History has not dealt kindly with the aftermath of protracted periods of low risk premium,” said Alan Greenspan back in August 2005 while he was Chairman of the Federal Reserve. Two years later a storm is brewing—will it result in a hurricane or merely a small craft warning?

The warning signals are present in the incidence of subprime mortgage defaults in the United States, increased equity volatility, widening credit spreads, and, most recently, reversion of shorter term U.S. interest rates to levels below their counterparts in Canada. The collapse of certain fixed income hedge funds at Bear Stearns has led some market participants to observe that credit conditions are now the worst in two decades. Credit concerns also increase the cost of leverage, thus eliminating the takeover premium in stocks such as BCE and contributing to the recent stock market decline.

Credit risk is of particular concern to pension plan sponsors now that funds are shying away from assuming interest rate risk in their fixed income portfolios as part of the movement towards liability-driven investment, and potentially assuming credit risk instead.

Credit risk is asymmetrical, and does not integrate well into the models used to assess other risks. It is often observed that in times of trouble, credit event correlations go to one. So while portfolio diversification is a great tool to smooth return expectations in the good years, there is no substitute for solid credit analysis in preparation for bad years. While analysis cannot expose fraud(one potential cause of credit default), it can identify deteriorating trends in key financial ratios, debatable accounting practices or an excessive affinity for complex financial engineering.

Credit analysis is a close cousin to its better known relative: equity analysis. While fixed income and equity managers ostensibly look at the same financial information, equity managers are looking for financial opportunities while fixed income managers are looking for financial threats.

Synthetic credit structures have created “AAA” rated instruments in quantities well in excess of what can be attributed to true “AAA” issuers.(There are some who maintain that the rating agencies have been too permissive in their rating of these instruments.)Blind reliance on credit ratings is imprudent at all times, but particularly for complex synthetic structures. Investors are well advised to do their own detailed analysis, just as they would for their equity portfolios.

Credit derivatives allow active trading in credit risk but have also been issued in notional amounts that exceed the issuance of the underlying physical securities by factors of 30 to 50. While ostensibly irrelevant where cash settlement is the norm, it raises the interesting question of what the “squeeze” would look like if the sellers of credit protection insisted on settlement in kind, thus inflating prices temporarily and mitigating their risk.

What does this mean for market participants, and pension funds in particular? While traders worry about widening and narrowing spreads, investors know that it’s the long-term that matters. With debt instruments, the question is whether the principal payments will be honoured at the maturity date. For synthetic structures, the additional question is whether the investor understands the underlying risks and has carefully reviewed the documentation.

Now is the time for a credit tune-up on fixed income portfolios to ensure that the forensic work has been done. But if a credit storm materializes, there will be opportunities for bold investors to assume credit risk under far more favourable conditions.

Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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