Sunday, February 04, 2007

Asset Class Reader: Alternate Fixed Income Asset Classes

The primary asset allocation purpose of fixed income investments is to dilute the riskiness of volatile equity asset classes. This risk reduction function is realized by allocating short to intermediate treasury bonds, inflation indexed treasuries, or investment grade corporate or municipal bonds to the portfolio mix.

However, the fixed income market is not restricted to such high quality debt. Among the riskier and potentially higher return portions of the market are high yield bond and emerging market debt securities. Both of these asset classes possess high volatility, considerable credit risk, and correlations with equities. The following papers supply data on the returns, risks, and characteristics of these high risk asset classes. (My personal judgment on these asset classes is that, if added to the allocation mix, they should replace equity allocation and not bond allocation in the equity/bond allocation split.)

Defaults and Returns in the High Yield Bond Market: The Year 2005 in Review and Market Outlook: Altman, Edward I. and Pasternack, Brent

Credit Risk: How Much? When?: William Bernstein

Determinants of Recovery Rates on Defaulted Bonds and Loans for North American Corporate Issuers: 1983-2003

Cantor, Richard Martin and Varma, Praveen, "Determinants of Recovery Rates on Defaulted Bonds and Loans for North American Corporate Issuers: 1983-2003" . Journal of Fixed Income, December 2004

This paper explores the determinants of recovery rates on defaulted loans and bonds for North American corporate issuers over a period of 21 years (1983-2003). The variables it examines include seniority, security, type of initial default event, and a wide variety of firm-specific, industry-specific, and macroeconomic factors. The report estimates their influence on recovery rates both through univariate analysis, presented in a tabular form, and through multivariate regressions. Not only do our findings corroborate results on seniority, security, and macroeconomic factors found elsewhere in the literature, but we also find that recovery rates are strongly affected by 1) the type of event precipitating default, 2) the amount of debt an issuer has outstanding that is subordinate to the defaulted security, 3) the tangibility of its assets, 4) the prevailing credit spreads at the time of default, and 5) the market-to-book ratio of the firm and its industry prior to default. The results of this study show that seniority and security are the two most important factors that impact recovery rates, followed by debt-cushion, leverage and asset tangibility. Industry and macroeconomic factors are also found to be correlated with recovery rates, sometimes very strongly.

Understanding Emerging Market Bonds:Claude B. Erb, Campbell R. Harvey and Tadas E. Viskanta

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