Corporate Securities Sector
Group 4:
Greg Hall
Ashle Walker
Joy Wright
December 9, 2008
Introduction
Corporate debt has been a secure market for investors and corporations to borrow and lend funds with
low risk and lower cost of capital. However, in recent history the market has changed dramatically and
the corporate sectors’ debt instruments are experiencing high volatility daily causing great
repercussions. Long-term instruments were created to provide a way of corporations to create long
term financing and for investors and corporations to adjust their liquidity positions. Short-term notes
are used to finance day to day operations by institutions and like long-term securities are used by
investors and corporations for liquidity positions. In spite of the current market crisis including high
unemployment, low lending and liquidity in the market, the greater likelihood of bankruptcies among
institutions and the increased expectation of high inflation; history has proven that the corporate debt
market has been able to persevere in highly volatile situations and rebound back into a successful and
thriving market for investors and corporations alike.
Investment Grade and High Yield Bonds
Investment Grade Bonds
Investment grade bonds provide security for both investors and corporations. Institutions use longterm debt to finance projects and balance their long-term assets on their balance sheet. Investors,
such as other corporations and banks, buy long-term corporate debt to balance their long term
liabilities on their balance sheets. Historically, there has been a basis point spread of investment grade
bonds above treasuries, in addition to a lower default risk than junk bonds.
High Yield Bonds
The reason investors buy into the high yield market is because
historically the promised yield on offered high yield bonds have been
substantial. Also in the long run, high yield corporate bonds have
outperformed investment grade bonds and Treasuries, even though
they have been outperformed by common stock. The recovery of
specific issues of high yield bonds is rated on the Fitch recovery rating
http://www.bondsonline.com/CorporateBondYieldIndex.php
system beginning in July 2005. The factors used to assign a recovery rating are the collateral, the
seniority relative to other obligations in the capital structure and the expected value of the issuer. 1
Ratings
Bonds are rated by agencies such as Standard & Poor’s, Moody’s and Fitch, based on their level of
credit risk. AAA (Aaa) is the highest grade a company can receive and D is the lowest. Bonds that are
rated BBB (Baa) and above are called investment-grade bonds which means they have low default risk.
If they rated below BBB (Baa) they are called high-yield bonds or junk bonds; these bonds have high
default risk. There are two types of high yield bonds: Bonds that were rated noninvestment grade at
the time they were issued or original issue high yield bonds and bonds that were investment grade
when issued and then downgraded to noninvestment grade. Downgraded bonds consist of issues that
have been downgraded because the issuer voluntarily increased their debt significantly as a result of a
leveraged buyout (LBO) or recapitalization or have been downgraded for reasons other than previously
stated; which are also known as “fallen angels.”
1
Bondsonline/highyieldbonds.com
There are different options and structures provided for these instruments which allow increased
liquidity for the issuers such as call options, deferred coupon structures and refunding.
Secondary Market for Corporate Bonds
The principal secondary market for corporate bonds is the over-the-counter (OTC) market. The major
concern in this market is transparency. In order to address this issue, the NASD in July 2002 required
mandatory reporting of OTC transactions in the secondary market on TRACE or Trade Reporting and
Compliance Engine. TRACE requires that all brokers or dealers who are NASD member firms to report
transactions in corporate bonds that meet a certain criteria. In July 2002, TRACE included 500 U.S.
investment grade corporate bonds with an issue size of $ 1 billion. By February 2005, the requirements
included almost all of the corporate bond market. At the end of the trading day, market statistics are
published on the corporate bond market activity.2
Private Placement Market
Securities that are privately placed are exempt from registration with the SEC because they are issued
in transactions that do not have a public offering. This market has changed since the SEC Rule 144A
was adopted in 1900. This rule allows the trading of privately placed securities among qualified
institutional buyers. Rule 144A divides the market into two sectors: the traditional market which
includes non-144A securities and the market for 144A securities. Issuers of privately held securities
tend to be less well known, than in the public market. Issuers of privately placed bonds tend to be
2
Fabozzi, Frank. Bond Markets, Analysis and Strategies. New. Jersey: Prentice Hall, 2007
medium-sized corporations. The liquidity of private issues has increased since Rule 144A has been
active, but it is not more liquid than publicly offered issues. On the other hand, the yield on privately
placed debt is higher than publicly offered debt.
