Showing papers in "The Journal of Fixed Income in 2011"
TL;DR: The authors empirically investigated the determinants of loss given default (LGD) and built alternative predictive econometric models for LGD on bonds and loans using an extensive sample of most major U.S. defaults in the 1985-2008 period.
Abstract: Loss given default (LGD) is a critical parameter in various facets of credit risk modeling. This study empirically investigates the determinants of LGD and builds alternative predictive econometric models for LGD on bonds and loans using an extensive sample of most major U.S. defaults in the 1985–2008 period. The authors build simultaneous equation models in the beta-link generalized linear model (BLGLM) class, identifying several that perform well in terms of the quality of estimated parameters as well as overall model performance metrics. This extends prior work by modeling LGD both at the firm and the instrument levels. In a departure from the extant literature, the authors find the economic and statistical significance of firm-specific debt and equity market variables. In particular, they find that information from either the equity or the debt markets at around the time of default (measures of either cumulative equity returns or distressed debt prices, respectively) have predictive power with respect to the ultimate LGD, which is in line with recent prior recovery and asset pricing research. They also document a new finding: Larger firms have significantly lower LGDs while larger loans have higher LGDs.
27 citations
TL;DR: In this article, the authors examine price pressure in a setting where trades occur because of regulations and when information effects are absent, and they find that price pressure is negligible, if not nonexistent.
Abstract: We examine price pressure in a setting where trades occur because of regulations and when information effects are absent. Our study of fallen angel bond sales by insurance-companies shows that price pressure is negligible, if not nonexistent. We attribute our results to the fact that trades occur when fundamentals are unchanged and dealers know that the sales are not motivated by private information about future returns. Our results confirm the prediction of several theoretical models that sellers will benefit from a higher price when they are able to separate themselves out to dealers as uninformed. Consistent with following a strategy of sunshine trading (as in Admati and Pfleiderer [1991]), we find that insurers do not attempt to hide their trades by selling bonds before they are downgraded.
25 citations
TL;DR: In this article, the authors explore the strategic factors that may affect borrower decisions to default on first vs. second lien mortgages and find that borrowers are more likely to remain current on their second liens if it is a home equity line of credit (HELOC) rather than a closed-end home equity loan.
Abstract: Strategic default behavior suggests that the default process is not only a matter of the inability to pay. Economic costs and benefits affect the incidence and timing of defaults. As with prior research, this article finds that people default strategically as their home value falls below the mortgage value (exercise the put option to default on their first mortgage). While some of these homeowners default on both first mortgages and second lien home equity lines, a large portion of the delinquent borrowers have kept their second lien current during the recent financial crisis. These second liens, which are current but stand behind a seriously delinquent first mortgage, are subject to a high risk of default. However, relatively few borrowers default on their second liens while remaining current on their first. This article explores the strategic factors that may affect borrower decisions to default on first vs. second lien mortgages. This study finds that borrowers are more likely to remain current on their second lien if it is a home equity line of credit (HELOC) rather than a closed-end home equity loan. Moreover, the size of the unused line of credit is an important factor. Interestingly, we find evidence that the various mortgage loss mitigation programs also play a role in providing incentives for homeowners to default on their first mortgages.
24 citations
TL;DR: In this paper, the authors empirically demonstrate that regulatory arbitrage opportunities between the trading business and the loan business existed under the Basel I and Basel II framework and are likely to subsist under Basel III regime.
Abstract: Based on anecdotal evidence, regulatory arbitrage was a major catalyst of the recent financial crisis. However, regulatory arbitrage is both theoretically and empirically not yet adequately explored. This article develops a theoretical model of regulatory arbitrage. The model is based on a set up where regulatory risk weights act as a certification of the riskiness of a bank’s opaque balance sheet. When regulatory risk weights are misspecified, regulatory arbitrage for the (informed) banks exists. The authors empirically demonstrate that regulatory arbitrage opportunities between the trading business and the loan business existed under the Basel I and Basel II framework and are likely to subsist under the Basel III regime. Their analysis is based on the so-called asset correlation parameter that plays a crucial role for capital requirements under Basel II and Basel III.
