Forecasting Credit Risk

1 16 June 2008
Using Duration Times Spread to
Forecast Credit Risk
European Bond Commission / VBA
Patrick Houweling, PhD
Head of Quantitative Credits Research
Robeco Asset Management
Quantitative Strategies
16 June 2008
Forecasting Credit Risk
2 16 June 2008
Contents
Capturing Changing Volatility
Building the Risk Model
Testing the Risk Model
Using the Risk Model
Conclusions
Forecasting Credit Risk
3 16 June 2008
How to Capture Changing Volatility?
Volatility of excess returns is not constant
Historical volatility is not suited to predict future volatility
Using historical volatility to measure current risk means lagging the market
rolling 36m excess return volatilities US IG corporate bonds
0.0%
0.2%
0.4%
0.6%
0.8%
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IG
Forecasting Credit Risk
4 16 June 2008
Can Ratings Capture Time-Varying Volatility?
Volatility of rating classes is not constant
Using only ratings to measure current risk means lagging the market
rolling 36m excess return volatilities US IG corporate bonds
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
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AAA AA A BBB
Forecasting Credit Risk
5 16 June 2008
Can Spreads Capture Time-Varying Volatility?
When spreads are high, credit markets are more volatile and vice versa
So: volatility highly correlates with spread
Spread per rating class: Volatility per rating class:
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
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AAA AA A BBB
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AAA AA A BBB
Forecasting Credit Risk
6 16 June 2008
Why and How Should We Use Spreads?
Excess returns ER over Treasuries consists of
carry return (spread)
spread change return (spread-duration D times spread change s):
which is equivalent to
Excess return volatility
ER
can thus be approximated by either
or
s D ER
s
s
Ds ER


absolute
spread ER
D =
relative
spread ER
Ds =
absolute spread change
relative spread change
absolute spread change volatility
relative spread change volatility
Forecasting Credit Risk
7 16 June 2008
Which Spread Volatility?
Relative spread change volatility is much more constant than
absolute spread change volatility
Also: differences between ratings are much smaller
rolling 36m absolute spread change volatilities
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25
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AAA AA A BBB
rolling 36m relative spread change volatilities
0%
2%
4%
6%
8%
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12%
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AAA AA A BBB
Forecasting Credit Risk
8 16 June 2008
Measure Excess Return Volatility per Unit DTS!
Best way to measure excess return volatility is using relative spread
change volatility
Relative spread change volatility can be estimated accurately using
historical data
Duration Times Spread (DTS) can change on a daily basis, reflecting
current market conditions
Their product gives an estimate of current excess return volatility
Alternative interpretation:
Relative spread change volatility can thus be interpreted as the excess
return volatility per unit of DTS
It can be estimated as the volatility of excess returns divided by DTS
relative
spread ER
Ds =
duration times spread (DTS)
Forecasting Credit Risk
9 16 June 2008
From Market Level to Bond Level
Each month assign bonds to duration times spread (DTS) quintiles and
subdivide each quintile in 6 spread buckets
For each bucket, calculate the average monthly return and its time series
volatility and the average monthly DTS and its time series average
Duration Times Spread vs. excess return volatility
0.00%
0.25%
0.50%
0.75%
1.00%
1.25%
1.50%
1.75%
0 500 1000 1500 2000
duration (y) x spread (bps)
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Spread Bucket 1 - Low Spread Bucket 2 Spread Bucket 3
Spread Bucket 4 Spread Bucket 5 Spread Bucket 6 - High
Forecasting Credit Risk
10 16 June 2008
Idiosyncratic Spread Change Volatility is
Also Related to Spread Level
Each month bonds are assigned to 3 sector (Financials, Industrials,
Utilities) x 3 duration buckets x 6 spread buckets
We calculate the idiosyncratic spread change as the spread change minus
the average spread change of the bucket
We estimate the standard deviation of idiosyncratic changes and the
average spread per bucket
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0 100 200 300 400 500 600 700
Spread (bps)
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Forecasting Credit Risk
11 16 June 2008
Contents
Capturing Changing Volatility
Building the Risk Model
Estimating Factor Returns
Significance Tests
Estimating Covariance Matrix of Factor Returns
Measuring Risk
Testing the Risk Model
Using the Risk Model
Conclusions
Forecasting Credit Risk
12 16 June 2008
Estimating Factor Returns
We model a corporate bonds excess returns as
S indicates whether bond i belongs to sector j in month t
N is the number of sectors
s and s are the factor returns
Systematic returns are linear in DTS per sector
Specific return volatility is proportional in DTS
( )
1 , ,
2
, ,
,
1
1 , , , 1 ,
1
1 , , , ,
, 0 ~