Collateralized Debt Obligation (CDO) and Credit Default Swaps (CDS)
Investors use CDOs to find durations and maturities that back their liabilities and can choose a level of
risk based on which traunche the investor puts their money into. Corporations issue CDOs as a means
of packaging up cash flows and selling them off in order to receive money in the present. In the past
they have been a way to obtain liquidity in a portfolio. Recently, CDOs have been characterized as risky
because of the value and grade of the underlying assets were improperly rated.
The use of CDSs has been a way for investors to insure a risky or large investment to protect itself from
default risk. CDSs are often purchased on CDOs from other institutions. Many of the institutions that
issue CDSs did not anticipated the call on most swaps at once. A combination of over leveraged
companies and under-collateralized firms caused much of the current economic crisis.
Short Term Commercial Debt
Medium Term Notes
Medium Term Notes do not have a secondary market. MTNs are distributed when they are initially
sold. Usually, MTNs have been issued on a best efforts basis by an investment bank or brokers/dealer
acting as agents. They are usually sold in small amounts on a continuous basis instead of large, discrete
offerings like corporate bonds. The SEC registration for MTN offerings is between $100 and $1 billion.
After registration, the issuer posts rates over a range of maturities. These rates are over a spread of a
similar security on the Treasury curve. The rates will only be posted for maturities that the issuer is
going to sell. The rate offering schedule can change depending on the issuers’ response to market
conditions or because the issuer has raised the desired amount of funds at a given maturity.
Commercial Paper
Investors of commercial paper include dealers who sell to the market, other corporations, banks, and
highly sophisticated investors such as those in hedge funds. Commercial paper can be issued in two
forms that include asset-backed and non-asset backed securities. The asset-backed commercial paper
is usually issued by companies such as banks that can insure their debt with another asset such as
reserves or inventory for non-banks. Any corporation may also issue non-asset backed paper but this is
more risky and will carry a higher yield. All commercial paper has short term maturities and most have
low credit risks. The debt will not last longer than 270 days and is used only for current assets and
everyday operations such as inventories or accounts receivable3. However, some corporations that are
less prominent have lower credit ratings and issue commercial paper that has more risk, but a higher
return. Higher risk commercial papers are classified as Tier 2 commercial paper and lower-risk, more
popular, commercial paper is classified as Tier 1 commercial paper.
Maturities are very short, so there is no secondary market for commercial paper. The liquidity is high
and investors almost always hold the paper to maturity because if its short term life span. For investors
there is a $100,000 minimum investment for maturities greater then 90 days and $500,000 investment
with maturities less then 90 days.4 Commercial paper provides a short term, lower risk, higher yield,
investment for investors and corporations to enhance liquidity positions and finance day to day
operations at a low cost, respectively.
Current Economic Conditions
Heavy borrowing and the misinterpretation of how risky investments were, led to the volatile current
market conditions.5 Corporate debt is no exception because of the tightening credit crunch due to
uncertainty in the corporate world. Institutions are reluctant to lend to each other because of high
default risk, which has caused decreased liquidity and high borrowing rates. As a result, institutions
face a high cost of funding operations and are causing many firms to file for bankruptcy or layoff
employees.
3
http://www.investorwords.com/1245/current_assets.html
4
http://personal.fidelity.com/products/fixedincome/pocommercial.shtml
5
Prins, Nomi. The Risk Fallacy.October 28,2008. CNNMoney.com
The lack of demand for corporate debt has increased the yields and lowered the prices. This is mostly
true for long-term debt because of the currently unprecedented high corporate yield rates. Short-term
corporate debt is traditionally much more popular than long term debt because it is more liquid. No
debt instruments have a greater demand than another throughout this sector of the economy. Even
commercial paper is struggling due to its lack of liquidity in the highly unsecured corporate market.