20 citations
TL;DR: In this article, the authors examined the effects of liquidity and counterparty risk factors on CDS pricing and found that both liquidity and risk factors are important over and beyond the effect of traditional default variables implied by the structural model.
Abstract: This article examines the effects of liquidity and counterparty risk factors on CDS pricing. Using a marketwide counterparty risk measure, the authors estimate the risk premium associated with systematic counterparty defaults. They find evidence that both liquidity and counterparty risk factors are important over and beyond the effects of traditional default variables implied by the structural model. The effects of these factors are economically significant and stronger for reference entities with lower ratings. Systematic counterparty risk exerts a positive effect on the CDS spread. The relationships between CDS spreads and liquidity and default and marketwide counterparty risk factors vary in the face of changes in the market liquidity condition. Default and counterparty risk become greater concerns for investors during times of low liquidity in the financial market.
17 citations
TL;DR: In this article, a sample of investment-grade corporate bond yields for the period 9/2009 to 9/2010 was used to examine all data points where the trade price reflects a negative spread, and the observed credit spread does not violate arbitrage restrictions once the bid-ask spread and liquidity are accounted for.
Abstract: Recent reports in the financial press regarding negative spreads in the investment-grade corporate bond market have drawn the attention of policy makers and market participants alike. Using a sample of investment-grade corporate bond yields for the period 9/2009 to 9/2010, the authors examine all data points where the trade price reflects a negative spread. There are a total of 67 instances distributed among 10 companies where the credit spread is negative based on reported trade prices. The observed credit spread does not violate arbitrage restrictions once the bid–ask spread and liquidity are accounted for. In terms of default risk, CDS prices are higher than the bond yield spread on these days, but funding and asset-specific liquidity constraints possibly limit the ability to exploit the arbitrage.
17 citations
TL;DR: In this article, the authors developed a tractable framework to simultaneously estimate default probabilities and implied recovery values from sovereign bond prices, and applied the model to analyze the Greek debt crisis in 2010.
Abstract: This article develops a tractable framework to simultaneously estimate default probabilities and implied recovery values from sovereign bond prices. The model is simple and parsimonious yet allows for a term structure of default probabilities and provides an implicit recovery value. The latter is especially valuable in the context of sovereign credit risk where historical default rates are both rare and country specific. The model is applied to analyze the Greek debt crisis in 2010. In April and May, the probability of a Greek default quickly rose from 5% to 40%. After the €750 billion EU-wide rescue package is announced, the default probability instantaneously drops below 10%. The implied recovery value remains between 40 and 60 cents on the euro throughout this period.
17 citations
TL;DR: In this article, the authors show that the key ingredients of modification success are principal reduction, substantial pay relief, and modifying early in the delinquency cycle, and when all three of these ingredients are present, a modification has a good chance of success.
Abstract: In this review of modification activity, the authors show that the key ingredients of modification success are principal reduction, substantial pay relief, and modifying early in the delinquency cycle. When all three of these ingredients are present, a modification has a good chance of success. They also demonstrate that success rates on modifications generated by the market’s methods are overstated: These methods do not take into account loans that have liquidated or re-defaulted on an earlier modification.
14 citations
TL;DR: In this paper, the authors provide empirical evidence about the credit factors that affect the pricing of newly issued residential mortgage-backed securities (RMBS) in the U.K. They show that credit factors such as subordination level and collateral type still have a significant impact on the new issuance spread even after accounting for the credit rating.
Abstract: We provide empirical evidence about the credit factors that affect the pricing of newly issued residential mortgage-backed securities (RMBS) in the U.K. Our findings add an important element to the current debate by regulators throughout the world regarding whether investors rely exclusively on credit ratings in making investment decisions. Our results show that credit factors such as subordination level and collateral type that are taken into account by credit rating agencies when assigning a rating still have a significant impact on the new issuance spread even after accounting for the credit rating. The implication is that investors do not rely exclusively on ratings.
