The Credit Conundrum- Warning - Holding Credit is not Without Risk
26th March 2009The Credit ConundrumSession 5: Warning - Holding credit is not without risk
2Global Equity47%Alternatives3%UK Property4%Cash6%Corporate Credit6%Gilts34%Current Asset Allocation (estimate) Q4 2008 Asset Allocation End 2009?Warning: Holding credit is not without riskAsset AllocationSource: Goldman Sachs Asset Management - 2008 Source: Redington PartnersNote: Includes 50%-70% duration overlay using swaps ,Gilts, and /or synthetic equity replication using futures over Gilts.Global Equity25%Alternatives3%UK Property4%Cash6%Corporate Credit27%Gilts25%Supranationals10%
3However timing is important: Excess return over Libor – 2008Warning: Holding credit is not without riskCredit, Fixed Income and Equity Returns for 2008Source: Redington Partners
4Credit – A Long term investmentWarning: Holding credit is not without riskCredit – A long term investment?Price volatility• Liquidity worsens• Risk aversion increases(market panics onworsening economicnews)• Default probabilities seenas rising• VaR increases, valuationsdecrease, deficits riseDowngrade risk• Downgrades to High Yield• Can you hold them?• No buyers – pricesfalling off a cliff• Mandate design crucial• How long can yourPortfolio Manager holddowngraded bonds?• Fire sale prices to beavoided
5Year on Year European GDP vs. 12-month Trailing Upgrade/Downgrade RatioSource: Deutsche BankWarning: Holding credit is not without riskCredit – A long term investment?
65 year cumulative implied default rates based on spreads v Govt for IG and HY bonds (£)Source: Deutsche bank ~Default study 17th March 2009Warning: Holding credit is not without riskDefault rates – Sterling Corporate BondsSpread Implied Default rate Actual Default Rate (since1970)Source Sector Average 5 yrspread (bps)AverageRecoveryZeroRecoveryWorst AverageiBoxx Corporate 769 51% 33% 2.4% 0.9%Non-Financial 397 30% 18% N/A N/AFinancial 986 60% 40% N/A N/AAA 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%
7Type of RMBS No. of Upgrades/Downgrades Barclays Capital rating outlookRMBS: UK Prime 13/0 StableRMBS: UK NC (Subprime) 90/462 NegativeRMBS: Spanish 16/104 NegativeRMBS: Dutch 31/13 Stable to positiveRMBS: Portuguese 3/8 Stable to negativeRMBS: Irish 4/0 Stable to positiveRMBS: Greek 10/0 Stable to positiveCMBS: UK 10/91 NegativeAuto ABS: German 5/2 StableAuto ABS: French 0/0 Stable to positiveAuto ABS: Spanish 1/5 NegativeAuto ABS: Italian 0/0 NegativeTotal 183/6852008: Upgrades/Downgrades European ABS plus outlooksSource: Barclays Capital 2009 Global Securitisation Annual“Globally,given thenegativefundamentaltrends and thepossibility ofratingmethodologyrevisions bythe ratingagencies, weexpect evenmoredowngrades in2009”Global 2009 ABS outlook- Barclays CapitalWarning: Holding credit is not without riskUpgrades/Downgrades on European ABS
8Warning: Holding credit is not without riskEstimated equities returns 1998 - 2018Source: Redington PartnersProjected levels required from FTSE All TR based on approx. 3% risk premium over gilts
Warning: Holding credit is not without riskCredit vs. Equities910-year Rolling Rate of Return on FTSE 100 versus 10 yr swaps (10 yr to date)Source: Redington Partners
Warning: Holding credit is not without riskCredit vs. Equities10Annual 20-Year returns for the UK stock marketSource: Global Financial Data, Datastream
•Shares plummeted against falling property valuations•March 16th 2009 Brixton axed final dividend and announcednew rights issue11In 2008 Dividends axed or slashed across the board –Losses of USD 903bn worldwideCapital raising of USD 906bn worldwideProperty companiesMain stream blue chip corporatesFinancials•General Electric announced a 68% cut in dividend for the firsttime since 1938•Dow Chemicals cut theirs by 64% for the first time since 1912•L&G slashed final dividend by 50% on 25th March 2009Equities - Dividends Slashed/Share dilution through Rights Issuance•S& P predicts thatdividends in US couldfall by 25% in 2009.•From 1931 – 35American dividendsfell 45%.20082009Warning: Holding credit is not without riskEquities Outlook
Capital Structure – Order of Seniority12Secured•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 levelsSeniorunsecured•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 2Upper Tier 2Tier 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 structureEquity•Dividend – not guaranteed in either magnitude or existence•Price of share – not limited to 100 redemption•Equities take the first lossesWarning: Holding credit is not without riskCredit vs. Equities
Minimum Funding LevelCone of UncertaintyCone of UncertaintyFRS 17/IAS 19BUYOUT S7513Warning: Holding credit is not without riskCredit and the Flight PlanUsing Credit in your Strategic Asset Allocation – Matching, Return or Both?
15Buyout - “Preferred” AssetsBondsGiltsSterling investmentgrade bondsOverseas investmentgrade creditCredit DerivativesStructured CreditCashBankdepositsSwapsInterest RateInflationSubject tocounterpartyagreementEquitiesExchange tradedPrivateWarning: Holding credit is not without riskCredit – preferred assets
16Buyout – Risk Profile of investment Strategies60 / 30 / 10 – Traditional AllocationInterest rate and inflation hedgingTransition Growth Assets toMatching/Eligible assetsBuy-in hedge portfolio/longevityswapsBuy-in/BuyoutHigh RiskMedium RiskLow RiskLeast RiskWarning: Holding credit is not without riskGetting your ducks in a row