Currently, the Fed is planning to buy commercial paper and secure it in order to encourage its
purchase.6
Yield Curve Expectations
The current US corporate yield curve is well above the US Treasury bond
yield curve with the highest spread being at the 5 yr rates. The corporate
bond yield is at about 7.4% and the Treasury yield is at 1.7% at the 5 yr
rate. The difference is a spread of 570 basis points. The corporate curve is
upward sloping from the 2 yr yield to the 5 year yield which implies that
http://www.bondsonline.com/Todays_Market/Treas
ury_Yield_Curve.php
demand for short-term is present. Demand will increase as corporations
restructure and hire new employees, which will increase spending and
revitalize the economy. Next, the curve turns downward sloping from the 5year yield to the 10 year yield with a slight upward trend of about 20 basis
points from the 10 year yield to the 20 year yield. The demand for long-term
corporate bonds is high but not as high as the demand for corporate bonds in
6
http://www.bondsonline.com/Todays_Market/Chart_
Center.php
http://www.efinancialnews.com/homepage/pressdigest/content/2452099779/restricted. Fed unveils plan to invest in US
commercial paper market. October 8, 2008.
the short-term. Demand will increase in the long term on the expectations that inflation will decrease.
According to the current yield curve, which shows very high yields, the expectation is that yields will go
down in the future due to an increase in demand after consumer confidence is restored in corporate
debt and inflation decreases.
Review of the Current Performance of Debt Instruments
The current economic conditions in the corporate debt market have created an environment were
investors need to reevaluate the instruments used in this market and how they will now be used in the
future. These evaluations will allow investors to clearly see how the industry is performing and how to
estimate a new value for the securities.
Market Overview: Investment Grade and Junk Bonds
The history of investment grade corporate bonds in terms of yield has been very close to the U.S.
Treasury Yield curve. This is because investment grade bonds were not thought of as risky because
credit in the market was stable and institutions were thought to be trustworthy. However, in the
present debt is so risky because of the progression of ‘bad debt’ beginning with mortgages defaulting
and creating the credit crises in the economy. This spreads to the corporate sector because banks do
not want to lend to anyone. Also, the other big investors in corporate bonds such as pension funds and
insurance companies can not invest in corporate bonds because they were also big players in the
mortgage market who lost. In turn, even investment grade bonds are getting risky because of all the
bad debt and no one to support the market. In 2006, spreads above the US Treasury curve ranged from
14 basis points to 90 basis points for the highest quality bonds. On the other hand, for junk bonds the
spread ranges from 450 basis points to 545 basis points. Currently, “Average investment-grade spreads
had closed on Wednesday at 264 basis points over Treasuries, just 8 basis points shy of a record set on
Oct. 10, 2002, a year of massive bankruptcies, according to Merrill Lynch data going back to December
1996. Thursday's widening was likely to put the index at or close to a new record, analysts said.”7 In the
near to immediate future we expect rates to go down because of the escalation of current rates and
the expectation of the market to correct itself.
Evaluation: Investment Grade Bonds
Currently, according to Yahoo Finance the 5 yr, 10 yr, and 20 yr, AAA bonds are 5.58%, 5.5%, and 6.35%
respectively. The 5 yr bond itself is 326 basis points over the 5 yr treasury rate of 2.32%. 8 Even with
such high rates, the main investors of corporate bonds such as banks, insurance companies, pension
funds, and individuals are still hesitant to lend their money to even the most historically successful
corporations. The reasons for the lack of liquidity and money flow in this market are based on the
current credit crunch. With no investors willing to lend money because of the fear of defaults,
corporations are having trouble raising capital to invest in new projects and even for everyday
operations.
7
http://www.reuters.com/article/fundsFundsNews/idUSN0658285120080306?sp=true
8
http://finance.yahoo.com/bonds/composite_bond_rates
The effect on investment grade bonds are only the beginning and the effect is even greater for
corporations who issue average investment grade bonds. Their costs of capital are even more
expensive and in turn they cannot make enough on their money to pay back the bonds. Additionally,
the current downgrade of formally investment grade corporations hurts their bond issuance. One
current example is that of Constellation Energy who was downgraded from Baa1 to Baa2. This hurt
their financing and also their stock price plunged; because investors
knew this will hurt profits. The company decided to merge with
Warren Buffets Mid American Energy to help with funding.9 Even if
investors get into the market, there is a limited secondary market
and liquidity is currently very low. We expect long term bonds to
continue as tools for raising capital and the market to balance out
when credit loosens up. It is hard to say when the market will come
into balance because of all the credit problems and liquidity issues that need to be resolved. The fed is
currently lowering rates and offering bailouts of bad debt and only time will tell when the corporate
world can return to business as usual.
