Asset Class Reader: Nominal Bonds

Explaining the Rate Spread on Corporate Bonds

EDWIN J. ELTON, MARTIN J. GRUBER, DEEPAK AGRAWAL,
and CHRISTOPHER MANN, THE JOURNAL OF FINANCE • VOL. LVI, NO. 1 • FEBRUARY 2001

ABSTRACT

The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds

Macroeconomic Factors and the Correlation of Stock and Bond Returns

Li, Lingfeng, "Macroeconomic Factors and the Correlation of Stock and Bond Returns" (November 2002). Yale ICF Working Paper No. 02-46; AFA 2004 San Diego Meetings.

Abstract:

This paper examines the correlation between stock and bond returns. It first documents that the major trends in stock-bond correlation for G7 countries follow a similar reverting pattern in the past forty years. Next, an asset pricing model is employed to show that the correlation of stock and bond returns can be explained by their common exposure to macroeconomic factors. The link between the stock-bond correlation and macroeconomic factors is examined using three successively more realistic formulations of asset return dynamics. Empirical results indicate that the major trends in stock-bond correlation are determined primarily by uncertainty about expected inflation. Unexpected inflation and the real interest rate are significant to a lesser degree. Forecasting this stock-bond correlation using macroeconomic factors also helps improve investors' asset allocation decisions. One implication of this link between trends in stock-bond correlation and inflation risk is the Murphy's Law of Diversification: Diversification opportunities are least available when they are most needed.

Benefits of International Bond Diversification

Hunter, Delroy M. and Simon, David P., "Benefits of International Bond Diversification" . Journal of Fixed Income, Vol. 13, pp. 57-72, March 2004

Abstract:

This paper assesses the incremental diversification benefits to US investors from investing in international government bonds. In light of suggestions that these benefits have fallen sharply in the recent decade due to more closely synchronized business cycles, we use mean-variance spanning tests to show that currency-hedged bonds provide significant diversification benefits over the period from January 1992 to September 2002. Using a bivariate GARCH framework, we find that US bond returns have become increasingly correlated with UK and German bond returns, but have experienced declining correlations with Japanese bonds. The changing correlations are consistent with variation in the synchronization of business cycles. However, the evidence suggests that correlations have not become high enough to threaten the gains from diversification and that these gains on a currency-hedged basis are not diminished during periods of weakness or increased volatility in US or foreign bond markets. Conditional Sharpe ratios also demonstrate that risk-reward tradeoffs for each bond market vary in a predictable manner, which further underscores the potential benefits of international bond investing. Finally, we demonstrate how conditional yield betas and conditional yield beta adjusted foreign bond durations can be constructed from our model estimates.

A Conditional Assessment of the Relationships Between the Major World Bond Markets

Hunter, Delroy M. and Simon, David P., "A Conditional Assessment of the Relationships Between the Major World Bond Markets" (June 24, 2003)

Abstract:

This paper uses a bivariate GARCH framework to examine the lead-lag relations and the conditional correlations between 10-year US government bond returns and their counterparts from the UK, Germany, and Japan. We find that while mean and volatility spillovers exist between the major international bond markets, they are much weaker than those between equity markets. The results also indicate that the correlations between the US and other major bond market returns are time varying and are driven by changing macroeconomic and market conditions. However, in contrast to the finding that the benefits of international diversification in equity markets evaporate during high-stress periods, we find that the benefits of diversification across major government bond markets do not decrease during periods of extremely high bond market volatility or following extremely negative US and foreign bond returns.

