Managing Portfolio Credit Risk/ Structuring a Credit Analysis Process October 12, 2017
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Agenda What are the Risks? Policies and Procedures What should we Look at? Managing Risk
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What are the risks?
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Assessing Credit Risk Likelihood of a default Downgrade/Upgrade Risk Spread tightening/narrowing Generating excess return/yield Liquidity impairment Counterparty Failure
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Investment Grade
Corporate Long-Term Ratings Definitions S&P
Moody’s
Fitch
Definitions (by Moody’s)
AAA
Aaa
AAA
AA
Aa
AA
A
A
A
Obligations rated A are considered upper-medium grade and are subject to low credit risk.
BBB
Baa
BBB
Obligations rated Baa are subject to moderate credit risk. They are considered medium grade and as such may possess certain speculative characteristics.
BB
Ba
BB
Obligations rated Ba are judged to have speculative elements and are subject to substantial credit risk.
B
B
B
Obligations rated B are considered speculative and are subject to high credit risk.
CCC
Caa
CCC
CC
Ca
CC
Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest.
C
C
C
Obligations rated C are the lowest rated class and are typically in default, with little prospect for recovery of principal or interest.
Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk. Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.
Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk.
Source: Moody’s Investor Services, Standards and Poor’s, Fitch Ratings.
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Corporate Ratings Landscape Continues to Evolve Composition of Merrill Lynch 1-5 Year Corporate Index By Issuers 100%
9 49
By Face Value
10
7
40
54
100%
90%
90%
80%
80%
6%
1%
1%
14%
15%
47%
44%
38%
40%
2012
2016
20%
70%
201
249 AAA
193
60%
AA
50%
A
70% 60% 50%
44%
40%
40% BBB 424
30%
494
30%
276 20%
20%
10%
10%
30%
0%
0% 2008
2012
2016
2008
Source: BofA Merrill Lynch Indices composite ratings.
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Letter Rating Migration Rates 2016 One-Year Letter Rating Migration Rates From\To: Aaa Aa A Baa Ba B Caa Ca-C
Aaa 100.0% 0.3% -
Aa 91.7% 0.7% -
A 5.6% 89.8% 1.3% -
Baa 5.7% 87.1% 5.2% 0.2% -
Ba 0.1% 6.7% 77.6% 4.5% -
B 0.8% 8.6% 71.9% 5.5% 1.1%
Caa 0.2% 1.0% 10.0% 70.3% 1.1%
Ca-C 0.3% 0.2% 4.4% 42.0%
Default 0.1% 1.4% 6.2% 44.3%
WR 2.6% 3.8% 3.8% 7.4% 11.8% 13.6% 11.4%
Default 0.0% 0.1% 0.2% 0.9% 3.4% 8.4% 25.6%
WR 3.7% 5.0% 4.6% 5.2% 0.8% 10.6% 14.1% 22.9%
Average One-Year Letter Rating Migration Rates, 1970-2016 From\To: Aaa Aa A Baa Ba B Caa Ca-C Legend:
Aaa 87.6% 0.8% 0.1% 0.0% 0.0% 0.0% -
Aa 8.1% 85.2% 2.5% 0.1% 0.0% 0.0% 0.0% -
A 0.6% 8.4% 86.7% 4.2% 0.4% 0.1% 0.0% 0.1%
Baa 0.1% 0.4% 5.4% 85.5% 6.1% 0.5% 0.1% -
Ba 0.0% 0.1% 0.5% 3.9% 76.2% 4.8% 0.4% 0.6%
Upgrades Downgrades to Non-Investment Grade
B 0.0% 0.0% 0.1% 0.7% 7.2% 73.5% 6.7% 2.5%
Caa 0.0% 0.0% 0.2% 0.7% 6.6% 67.4% 8.8%
Ca-C 0.0% 0.0% 0.0% 0.1% 0.5% 2.8% 39.5%
Downgrades to Investment Grade Defaults
Source: Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2016.
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Default History Number of Non-Investment Grade Corporate Issuer Defaults 300
25
250
20
200
15
150
10
100
5
50
0
0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
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1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Number of Investment Grade Corporate Issuer Defaults
Source: Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2016.
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Policies and Procedures
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Develop polices that Achieve Risk Objectives
• Who has the authority to take certain actions?
• Who has an oversight role?
• How will decisions be made?
• Set standards for due diligence and review.
• What is the risk appetite and what do I hope to achieve?