Evaluation: Junk Bonds
In the graph you can see how much higher the yield is for junk bonds over investment grade bonds.
Investors can lock in an abnormally large rate for a long time but for corporations it is getting more
expensive to finance operations and this could cause more and more bankruptcies. In the junk bond
9
http://online.wsj.com/article/SB122636338372115691.html?mod=googlenews_wsj
sector of the corporate industry rates are at an extreme high and this means that risk is at extreme
high. In general, these speculative bonds should be an avoided investment unless you are an investor
who is not risk averse. An additional reason to secure junk bonds would be for profit purposes in the
case that there is conclusive information that the market is going to be corrected and rates are going
to be falling fast.
Recommendation: Investment Grade and Junk Bonds
As a large institution, a bond portfolio manager may want to be very careful about investing in
corporate bonds and try to be risk averse. However, if an individual investor is willing to take on more
risk for what may be considered to be a return that is worth while than they should consider going into
the market. For investors this is a great time to get into the market depending on their risk tolerance.
Given that investors rarely hold a bond to maturity, the lenders must realize that liquidating these
bonds may be very hard to do and that a short-term investment may be the better way to go for a
short term investment horizon. The long-term side of the corporate bond yield curve could be very
lucrative given the struggling economy and expectations that it may take awhile for the corrections to
take place. An investor should invest in long term non-callable bonds if they expect rates to go down
because as soon as rates go down prices go up and financing will be cheaper for corporations. This
means that corporations will be a less risky investment and the value of the long-term bonds will be
extremely high. In our opinion, junk bonds are too risky to invest in because a high percentage of
corporations will not be able to pay off these bonds at this time. Therefore, the position taken by an
investor in the corporate bond market will depend on risk tolerance, and their market expectations.
Market Overview: Commercial Paper
In the last few years up until the economy crisis, the commercial paper market was very favorable has
growing 56% from 2005 to 2007 which consisted mostly of asset backed commercial paper. 10 Assets
underlying the commercial paper vary but a few examples are trade receivables, equipment loans and
leases, automobile loans and
leases, bank loans, consumer
loans, manufactured house
loans, etc. Commercial paper
is important because many
companies depend on it for
financing, payroll and
producing goods and services.
If the market deteriorates,
companies may have to
(http://macroblog.typepad.com/macroblog/2008/10/the-commercial.html)
borrow from banks with higher rates and also may suffer from not having the means to run their
business.
The current market conditions have caused investors to stop investing in commercial paper and
finding other ways of financing causing interest rates to increase. For instance, General Motors
10
http://macroblog.typepad.com/macroblog/2008/10/the-commercial.html. October 28, 2008, Mike Hammill and Andrew
Flowers
Acceptance Corporation (GMAC) is one of the largest issuer, but due to the current auto crisis,
investors should stay away from their commercial paper.11 In September, the spread between
commercial paper and Treasury bills was very wide because investors demanded higher yields. As
financial institutions lost high credit ratings starting in late 2007 and the uncertainty of assets
underlying some of the asset backed commercial paper grew, a decline in commercial paper
outstanding increased, which is illustrated in the graph below resulted.
Money Market Funds is an example of investors that have been affected by the commercial paper
problem. They purchase about 60 percent of commercial paper and therefore began experiencing a
loss because investors began redeeming their funds. This in return caused money market funds to
reduce their commercial paper purchases.12 This also can become a problem to the economy because
companies that can not finance their business may have to file for bankruptcy and too many
bankruptcies can result in a deflationary spiral. Due to these conditions the Federal Reserve created a
program, October 7, 2008, called Commercial Paper Funding Facilities (CPFF) in which the Fed buys
debt directly from only top ranked companies. According to Scott Lanman, “interest rates on the
highest-ranked 90-day commercial paper have dropped 1.45 percentage points since then to 1.99
percent” which demonstrates that CPFF is working to help out the commercial paper issue. 13 In the
near future, we expect rates of commercial paper to continue to go down due to the CPFF getting
more investors to use commercial paper again.
