Risk arising from single issuer credit events
So far we have described a rather intuitive way of combining individual views in a portfolio. Top-down and bottom-up analyses have determined the overall strategy for the portfolio, spread class and sector selection and finally issuer weightings. This qualitative methodology does not require estimates of returns, risks and correlations between the investments, and therefore is easy to implement. Yet, it is not able to capture the full benefits of diversification and to tailor the expected risk/return profile of the portfolio to the preferences of the investor. Since the seminal work of Markowitz (1952), diversification is a central tenet of modern investment theory. In the context of credit portfolios it plays a crucial role, because it helps to control downside risk arising from single issuer credit events. Since the mid-1990s debt-financed M&A activities, share buybacks, and the introduction of new technologies have fueled the new issue pipeline and broadened the corporate bond universe. Meanwhile, the European corporate bond market offers sufficient market breadth and depth for institutional investors to construct thoroughly diversified portfolios. If the portfolio manager is capable of quantifying the risk and return characteristics of his investment alternatives, portfolio optimization approaches present a formalized and thus objective way of deriving investment recommendations. This applies irrespective of the performance target of the investor. Portfolio optimization can be used with respect to portfolios that are managed in absolute risk/ return terms as well as portfolios that are managed relative to a benchmark index.. Various constraints can be included, for example a short sales restriction for real money investors, maximum concentration limits or desired duration ranges.
A currency mismatch between credit and revenues
Transaction risk arises when a company has a currency mismatch between its costs and revenues, that is, revenues are generated in one currency while costs are denominated in another, the reporting currency. The sustained depreciation of the US dollar since February 2002, for example, has negatively affected the P&L and cash flow statements of European exporters.
Although it proves difficult to obtain a breakdown of the cost structure of a company by currency, the automotive sector and the aerospace sector seem to be hit most by transaction risk.
Therefore, many companies try to offset at least a part of their currency exposure via natural hedging. That is, they try to match currency flows that result from exports and imports of goods and services. A high degree of flexibility with respect to input factors and capacity utilization of plants in different regions also provides an effective hedge against adverse currency movements. Another possibility of reducing currency risk is through derivatives, primarily forward exchange contracts and currency options. In our experience most companies that are significantly exposed to currency risk use some form of derivatives hedging. Yet, most contracts are set up for a period of 1–2 years at most. In the long term, it is difficult for companies to assess their demand for hedging because they have no reliable information
about the future demand for their products and services so that the future cost and earnings situation is unknown. For longer term trends in exchange rates, natural hedging usually is more effective. Credit analysts often lack a thorough insight in currency hedging strategies, especially with regard to derivatives hedging. Since they are hardly able to assess the true currency exposure in the short term, they tend to prefer the longer term and more transparent natural hedging strategies.