The world has many ways to measure risk, but if the recent financial crisis has taught us anything, it is that asset price is the great equalizer in the fixed income markets. When global markets began to crash over a year ago, traditional measures of risk in credit markets became completely decoupled from asset prices. The ensuing market turmoil churned up the major structural weaknesses in our financial system and exposed them to plain sight.
This disruption did have one positive outcome: It taught market participants a critical lesson about the importance of developing a more robust approach to assessing risk and value in portfolios.
Nearly every investor weve spoken with over the past year agrees there is a need for change in the discipline of credit and risk valuation as it relates specifically to price and price risk. At the same time, however, it has been difficult to coalesce all of the pieces necessary to deliver truly comprehensive methods for security and portfolio valuation. This is the next step the market needs to take.
A Multi-Model Credit Discipline
To get to that point, we need new and innovative methods of analysis that build on the lessons of the crisis and clearly identify the relationship between risk and asset price for all credits in all types of market conditions. Investors need to be able to easily deploy an analytic discipline that moves beyond traditional notions of risk management, static benchmarking and probability of default metrics in order to incorporate a comprehensive, cross-asset view of credit quality.
What we learned from the experience of the last year is that the vital risk assessment process is an evolutionary one that must address the dynamic nature of change that accompanies rapidly evolving financial markets and products.
Sophisticated investors are now demanding a reliable cross-asset, cross market perspective that incorporates those components of risk that drive changes in market valuation. Included in this view should be an understanding of an assets risk to price, capital structure issues, volatility, liquidity and more.
Risk to Price
Dozens of variables have direct and indirect impacts on asset prices: probability of default, loss recovery, interest rate risk, liquidity and volatility, to name a few. When these variables start moving in different directions, asset price is going to be impacted. It all boils down to a basic question: does a bonds yield adequately compensate its owner for the credit and market risks being faced? Often, traditional analysis does not provide a sufficiently clear answer to that question. Accordingly, we have been working on a scoring methodology designed to assist investors in determining the extent that a bonds yield is commensurate with the risks it incorporates.
Investors need to be able to quickly and accurately identify the scope of these impacts under many different market conditions. By developing methods to evaluate the price of an asset relative to variables that incorporate both market and credit risk, it is possible to determine gaps in risk to price and, therefore, spot potential mispricing.
Market Derived Signals
In addition to monitoring credit ratings, it is crucial for investors to use models that incorporate the prices of Credit Default Swap (CDS) contracts to capture the markets sentiment regarding a companys perceived credit risk. By regularly measuring that sentiment against the ratings, it is possible to spot deviations in market sentiment that may have a bearing on an investment decision.
For example, over the past year, McDonalds Corp.s credit default swaps have maintained strength relative to its peer group, indicating a market-derived rating of aa+ versus its corporate credit rating of A. This reflects a positive market sentiment that clearly has a bearing on credit price. Investors need to factor this kind of intelligence into their portfolio analysis and valuation.
Capital Structure Analysis
Investors also need much deeper insight into smaller, non-public, and/or un-rated firms that could pose substantial counterparty risks to a portfolio. This kind of due diligence cannot be treated as a sideline initiative; it needs to be integrated into the portfolio analysis workflow so investors can incorporate revenue health, operational health and liquidity into all investment analyses.
Only by evaluating the entire capital structure of their holdings will investors be able to truly understand the full risk profile of their securities from a multi-dimensional perspective.
Credit Research May Only Be One ComponentBut Its A Critical One
It is not enough to just throw a bunch of new analytics at the problem; investors also need to be able to analyze and deploy this information strategically. The practice of ongoing, cross-content and cross-asset class research and analysis that incorporates all available risk models needs to become de rigueur in the credit markets, and data and analytics companies need help investors meet this need by providing the resources and commentary they need to scrutinize their underlying assets.
The days of following gut instinct and relying on one or two data points to back it up are gone. Proof of price is the new Holy Grail for credit investors. To demonstrate that proof, a new level of rigorous analysis is required one that acknowledges the lessons learned in the crisis to restore the investor appetite for calculated risk and improve the health of the financial markets.
What Has To Be Done
The type of change requires a transformational effort on the parts of investors, originators, risk managers and information and analytics companies. Fortunately, the upside potential for all stakeholders associated with this analytic innovation is enormous, while the downside risk is nonexistent. In a world with so few sure things, we like the odds of success for an investment in better investor education. There is a very clear path to restoring liquidity to the fixed income markets; those who lead the way will be the firms who act now to up the ante on analysis and valuation.
Lou Eccleston is Executive Managing Director Standard & Poors Fixed Income Risk Management Services (FIRMS), an analytics and research unit separate from S&Ps ratings business that delivers solutions to help investors perform greater analysis on the financial instruments in their portfolios.