11
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aV5U_DNXh_s4. Scott Lanman, Nov. 13
12
(http://macroblog.typepad.com/macroblog/2008/10/the-commercial.html)
13
http://www.efinancialnews.com/homepage/pressdigest/content/2452099779/restricted
Evaluation
The commercial paper market has improved recently relative to the pervious months because of the
Federal Reserve program. The S&P Commercial Paper Index states, in October, the weighted average
yield to maturity declined 159 basis points. The weighted average yield to maturity spread over the
one month Treasury bill was 96 basis points which is a one month decline of 141 basis points.14 As of
November 12, 2008 the weighted average yield to maturity of commercial paper was 1.87% compared
to one month Treasury bill that was 1.01% and one month LIBOR that was 1.48%. Overall, the
commercial paper declined the most at 51 basis points and is not too far behind the one month
Treasury bill. Commercial paper issuers are still typically high credit rating companies so there will not
be high default risk. Commercial paper may also experience rollover risk which is the possibility of
investors not wanting to reinvest their money in the paper and companies losing their working capital.
It is important that commercial paper be put into tranches so that investors can know from the start
which securities have high ratings and prevent them from investing in companies with high default risk.
The CPFF allows unsecure commercial paper and asset backed commercial paper to continue on in
existence.
Recommendation
Because the yields of commercial paper are decreasing and will continue to decrease with the CPFF
program improving liquidity, companies will have no problem with using commercial paper as a means
14
http://www2.standardandpoors.com/spf/pdf/index/SP_Fixed_Income_Update_Oct08.pdf
of short term financing. Tranches will allow investors to choose companies with low default risk and
to avoid the companies with high default risk. For instances, with the subprime mortgage crisis these
type of asset backed commercial paper would be in a lower rated tranche and a company would not
invest in it due to the fact there will be high default risk. Strong banks such as Bank of America and JP
Morgan Chase are still issuing commercial paper and in the future as liquidity improves, the credit
market will loosen and that will create a more competitive and successful market. Commercial paper is
still a cheaper way to finance short term expenses then getting bank loans or other means of financing.
Market Overview: Collateralized Debt Obligation (CDO)
The history of CDOs and their involvement in the market only goes back to the beginning of the 1980’s.
Investment banks began buying MBS to diversify their portfolios; which now included balloon,
adjustable rate and floating mortgages. Because these loans at the time were new, there was little
information to the investor to predict the future performance. Investment banks determined with the
CDO, low quality assets can be transformed into highly rated securities. According to economist
Randall Dodd, “Optimism about how subprime mortgages would perform led to more than 90% of
securitized subprime loans being turned into securities with the top rating of AAA.”15 CDO issuance had
jumped to half a trillion dollars per year by 2007. The total amount of packaged assets in the market
went from $5 trillion to $13.8 trillion. This also included the invention of synthetic CDOs, which are
backed by derivatives, not the asset itself. Companies used the CDOs as collateral to borrow money
and the effect was that there was too much money borrowed on assets that no one would buy. With
15
Prins, Nomi. The Risk Fallacy.October 28,2008. CNNMoney.com
the credit crisis 50% of AAA rated subprime ABS and 100% of all AAA CDOs partially defaulted. CDOs
are a result of essentially institutions misunderstanding the risk involved with their investments.16
Evaluation
The current market for CDOs is very slow and actually negative in growth. The issuance of CDOs in 2008
was only 10% of the amount issued in 2007.17 Christopher Flanagan, head of CDO research at J.P.
Morgan states, “The CDO market isn’t coming back-not in our lifetimes.” That statement is very
definitive and we disagree. We believe that the current market for CDOs is never going to be the
liquidity option it was, but that the market will exist. The market will be different because of new
regulation that will be put on CDOs. There will be stricter lending practices in the short term, but
making the companies involved accountable for their own risk will be the challenge.
Recommendation
The recommendation for this security is to hold off on investing until there are more regulations put in
place so the security will be desirable and the assets sold will be worth something. To not invest in
CDOs at all in the future would be a mistake for institutions because they need other ways to create
more capital for themselves.
