Rethinking Risk Management
by Joe Sarbinowski, Global Head of Institutional Liquidity Management Distribution, DB Advisors
Why do treasurers and other fixed income investors need to rethink risk management?
The composition of bond markets has changed dramatically in recent years, first due to stresses in the financial sector, later as a consequence of sovereign debt problems and subsequent downgrades. Simply put, there are fewer high quality, highly rated securities than there used to be, while markets have become more volatile.
How serious is the challenge?
At the end of last year, only about 7% of the corporate ratings issued by Standard & Poor’s worldwide were ‘AAA’ or ‘AA’, with fewer than 40 companies in the top rating band and only about 360 in the second tier. In Europe, just 11 financial issuers and three non-financial ones hold the ‘AAA’ rating. The US corporate bond market tells a similar story: according to Fitch Ratings, in 2011 less than 10% of outstanding US company debt was rated higher than ‘A’, down from over 20% in 2005.
Can we expect an improvement?
Not in the near term. Downgrades are continuing to occur, and negative bias (the number of issuers with negative outlooks divided by the total number of issuers) stands at 30% for financials and 28% for sovereigns.
Why is this a problem?
Many investors have guidelines that strictly limit the types of securities they can buy, especially with respect to minimum or average credit ratings. Since there are fewer high quality issuers, some portfolios are becoming concentrated in fewer names. In particular, some investors are getting more exposure to financial issuers than they might want, simply because financial institutions generally carry higher ratings than most other issuers. That’s a problem because the financial sector remains volatile and can be subject to rather indiscriminate sell-offs when systemic fears increase.
With markets remaining volatile, shouldn’t investors be sticking to the highest rated securities?
Not necessarily. A ‘BBB’ rated non-financial issuer – a utility company, for example – may well be a better credit risk than an ‘A-’ rated bank. It carries a lower rating because it has higher leverage, but given the stable nature of its business, it can generally service its debt. Financial issuers may be more likely to be negatively affected by a systemic event.
Another area where ratings may diverge from real credit risk is when the rating on a large company – a bank in a peripheral European country, say – reflects the domestic sovereign rating rather than the actual (potentially lower) credit risk associated with the company’s globally diversified operations.
Can ratings be relied upon?
Rating agencies do valuable work. The point is that investors need to take a wider perspective, looking at what the market is saying in addition to considering the agencies’ view. For example, credit default swap premiums – i.e., the cost of insuring against default – are much higher for some banks in the ‘A-‘ to ‘AA-‘ range than for some ‘BBB’ rated non-financials. In other words, the collective view of market participants is that money is safer invested in the debt of the lower-rated non-financial issuers than in that of the higher-rated financial issuers. That is a perspective that ought to be considered.
What are the implications for money market funds?
Money market funds will continue to be an essential tool for treasurers and other investors at the short end of the curve, and they will continue to invest in highly rated securities as their parameters require them to do. What has changed is that investors are rightly paying much more attention to the quality and breadth of their money managers’ resources, especially with respect to credit and risk analysis, and also in terms of transparency and reporting. At the same time, many traditional users of money market funds are having to broaden their perception of risk management.
Treasurers have to manage many different types of risk, so they need a multi-faceted approach to risk management. Managing risk with the objective of making sure that money will absolutely, definitely be available overnight – which is what money market funds provide – is very different to managing risk with the objective of not losing money in real terms over a quarter. We often use the term ‘risk bucketing’ to compartmentalise specific risk types. We work with our clients to help them construct portfolios designed to address each risk bucket for their liquidity.