14 citations
TL;DR: In this paper, an equilibrium model for quantifying such liquidity compressions in prices is proposed, which can produce extremely large discounts while there are no substantial changes in economic fundamentals and under very reasonable levels of risk preference.
Abstract: In the recent financial crisis, unprecedented compressions of securities prices were frequently observed. Such compressions were mainly driven by the lack of liquidity. We therefore propose an equilibrium model for quantifying such liquidity compressions in prices. We demonstrate that our model can produce extremely large discounts while there are no substantial changes in economic fundamentals and under very reasonable levels of risk preference. Furthermore, our model can be extended to explain high correlations among assets observed in a crisis and to include Merton-type default models to provide interactions between liquidity and credit risks. Such an implication helps further the construction of models for stress tests and risk management.
13 citations
TL;DR: In this paper, the impact of key events from the recent financial crisis on credit default swaps (CDS) was explored and it was shown that shocks from the CDS spread significantly coincide with major credit events, and the magnitudes of shocks are greater for negative events than for positive events.
Abstract: This study explores the impact of key events from the recent financial crisis on credit default swaps (CDS). We show that shocks from the CDS spread significantly coincide with major credit events, and the magnitudes of shocks are greater for negative events than for positive events. The CDS spreads of the financial industry jump prior to the occurrence of events. In the beginning of the crisis, competitive effects for the nonfinancial industry are present, and when the series of credit events continues, such competitive effects turn into contagion effects. The impact levels of the effects vary across sample firms with different industrial characteristics.
TL;DR: In this article, the authors examined the characteristics and price dynamics of fallen angels during a three-year period around their downgrade date and found that after their downgrade, fallen angels initially underperform high-yield bonds with similar characteristics but then experience a subsequent reversal lasting up to two years after the rating change.
Abstract: This article examines the characteristics and price dynamics of fallen angels during a three-year period around their downgrade date. Consistent with the implications of forced selling, we find that after their downgrade, fallen angels initially underperform high-yield bonds with similar characteristics but then experience a subsequent reversal lasting up to two years after the rating change. Moreover, the magnitude of price recovery by individual issuers tends to increase with the size of their initial underperformance. We attribute the results to the increased capital charges for holding high-yield bonds imposed on insurance companies and the formulation of current investment mandates that often require investors to dispose of their holdings immediately after the downgrade. We discuss the implications of our findings for traditional credit investors as well as for absolute return investors.
TL;DR: In this paper, a new way of modeling the dynamics of a firm's asset value and discusses how it could be useful in the computation of asset value correlations in multivariate credit risk models.
Abstract: In this article, the author suggests a new way of modeling the dynamics of a firm’s asset value and discusses how it could be useful in the computation of asset value correlations in multivariate credit risk models. The method relies on credit spreads from the credit default swap market, and by combining these spreads with stock prices and leverage ratios, the author shows how one can construct a proxy for the asset value. This proxy is then used to calculate asset value correlations among a group of major European banks selected from the stress test conducted by the Committee of European Banking Supervisors in 2010. The asset correlations are presented as a function of bank size, default risk, and geographic location.
TL;DR: In this article, the joint probability of default for multiple financial institutions operating in the credit default swap (CDS) market was estimated using a no-arbitrage argument based on market data from January 3, 2005 to March 15, 2010.
Abstract: Systemic default risk—that is, the risk of the simultaneous default of multiple institutions—has caused great concern in the recent past. The aim of this article is to estimate the joint probability of default for multiple financial institutions. Both bond and credit derivative markets convey information on the default process: The former provides information on the marginal, the latter, on the joint default probabilities. We consider the corporate bond and the credit default swap (CDS) markets. The over-the-counter nature of the CDS market implies the presence of counterparty risk, or the risk that the protection seller will fail to fulfill its obligations. The counterparty risk is reflected in the CDS price through the joint default probability of the reference entity and the protection seller. Applying a no-arbitrage argument, we extract from market data forward-looking joint default probabilities of financial institutions operating in the CDS market from January 3, 2005–Mar 15, 2010.