=

=

=
+ + =

t i t t i
t i t i
t i
N
j
t j i t j t i
N
j
t j i t j t i
DTS
N
S DTS S ER



Forecasting Credit Risk
13 16 June 2008
Significance tests
Data: monthly, from June 1993 to January 2006
Universes: Lehman Brothers US IG and HY index constituents
Estimation method: Generalized Least Squares regression
Test 1: sector coefficients are jointly different from zero
Test 2: sector coefficients differ from each other
Percentage of months in which Wald tests indicate significance at
95% confidence level (USIG results:)
Test 1 Test 2
s s s s
s only - 78% - 41%
s and s 97% 90% 93% 80%
t i
N
j
t j i t j t i
N
j
t j i t j t i
S DTS S ER
,
1
1 , , , 1 ,
1
1 , , , ,
+ + =

=

=

Forecasting Credit Risk
14 16 June 2008
Estimating Covariance Matrix of Factor Returns
We robustly estimate volatilities and correlations of factor returns
to calculate the covariance matrix of our risk factors
We shrink the covariance matrix by assuming:
Equal volatility for all sector intercepts (s)
Equal volatility for all sector DTS slopes (s)
Equal correlation for all pairs of (un)loaded sectors
sector intercepts sector slopes
sector
intercepts
sector
slopes
2