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An Approved List can be an Important Risk Management Tool •
An approved list restricts purchases made by those authorized.
•
Helps to strengthen the oversight process.
•
Aware of potential risk at all times.
•
Focus resources on areas of potential exposure.
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Broker/Dealer Approved List Manages Counterparty Risk • Manage the risk that a counterparty will not be able to meet its obligations.
• Financial strength of company.
• Availability of product.
• Competitiveness of pricing.
• Quality of sales coverage.
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What are we looking at?
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Narrowing The Universe of Potential Issuers? • Does an issuer’s ratings meet policy requirements?
• Does an issuer have value?
• Is a company in a risky or volatile business?
• What is its competitive position and fundamental condition relative to peers?
• Narrowing the list produces candidates for further review.
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AAA/AA Rated Representative Issuer List # of Issues
Amount Outstanding (millions)
% of Corp Index
Moody’s
S&P
Fitch
Apple
10
$18,400
0.77%
Aa1
AA+
-
Westpac Banking
14
$16,450
0.69%
Aa2
AA-
-
Chevron
11
$15,950
0.67%
Aa2
A
WD
Shell International
11
$15,750
0.66%
Aa2
A
AA-
Toronto-Dom. Bank
12
$15,750
0.65%
Aa1
AA-
AA-
Microsoft
10
$14,950
0.62%
Aaa
AAA
AA+
Royal Bank of Canada
11
$13,700
0.57%
Aa3
AA-
AA
General Electric
11
$12,375
0.55%
A1
AA-
AA-
Bank of Nova Scotia
11
$12,350
0.52%
Aa3
A+
AA-
Coca Cola
9
$10,324
0.43%
Aa3
AA-
A+
Top 10 Issuers
Representative list for informational purposes only; not an investment recommendation. Source: BofA Merrill Lynch 1-5 Year U.S. Corporate Index, as of 12/31/2016.
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A Rated Representative Issuer List # of Issues
Amount Outstanding (millions)
% of Corp Index
Moody’s
S&P
Fitch
J.P. Morgan Chase
19
$44,850
1.93%
A3
A-
A+
Morgan Stanley
19
$42,485
1.86%
A3
BBB+
A
Goldman Sachs
17
$38,750
1.69%
A3
BBB+
A
Bank of America
14
$33,964
1.48%
Baa1
BBB+
A
Citigroup
16
$27,350
1.15%
Baa1
BBB+
A
Wells Fargo
11
$24,950
1.05%
A2
A
AA-
Cisco Systems
11
$18,100
0.77%
A1
AA-
-
Toyota
16
$16,850
0.71%
Aa3
AA-
A
Daimler Finance
16
$15,950
0.66%
A2
A
A-
Sumitomo Mitsui
14
$14,500
0.60%
A1
A
A
Top 10 Issuers
Representative list for informational purposes only; not an investment recommendation. Source: BofA Merrill Lynch 1-5 Year U.S. Corporate Index, as of 12/31/2016.
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Fundamental Condition • A consistent and repeatable framework to monitor the fundamental condition of a company should exist.
• Tools like Bloomberg can greatly assist with the gathering and analysis of data.
• Data can be compared to peers, historically or to rating agency targets to review the fundamental condition of a company
• Select metrics for each important category and develop a framework to gather and review data.
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Measures of Fundamental Condition Vary • Depending on the industry the measure of fundamental condition will vary.
• In the industrial sector the analysis will focus on profitability, cash flow generation and leverage.
• When assessing the banking sector the focus may be on capital and asset quality in addition to profitability.
• Comparison across industries will vary, some operate at higher levels of leverage for example.
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Examples of Measure of Leverage
• Debt/EBITDA • EBIT/Interest Expense • Residual Free Cash Flow/Debt
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Measures of Profitability • Operating Margin • EBITDA Margin
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Second Quarter Corporate Earnings Remains Strong • The S&P 500 posted another strong quarter of corporate earnings, as earnings per share grew 16% in Q2, based on 99% of companies that have reported so far. • Over 75% of the companies have reported earnings that beat analysts’ expectations
% of S&P 500 Companies Reporting Better/Worse Earnings in Q2 ‘17
S&P 500 EPS Growth (YoY) 20%
18% 16%
Positive Surprise
Inline
Negative Surprise
100% 80%
10%
60% 40% 20%
0%
Telecom.
Energy
Consumer Staples
Materials
Utilities
Industrials
Consumer Disc.
