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Managing credit risk requires healthy dose of cynicism

In the world of credit risk, you need to understand the capacity of the borrower to pay what they’ve promised, then assume that they will let you down anyway and avoid concentrating your portfolio

Successful investing is about taking appropriate risks for appropriate rewards to achieve realistic return objectives. If credit risk is not managed properly, it can be potentially disastrous for a portfolio. Managed well, credit risk can provide reliable, attractive income, with good levels of capital stability. This two-part series helps achieve the latter, especially at a time when many investors are switching out of term deposits in search for better yields.

Part 1 provided an overview of credit risk – what it is and why is it important. In this 2nd part the focus is on the key elements of managing credit risk. How can an investor not only capture the additional yield that credit risk provides, but keep that extra return rather than losing it to defaults? Capturing and keeping excess returns is the goal of credit risk management.

Corporate bonds, debentures and the like provide investors with an opportunity to capture higher returns than are paid by the safest investments such as cash or Australian government bonds. Markets have historically priced corporate bonds so that lower credit quality securities pay a higher yield than higher quality assets. AAA and AA rated bonds have normally paid investors around 1% more than similar maturity government bonds, with the spread widening to above 2% for BBB rated securities and more like 4 – 7% on BB and B.

There are more determinants of the yield on an individual bond than just its credit rating, but it’s a major influence.

Turning those higher yields into higher returns is the key to sound investment strategy. How can that be done?

Need for a cynical attitude

The simple answer is: avoid the duds. In the ideal situation you will do your research and always make very clever choices so that you never invest in companies that fail.

Credit research is different to equity research. Stock picking in the share market is mostly about looking for the positive stories, searching for upside opportunities for a company’s share price. Credit risk rating requires a cynical attitude. There is no ‘upside’ with bond investing. Either you earn your interest and get the principal back or you incur default losses which could be from small amounts to 100% of capital. That is why credit research has to focus on looking for what could go wrong, evaluating the downside risk. Assessing a borrower’s capacity to pay back their debt is very different to evaluating the prospects for growing earnings.

Further, you have to monitor each investment because credit quality can change. It’s not good enough to form a view when you buy an asset and then forget about it. Managing credit risk requires that if you detect deterioration in credit quality you think carefully about whether to sell out of that asset before things get worse.

Of course, in reality no one gets every decision right. Even if your research has been excellent, the world can change and a business’s franchise unravel. There is also the possibility of fraud. For these reasons, investors have to assume that some companies they believe are of good quality will fail. None of the credit ratings summarised in part 1 has a non-zero probability of default, even AAA.

You have to assume that even the best quality issuer, with the best intentions in the world, could let you down.

Minimise the impact of a bad credit

 

Therefore, the answer to the question about how to capture and keep the extra returns from credit investing has a second element: ‘minimise the impact of the duds on your portfolio’. This requires a high standard of portfolio construction, with an emphasis on diversification, which is the only way to effectively manage credit risk.

What does ‘diversification’ mean? In essence, diversification of a credit portfolio involves holding a large number of different investments, none of which is a significant proportion of the total.

Let’s say you have a portfolio of corporate bonds that provide an average yield that is 1.5% more than a ‘risk-free’ portfolio – say, a mix of cash and government bonds. If this portfolio is made up of only 10 individual assets, then if one of them defaults you could lose up to 10% of your total portfolio. That wipes out about 7 years’ worth of that extra 1.5% per annum in income you had expected to earn.

If, however, you had 100 individual assets in the portfolio and one of them defaulted, your loss would be only up to 1% of your capital. That would reduce your excess return in the year in which it happened to 0.5% above the risk-free return, but the remaining 99 bonds would continue to earn their average yield – close to 1.5% – thereafter. Obviously, if you have even more individual assets, then the impact of any one default reduces further. Conversely, a retail investor will not be able to assemble 100 individual bonds, but the same general risk diversification principle applies.

Reducing the impact of any default

The next element of a good diversification strategy is to minimise the risk that if one of your holdings defaults then so will another. You don’t want risks that are correlated. For example, if you have 2 or 3 bonds in the same industry in the same country, then if demand for their product dries up there’s a good chance that all of them might fail, not just 1 of them. It’s better to have both than only 1 (provided the credit quality is similar), but it’s even more properly diversified if you halved the weight for both of them and replaced that half with exposures to different industries altogether.

Finally, it is sound practice to have lower limits on the lower credit rated assets. A portfolio of AAA and AA assets can be more concentrated than one that goes down into A and BBB, and it is wise to have even smaller exposure limits on BB and B rated bonds. The probability of default should be inverse to the amount you invest.

The beauty of this is that you don’t have to give up return in order to manage risk. 100 bonds paying 1.5% above your benchmark will deliver the same gross return as 1 bond paying 1.5% above your benchmark. But you have a much greater chance of actually earning that 1.5% in a diversified portfolio than a single security investment.

In the world of credit risk, you need to understand the capacity of the borrower to pay what they’ve promised, then assume that they will let you down anyway and avoid concentrating your portfolio with them. Taking a large number of smaller exposures is the best way to capture and keep the returns that you are looking for.

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