cov 2

cov
Forecasting Credit Risk
15 16 June 2008
Calculating Tracking Error and Beta
Model
Risk factors have covariance matrix
Portfolio has exposures P to the risk factors
Benchmark has exposures B to the risk factors
Bet = P B
Systematic Tracking Error (TE)
TE is defined as the volatility of the bets returns
TE
2
= variance (P B) = (P B)(P B)
CAPM beta
Beta is defined as the covariance of the portfolio with the market (benchmark)
divided by the variance of the market
beta = covariance (P,B) = PB
variance (B) BB
Forecasting Credit Risk
16 16 June 2008
Contents
Capturing Changing Volatility
Building the Risk Model
Testing the Risk Model
Using the Risk Model
Conclusions
Forecasting Credit Risk
17 16 June 2008
Simulation Setup
We test the risk model in a Monte Carlo simulation
Data: June 1993 January 2006
Universe: Lehman Brothers US Investment Grade index
Portfolios: 1.000 random portfolios of 80 bonds each month
Covariance matrix is estimated on 60-month rolling window
For each portfolio compare ex-ante Tracking Error to ex-
post 1-month outperformance
Criteria
Level of risk
Exceedings of tracking error multiples
Discrimination of more risky and less risky portfolios
Forecasting Credit Risk
18 16 June 2008
Ex-Ante Tracking Errors Vary with Market Spread
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Ex-ante tracking errors and market spread (IG)
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90% TE bounds
median TE
market spread
Forecasting Credit Risk
19 16 June 2008
Ex-Ante Tracking Errors Correspond Well to
Ex-Post Returns
Ratio of ex-post return to ex-ante tracking error should be
standard normally distributed standard deviation should be 1
< 1 means risk is overestimated, > 1 means underestimation
Standard deviation of ratio is 1.04 on average, but
overestimations and underestimation occur frequently
95 96 97 98 99 00 01 02 03 04 05 06 07
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9
10
5% percentile
standard deviation
95% percentile
Forecasting Credit Risk
20 16 June 2008
Risk Model Distinguishes High and Low Risk
Portfolios
Each month create buckets of 20% ex-ante least risky portfolios
and of 20% most-risky portfolios
Calculate ex-post standard deviation of both buckets
Least risky bucket indeed has lowest standard deviation in 92% of
months
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least risky quintile
most risky quintile
Forecasting Credit Risk
21 16 June 2008
Contents
Capturing Changing Volatility
Building the Risk Model
Testing the Risk Model
Using the Risk Model
Conclusions
Forecasting Credit Risk
22 16 June 2008
Risk Attribution
We measure the risk of
Market
Sectors
Issuers
Issues
We report
Total risk
Risk contributions per bet
Beta of the portfolio
Tracking Error Report
Forecasting Credit Risk
23 16 June 2008
Credit Risk Report
Tracking error
Systematic risk 1,14%
Market 0,94%
weight 0,15%
weight x spread x duration 1,00%
Sector 0,53%
weight 0,14%
weight x spread x duration 0,57%
Specific risk 0,37%
Issuer 0,20%
Issue 0,31%
Total 1,20%
CAPM-beta 1,57
1. Systematic risk
2. Specific risk
3. Beta
1
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3
Forecasting Credit Risk
24 16 June 2008
Attribution of Tracking Error to Sectors
Sector Risk Report
portfolio benchmark bet specific total
1 Banking 731 330 401 0,40% 0,30% 0,50%
2 Brokerage 13 45 -32 0,06% 0,03% 0,07%
3 Finance companies 3 29 -26 0,04% 0,06% 0,08%
4 Insurance 121 75 45 0,07% 0,09% 0,12%
5 REITS 0 6 -6 0,01% 0,01% 0,01%
6 Financial other 3 5 -1 0,00% 0,01% 0,01%
7 Basic industry -5 25 -30 0,05% 0,03% 0,06%
8 Capital goods 13 36 -23 0,04% 0,03% 0,05%
9 Consumer cyclical -17 27 -44 0,07% 0,02% 0,07%
10 Consumer non-cyclical 7 39 -32 0,05% 0,06% 0,08%
11 Energy 5 7 -2 0,00% 0,02% 0,02%
12 Technology 13 3 11 0,02% 0,03% 0,04%
13 Transportation -2 24 -25 0,04% 0,02% 0,05%
14 Communications 85 74 11 0,02% 0,07% 0,07%
15 Other industrial 1 6 -5 0,01% 0,01% 0,01%
16 Utilities 5 40 -35 0,06% 0,02% 0,06%
17 Supranat./Sovereigns/Agencies 3 0 3 0,02% 0,01% 0,02%
18 ABS/Mortgages 151 0 151 0,28% 0,12% 0,30%
99 Non-corporate 81 0 81 0,13% 0,08% 0,15%
Total 1.211 769 443
TE contribution 1,00% 0,53% 0,37% 0,65%
tracking error weight x spread x duration
systematic
Issuer Risk Report
Sector Subsector port BM bet port BM bet issuer TE issue TE total TE
Banking Lower Tier II 1,11% 0,04% 1,07% 58 2 56 0,082% 0,121% 0,146%
Banking Tier 1 2,46% 0,76% 1,69% 36 11 25 0,036% 0,075% 0,083%
Banking Lower Tier II 1,97% 0,71% 1,26% 39 4 35 0,051% 0,061% 0,080%
Banking Upper Tier II 0,90% 0,23% 0,67% 30 6 24 0,035% 0,063% 0,072%
Banking Banking 3,07% 1,36% 1,71% 41 15 26 0,038% 0,057% 0,069%
ABS/Mortgages ABS 1,06% 0,00% 1,06% 26 0 26 0,038% 0,058% 0,069%
Banking Banking 2,58% 0,84% 1,74% 41 11 30 0,044% 0,051% 0,067%
Banking Lower Tier II 1,03% 0,24% 0,79% 29 4 25 0,036% 0,050% 0,062%
Banking Tier 1 0,78% 0,09% 0,70% 23 1 22 0,032% 0,052% 0,061%
ABS/Mortgages ABS 0,79% 0,00% 0,79% 24 0 24 0,035% 0,049% 0,060%
Banking Senior 1,02% 0,25% 0,76% 29 4 25 0,037% 0,046% 0,059%
Insurance Life 2,09% 0,34% 1,75% 27 3 24 0,035% 0,046% 0,058%
Banking Lower Tier II 2,53% 1,28% 1,26% 37 15 22 0,032% 0,048% 0,058%
Finance companies Non-captive -0,17% 0,23% -0,40% 0 7 -6 0,009% 0,056% 0,057%
Banking Banking 2,59% 0,86% 1,73% 30 6 24 0,035% 0,042% 0,055%
Banking Senior 0,98% 0,25% 0,72% 18 1 17 0,024% 0,041% 0,048%
Banking Banking 0,93% 1,04% -0,11% 13 8 6 0,008% 0,046% 0,047%
Banking Tier 1 1,34% 0,05% 1,29% 17 1 17 0,024% 0,039% 0,046%
Banking Upper Tier II 1,79% 0,07% 1,72% 17 0 17 0,025% 0,039% 0,046%
Banking Banking 3,46% 1,71% 1,76% 29 9 21 0,030% 0,034% 0,045%
Brokerage Brokerage 0,00% 1,05% -1,05% 0 11 -11 0,016% 0,009% 0,018%
weight tracking error weight x spread x duration
Forecasting Credit Risk
16 June 2008
Attribution of Tracking Error to Issuers
1. Largest overweight, not highest risk
2. Not investing in an issue is a risk as well
3. Short position (with CDS) to exploit our strong view
1
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Forecasting Credit Risk
26 16 June 2008
Contents
Capturing changing volatility
Building the risk model
Testing the risk model
Using the risk model
Conclusions
Forecasting Credit Risk
27 16 June 2008
Conclusions
Use duration times spread to capture changing volatility of
Market
Sectors
Issuers
Issues
Dont use ratings!
Risk model adequately captures time-varying volatility and
distinguishes high and low risk portfolios
Attribution to risk factors enhances insight in portfolio positioning
Forecasting Credit Risk
28 16 June 2008
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The information relating to the performance is for historical information only.
Past performance is not indicative for future results