The Global Credit Crunch – What does it mean for Income Investing? Andrew Smith Managing Director...
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Transcript of The Global Credit Crunch – What does it mean for Income Investing? Andrew Smith Managing Director...
The Global Credit Crunch – What does it mean for Income Investing?
Andrew SmithManaging Director - Australia and New Zealand11th June 2008
Fitch locations
What are Credit Ratings?
An opinion on an entity’s ability to
meet its financial commitments on a timely basis
– Interest
– Repayment of Principal
– Preferred dividends
Credit Ratings are not:
recommendations to buy or sell- we do not comment of the ‘value’ aspects
Credit Ratings are:
like a building inspection
- we opine on an entity’s soundness
- not if it is a good buy
What rating agencies do
Rating Agencies look for downside risk
Bondholders are risk averse
We are Professional Pessimists
Pessimists - always looking for the downside
Professional - assessing it systematically
The difference between bonds and shares
Shares
> Participate in growth (profits, dividends and share price can grow)
> Are prepared to take risks if growth prospects are good
Bonds
> Do not participate in growth (a bondholder will only get back their principal) , but may participate in losses.
> Do not like companies taking risk if it means they may go bankrupt
> Rating agencies look at companies’ ability to pay back bonds, if things go wrong
Fitch Long Term Ratings – Investment Grade>AAA - Highest Credit Quality
>‘AAA’ ratings denote the lowest expectation of credit risk. They are assigned only in case of exceptionally strong capacity for timely payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.
>AA - Very High Credit Quality
>‘AA’ ratings denote a very low expectation of credit risk. They indicate very strong capacity for timely payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events.
>A - High Credit Quality
>‘A’ ratings denote a low expectation of credit risk. The capacity for timely payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to changes in circumstances or in economic conditions than is the case for higher ratings.
>BBB - Good Credit Quality
>‘BBB’ ratings indicate that there is currently a low expectation of credit risk. The capacity for timely payment of financial commitments is considered adequate, but adverse changes in circumstances and in economic conditions are more likely to impair this capacity. This is the lowest investment-grade category.
>BB - Speculative
>‘’BB’ ratings indicate that there is a possibility of credit risk developing, particularly as the result of adverse economic change over time; however, business or financial alternatives may be available to allow financial commitments to be met. Securities rated in this category are not investment grade .
>B - Highly Speculative
>‘B’ ratings indicate that significant credit risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is contingent upon a sustained, favourable business and economic environment.
>CCC, CC, C - High Default Probability
>Default is a real possibility. Capacity for meeting financial commitments is solely reliant upon sustained, favourable business or economic developments. A ‘CC’ rating indicates that default of some kind appears probable. ‘C’ ratings signal imminent default.
>RD - Default
>Indicates an entity that has failed to make due payments (within the applicable grace period) on some but not all material financial obligations, but continues to honor other classes of obligations.
>D - Default
>Indicates an entity that has defaulted on all of its financial obligations.
Fitch Long Term Ratings – Speculative Grade
How investors use ratings
cumulative default statistics
0
5
10
15
20
25
30
35
1 2 3 4 5 6 7 8 9 10
Years After Original Rating
Cum
ulat
ive
rate
of
defa
ult
(%)
A BBB BB B
How investors use ratings
Transition matrices
AAA AA A BBB BB B
AAA 95.74 4.26 0.00 0.00 0.00 0.00
AA 0.00 98.80 1.20 0.00 0.00 0.00
A 0.00 2.66 93.98 3.01 0.35 0.00
BBB 0.00 0.46 6.49 90.27 2.67 0.12
BB 0.00 0.00 0.49 12.93 77.56 8.78
B 0.00 0.00 0.00 0.96 12.98 84.13
Source: Fitch
Corporate Finance Migration Rates for 2006 (%)
The basics of RMBS
Housing Loans
Senior Debt
AAA
Very safe assetsInvestors like security of AAA rating
Junior debt(‘first loss tranche’)often acquired by bankLikely level of
loss
BBB
BH
P B
illiton
Wal-M
art
RM
BS
- BB
B
Nestle
To
kyo E
lectric
Senior Tranche
Subordinated Tranche
Junior Tranche(1st loss Piece))
The Basic CDO
Savers
Borrowers
BanksBond
Markets
Professional Money Market Investors
Bond Insurers
Mortgage Insurers
Residential Mortgage Backed
Securities
Non-Bank Mortgage Originators
Commercial Mortgage Backed
Securities
Asset Backed Securities
- credit cards- mv financing- student loans
Collateralised Debt Obligationsguarantees
Structured Investment Vehicle
issues short-term CP
Provide liquidity back-up
Hold in trading book
The subprime virus in an interconnected financial system
The Aftershock Scenario
IKB
LBSachsen
Northern Rock
US Subprime
Conduits & SIVs
LBOs
Earnings
CDO of ABS
Monolines
Merrill Lynch
UBS
WestLB
Citigroup
Bear Stearns
Societe Generale
RAMS
Centro
Flight to Treasuries, not other AAA
3
4
5
6
7
8
9
2000 2001 2002 2003 2004 2005 2006 2007 2008
10-year US Treasury AAA corporate BBB corporate(%)
Bond Yields in US Market
Source: Federal Reserve Board
Similar pattern in the Australian market
4
5
6
7
8
9
2004 2005 2006 2007 2008
Commonwealth AAA corporate A corporate(%)
Bond Yields in Australian Market*
* 5-year Commonwealth Treasury Bond, 1-5 year corporate bondsSource: CEIC, RBA
Australian Residential Mortgage Performance
Australian postcode report
The Structured Finance Pendulum
June 2007
acceptable m
arket p
roduct
CDOs Squared Syntheti
c CDOs Cash CDOs CMBS
ABS
RMBS<20bp
more volatile less volatile
The Structured Finance Pendulum
February 2008 acceptable market product
CDOs Squared Syntheti
c CDOs Cash CDOs CMBS
ABS
RMBS>150bp
more volatile less volatile
The Structured Finance Pendulum
February 2009?
acce
ptab
le m
arke
t pro
duct
CDOs Squared Syntheti
c CDOs Cash CDOs CMBS
ABS
RMBS
more volatile less volatile
Fitch Ratingswww.fitchratings.comwww.fitchratings.com.au
SydneyLevel 43, AMP Centre50 Bridge StreetSydney, 2000NSW+61 2 8256 0300
BrisbaneLevel 30, AMP Centre10 Eagle StreetBrisbane, 4000QUEENSLAND+61 7 3222 8600
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