of low-grade securities it is not uncommon for the value of assets to increase under corporate actions while the value of debt declines. “Poison pills” and the like may indeed be designed to achieve precisely these effects.

The statistical complexities of the estimation of joint default probabilities, the lack of consistent, reliable data and the need to be aware of the detailed corporate intentions of not only the issuer, but also potential predators, leave portfolio approach-es to credit for low-grade issuers much more uncertain than portfolio approaches to market risk. To paraphrase Mark Twain: “better perhaps we should place all our eggs in one basket and watch it like a hawk”.

How many of our clients, though, with their preferences for liquidity, solvency, and certainty, can live with this management style?

Topics