TL;DR: The authors found that senior bonds realize large returns while junior bonds realize losses during bankruptcy reorganization and provided several explanations for the return anomaly observed in the distressed debt market, including liquidation, bankruptcy costs, and active involvement by hedge funds.
Abstract: By linking the trading price of distressed debt after Chapter 11 filing to the ultimate recovery for a large sample of Chapter 11 cases in the past decade, this article finds that senior bonds realize large returns while junior bonds realize losses during bankruptcy reorganization. In addition, this study provides several explanations for the return anomaly observed in the distressed debt market. Liquidation, bankruptcy costs, and active involvement by hedge funds contribute to the understanding of the returns of the distressed bonds. The large negative returns of the junior bonds during bankruptcy reorganization are most likely the result of their initial overvaluation, which was due to their lottery-like features.
TL;DR: In this paper, a factor-augmented vector autoregression (FAVAR) framework is applied for forecasting interest rates, and the authors operate in the space of latent yield and latent macroeconomic factors to analyze the relationship between the term structure of interest rates and the macroeconomic aggregates.
Abstract: Yield curve dynamics are usually analyzed in terms of the unobservable components—level, slope, and curvature. The factor-augmented vector autoregression (FAVAR) framework applied in this article has become increasingly popular for forecasting interest rates. To link these two strands of research, the authors operate in the space of latent yield and latent macroeconomic factors to analyze the relationship between the term structure of interest rates and the macroeconomic aggregates. They predict the yield curve dynamics by directly forecasting the unobservable yield curve factors. They use the FAVAR methodology to encompass a data-rich environment and to identify dynamic responses of the yield curve to the macroeconomic variables. The empirical results suggest that parsimonious FAVAR models with a few latent macroeconomic factors and a reduced lag order show superior short-horizon forecast performance over simple VAR systems and univariate autoregressions.
TL;DR: In this article, a decision-tree model that embeds known determinants of recovery value is presented, and simulations of historical default rates and correlated defaults using the model generate distributions of recovery values that replicate well the statistical properties reported in the literature.
Abstract: The amount recovered in default is as important as default probability for estimating expected losses on risky assets and for determining fair credit spreads, yet recovery value has been much less well studied than default. Recent research has increased substantially information about recovery value in default. From those studies, principles have emerged regarding the influence of collateral, credit cycle, seniority, industry sector, credit quality, and geography on loss given default. This article presents a decision-tree model that embeds known determinants of recovery value. Simulations of historical default rates and correlated defaults using the model generate distributions of recovery values that replicate well the statistical properties of recovery values reported in the literature.
TL;DR: In this paper, a Monte Carlo simulation framework for valuation of commercial mortgage-backed securities (CMBS) based on loan level net operating income (NOI) and market capitalization rate is proposed.
Abstract: This article proposes a Monte Carlo simulation framework for valuation of commercial mortgage-backed securities (CMBS) based on loan level net operating income (NOI) and market capitalization rate. By using geometric Brownian motions (GBM) to create stochastic paths for NOI and cap rate, one can simulate credit defaults and loss severity. Correlation is introduced between loan NOIs to allocate losses along the capital structure of the CMBS. Stochastic months-to-recovery variables are also generated through a Poisson process to capture equity tranche interest-only option value. The model offers a framework to systematically evaluate CMBS tranche prices by decomposing principal prepayment risk as well as credit default risk, which offers potential trading opportunities in the market.
TL;DR: In this paper, the main driver of spreads is the U.S. long-term rate, and it is shown that working on spreads relative to the German rate is a frustrating exercise while the use of the US rate as external reference allows for sharper results.
Abstract: The author investigates yield differentials from a different perspective. To account for the still non-negligible differences in long-term government bond yields of EMU members relative to Germany, the literature has placed much attention on the relative importance of liquidity and credit risk factors. In this article, the author argues that the main driver of spreads is the U.S. long-term rate. Results qualify earlier evidence and document an additional and independent role for the international risk factor. This article also shows that working on spreads relative to the German rate is a frustrating exercise while the use of the U.S. rate as external reference allows for sharper results.