S&P 500
Financials
Real Estate
Q2 '17
Q4 '16
Q2 '16
Q4 '15
Q2 '15
Q4 '14
Q2 '14
Q4 '13
Q2 '13
Q4 '12
Q2 '12
Q4 '11
Q2 '11
-10%
Health Care
IT
0%
Source: Bloomberg, as of 09/01/17, with 496 of the S&P 500 companies reporting so far for Q2.
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What is the Role of the Rating Agencies? • Rating agencies determine if an issuers debt meets policy requirements.
• Rating agencies have very good access to companies and as a result important insights.
• Historical data on individual issuers and sectors is valuable to investors.
• A good place to start when thinking about an issuer, but we need to be sure their assessment matches our risk tolerance.
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Understanding Market Sentiment is Important • Often an indicator of problems, stress or concern.
• We can judge market sentiment based on changes in stock, bond and derivative prices.
• Changes in prices can be compared to the broader market to judge if price movements are out of the ordinary.
• Traders should understand the relative value of issuers and be conditioned to spot outliers or significant changes.
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Credit Spreads Narrowing Requiring Careful Issue Selection 1-5 Yr. A-AAA Corporate Yield Spreads (OAS) 160
Strong investor demand has resulted in corporate spreads narrowing, which now warrants more careful selection of industry, issuer, and maturity.
140 120 100 80 60 40 Aug '12
Feb '13
Aug '13
Feb '14
Aug '14
Feb '15
Aug '15
Feb '16
Aug '16
Feb '17
Aug '17
Aug '16
Feb '17
Aug '17
0-5 Yr. AAA ABS Yield Spreads (OAS) 80 70
Yields spreads on ABS have also contracted, but still offer decent incremental value for AAA-rated structures.
60 50 40 30 20 Aug '12
Feb '13
Aug '13
Feb '14
Aug '14
Feb '15
Aug '15
Feb '16
Source: Bloomberg, Bank of America Merrill Lynch Indices, as of 08/31/17. OAS is Option Adjusted Spread.
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1-3 Year
1-5 Year
Master
1-3 Year
1-5 Year
MBS
Corp (A-AAA)
U.S. Treasury
ABS (AAA)
MBS
Corp (A-AAA)
Agency
U.S. Treasury
ABS (AAA)
MBS
MBS
Corp (A-AAA)
Agency
U.S. Treasury
ABS (AAA)
0% MBS
0% Corp (A-AAA)
1%
Agency
1%
U.S. Treasury
2%
ABS (AAA)
2%
MBS
3%
Corp (A-AAA)
3%
Agency
4%
U.S. Treasury
4%
Corp (A-AAA)
(Period ended 08/31/17)
Agency
5-Year Average Annualized Returns
(05/31/17 – 08/31/17)
U.S. Treasury
Trailing 3-Month Return
Agency
Corporates Continue to Outperform
Master
Source: BofA Merrill Lynch Indices. MBS and ABS indices are 0-3 and 0-5 year, based on Weighted Average Life.
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High Level Spread Movements – Market Moves
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Default Risk Analysis – A Component of Market Sentiment
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Default Risk Historical – Compare Individual Issuers
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Managing Risk
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Diversity can Help Mange Risk • Two theories, put all your eggs in one basket and watch the basket closely, diversify to guard against unknown circumstances.
• Not all adverse events can be predicted, how do we protect against this?
• Diversity limits can reduce the loss if there is a credit event, but might require additional work to maintain a larger approved list.
• Concentration limits can be based on maturity or credit quality or a combination of both.
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Maturity Restrictions can Effectively Manage Risk • Maturity limits can be used to manage risk.
• Limits can be set by the credit quality of an individual issuers, sector or issuers from a common geographical region
• Maturity limits can be used to mange around events that might happen in the near future.
• Limits can be changed to reflect the changing circumstances of an issuer.
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Understanding Market Values • Traders should understand the market for securities being transacted.
• Helps to ensures that prices paid for securities are fair, three quality bids.
• As discussed earlier, market sentiment is an important part of the process, traders are the first line of defense.
• Ensure proper trading procedures, comparative shopping and execution.
• Available tools include, Trace, BVAL and news flow from broker/dealers.
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Disclaimer This material is based on information obtained from sources generally believed to be reliable and available to the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities. The information provided in this presentation related to representative issuers is general in nature only and has not been prepared taking into consideration your particular needs, circumstances or objectives. Issuers depicted in this presentation are for illustrative purposes only.
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