Securitization and Collateralized Debt Obligations

Fabozzi, Frank J. and Kothari, Vinod, Yale ICF Working Paper No. 07-07
Lucas, Douglas J., Goodman, Laurie and Fabozzi, Frank J., . Yale ICF Working Paper No. 07-06

Securitization: The Tool of Financial Transformation

Two papers on Securitization and Collateralized Debt Obligations:



Securitization: The Tool of Financial Transformation

Fabozzi, Frank J. and Kothari, Vinod, Yale ICF Working Paper No. 07-07

Abstract:

Securitization as a financial instrument has had an extremely significant impact on the world's financial system. First, by integrating capital markets and the uses of resources - such as mortgage originators, finance companies, governments, etc. - it has strengthened the trend towards disintermediation. Having been able to mitigate agency costs, it has made lending more efficient; evidence of this can be observed in the mortgage markets. By permitting firms to originate and hold assets off the balance sheet, it has generated much higher levels of leverage and, though arguably, greater economies of scale. Combination of securitization techniques with credit derivatives and risk transfer devices continues to develop innovative methods of transforming risk into a commodity and allow various market participants to tap into sectors which were otherwise not open to them.

In its broadest sense, the term "securitization" implies a process by which a financial relationship is converted into a transaction. A financial transaction is the coming together of two or more entities; a financial relationship is their staying together. For example, a loan to a corporation is a financial relationship; once the loan is transformed into a tradable bond, it is a transaction. We find several examples in the history of the evolution of finance of relationships that have been converted into transactions. The creation of "stock," representing ownership in a corporation, is one of the earliest and most important examples of this process because of its impact on the growth of the corporate form of business organization. The process of converting loans to corporations of high credit quality corporate borrowers, and in the 1970s expanding that opportunity to speculative-grade corporate borrowers, into publicly traded bonds is another example of this. Commercial paper is another example of securitization of relationships as it securitizes a trade debt

Collateralized Debt Obligations and Credit Risk Transfer

Lucas, Douglas J., Goodman, Laurie and Fabozzi, Frank J., . Yale ICF Working Paper No. 07-06

Abstract:

Several studies have reported how new credit risk transfer vehicles have made it easier to reallocate large amounts of credit risk from the financial sector to the non-financial sector of the capital markets. In this article, we describe one of these new credit risk transfer vehicles, the collateralized debt obligation. Synthetic credit debt obligations utilize credit default swaps, another relatively new credit risk transfer vehicle.

Financial institutions face five major risks: credit, interest rate, price, currency, and liquidity. The development of the derivatives markets prior to 1990 provided financial institutions with efficient vehicles for the transfer of interest rate, price, and currency risks, as well as enhancing the liquidity of the underlying assets. However, it is only in recent years that the market for the efficient transfer of credit risk has developed. Credit risk is the risk that a debt instrument will decline in value as a result of the borrower's inability (real or perceived) to satisfy the contractual terms of its borrowing arrangement. In the case of corporate debt obligations, credit risk encompasses default, credit spread, and rating downgrade risks.

The most obvious way for a financial institution to transfer the credit risk of a loan it has originated is to sell it to another party. Loan covenants typically require that the obligor be informed of the sale. The drawback of a sale in the case of corporate loans is the potential impairment of the originating financial institution's relationship with the obligor of the loan sold. Syndicated loans overcome the drawback of an outright sale because banks in the syndicate may sell their loan shares in the secondary market. The sale may be through an assignment or through participation. While the former mechanism for a syndicated loan requires the approval of the obligor, the latter does not since the payments are merely passed through to the purchaser and therefore the obligor need not know about the sale.

Another form of credit risk transfer (CRT) vehicle developed in the 1980s is securitization [Fabozzi and Kothari (2007)]. In a securitization, a financial institution that originates loans pools them and sells them to a special purpose entity (SPE). The SPE obtains funds to acquire the pool of loans by issuing securities. Payment of interest and principal on the securities issued by the SPE is obtained from the cash flow of the pool of loans. While the financial institution employing securitization retains some of the credit risk associated with the pool of loans, the majority of the credit risk is transferred to the holders of the securities issued by the SPE.

Two recent developments for transferring credit risk are credit derivatives and collateralized debt obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another party without the sale of the loan. A CDO is an application of the securitization technology. With the development of the credit derivatives market, CDOs can be created without the actual sale of a pool of loans to an SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic CDOs.

In this article, we discuss CDOs. We begin with the basics of CDOs and then discuss synthetic CDOs. The issues for regulators and supervisors of capital markets with respect to CDOs, as well as credit derivatives, are also discussed.


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