TL;DR: In this paper, the authors examined different diversification patterns of structured securities that were deemed beneficial by investors and found that name diversification is largely ineffective and may even increase the risk of tranches.
Abstract: Diversification has been a frequently stated benefit of structured securitizations. In the subprime crisis, however, CDOs (especially ABS CDOs) proved to be concentrations of risk. In this article, the author examines different diversification patterns of structured securities that were deemed beneficial by investors and finds that name diversification is largely ineffective and may even increase the risk of tranches. Similarly, factor or sector diversification in the pool may not have the anticipated effect. Positive effects are only achievable for senior tranches, and for mezzanine tranches, the risks may even increase. These results shed new light on the diversification potential of CDOs, which is important in terms of both risk management and valuation.
Abstract: The author presents an original scheme to assess the creditworthiness of municipal revenue bonds and to track their credit progress before maturity. Prior studies have attempted to solve this matter from observed yield spreads of municipal bonds over riskless Treasury debt. In this article, the author assembles an analytical approach to directly appraise default probabilities from the prescheduled milestones and the feasible credit events of the underlying funded project. He derives various merits of the anisotropic random walk as the basic framework of his analysis and demonstrates them over a genuine scenario. The proposed model assists municipal investors as well as external and internal raters.
TL;DR: The authors make the case that a sizeable supply/demand imbalance has been created by the fact that the housing market faces a huge overhang of homes from borrowers who are either not making mortgage payments or will be unable or unwilling to do so in the future.
Abstract: The housing market remains very vulnerable. We make the case that a sizeable supply/demand imbalance has been created by the fact that the housing market faces a huge overhang of homes from borrowers who are either not making mortgage payments or will be unable or unwilling to do so in the future. At the same time, 19% of 2007 borrowers would not qualify for a mortgage today by virtue of payment history alone. And the demand for home ownership has further contracted because credit availability is limited. Every single governmental action seems to be moving toward limiting credit availability further still. We strongly believe that investors are the key to increasing housing demand, and the best way to encourage this is to increase financing for investor properties.
TL;DR: This article leveraged short-duration bonds to get the same dollar duration as the liability and generated between 0.40% and 0.90% of incremental annual returns over the last 56 years, depending on the liability profile.
Abstract: The term premium per year of duration declines with an increase in bond maturity due to an excess demand for long-duration bonds. Rather than holding the liabilityimmunizing long-duration bond, therefore, investors can capture a higher return by leveraging short-duration bonds to get the same dollar duration as the liability. This strategy would have generated between 0.40% and 0.90% of incremental annual returns over the last 56 years, depending on the liability profile. The mismatch in asset and liability maturities also exposes the investor to volatility, with lower (negative) returns when the yield curve flattens and higher returns when the yield curve steepens. The incremental volatility from this mismatch is small for plans with equity allocations, however, and even partly offsets large equity drawdowns as Fed action causes a steepening of the yield curve. A levered short-duration strategy thus can be an important tool for underfunded plans as they seek increased returns and improved efficiency relative to plan liabilities.
TL;DR: The authors showed that the average jump mean in bond prices can predict excess bond returns, capturing the countercyclical behavior of risk premia, and they showed that these jumps often take place at 8:30 and 10:00, directly linking them to specific macroeconomic news announcements.
Abstract: This article builds on the work of previous researchers who showed that the average jump mean in bond prices can predict excess bond returns, capturing the countercyclical behavior of risk premia. We show that these jumps often take place at 8:30 and 10:00, directly linking them to specific macroeconomic news announcements. Mean reversion, which looks at the total return over the past period rather than just the part related to jumps, has no predictive ability. Hence it is important to consider excess returns related to macroeconomic announcements that matter to market participants, and jumps are a good market proxy for what investors believe is important news. Our improved jump measure produces a Sharpe ratio of 0.52 in an out-of-sample market-neutral investment strategy.