16
17
Varchaver, Nicholas. The $55 Trillion Question. September 30, 2008. CNNMoney.com
Prins, Nomi. The Risk Fallacy.October 28,2008. CNNMoney.com
Market Overview: Credit Default Swaps (CDS)
The market for credit default swaps has increased with the sales of ABS and CDOs. In a decade, the
derivatives contracts went from very little to $54.6 trillion.18 CDS were the fastest growing type of
financial derivatives. This was for good reason. There was a large market for institutions to get
insurance on CDOs that they had in their portfolios to protect against risk. One of the appealing things
about the CDS market is that it is unregulated and transactions were not publicly disclosed. CDSs
eventually covered every type of risk; there were CDSs created that one could purchase a CDS that
would payout if the U.S government defaults. In the current market CDS are very contracted due to
many companies that issued CDS have filed for bankruptcy. Most firms now have these illiquid
instruments that are off book, but are still affecting their capital. Institutions that held these CDS and
were supposed to receive a pay out may never receive any payment from the company who insured
them. Many insurance companies insured too many instruments thinking that the buyer would rarely
call upon the premium. In the current crisis the opposite happened; everyone called on the premium at
once.
Evaluation
The current CDS market is under a lot of scrutiny from the SEC and its concern about short selling and
its effect on the current crisis. There is talk about new regulations the SEC may impose on the CDS
market to increase transparency to the public. Almost no new contracts are being issued at this time,
18
Varchaver, Nicholas. The $55 Trillion Question. September 30, 2008. CNNMoney.com
but we agree with Jamie Cawley of IDX capital when he states, “The market is here to stay.” 19 CDSs
have played an important role in providing liquidity and a hedge against risk for institutions, and
institutions a need a way to manage risk. One plan in progress is to create a swap clearing house
overviewed by the SEC and CFTC to provide more public information on risks and to prevent large
losses.20
Recommendation
The implementation of a CDS clearing house is a positive alternative to the current market to at least
try and generate some activity. The clearing house would absorb losses if another dealer fails. Recent
reports have shown that the increased unemployment rate is causing the price of CDSs increase for
fear that more companies will fail. In the present current prices will continue to rise, even though some
daily reports suggest small declines in price.21 For this reason we think that the CDS market, whatever
it will look like in the future, is necessary and beneficial to firms. Once more plans, such as, the clearing
house are implemented we believe CDS are still a good way for institutions to protect against risk.
Overall Market Recommendation
The current market crisis has crippled the ability for corporations and institutions to raise significant
capital. The instruments that are being held are illiquid or very close to it. Institutions will have a
19
Varchaver, Nicholas. The $55 Trillion Question. September 30, 2008. CNNMoney.com
Harrington, Shannon. Credit Swap Clearinghouse to be Running by Year-End. November 14, 2008. Bloomberg.com
21
Harrington, Shannon. Credit Swaps Fall from Record as Stocks Offer Late Day Boost. December 5, 2008. Bloomberg.com
20
difficult time in the near future in issuing debt of all forms, but the new regulation that is sure to come
in the market should make it easier to raise capital. The current market for the investor with extra
money can become a profitable one. If the investor does his research on securities and examine new
disclosure information from companies, he can make profits in the new restructured market. The only
instrument that has concerns about bringing a lot of risk to the investor is junk bonds. In the future,
this instrument could have a shrinking market and interest from investors. All the debt instruments are
vital to the corporate sector and even though they are weak at this time the expectation is that they
will come back stronger.
How to Use Corporate Debt Instrument in a Portfolio
Commercial Paper
Commercial paper is commonly used in a corporation portfolio as a short-term means of financing
everyday activities. Investors purchase CP because it is a low risk, short-term investment that is used to
match short-term liabilities in a portfolio. According to the U.S. treasury yield curve and future treasury
rate predictions; investors will experience a capital loss if they invest now as interest rates increase. An
investor that has short-term liabilities can use commercial paper to match short-term investment
horizons.
Investment Grade Bonds
In a portfolio, their return on assets is needed to exceed what they must pay or their issued bonds to
investors. Investment grade bonds are used in portfolios as a steady means of fixed income, match
long-term liabilities, and avoid certain price risk. Currently, as interest rates are expected to decrease,
it is an inopportune time to issue bonds because it costs more. On the other hand, investors should
seek to buy creditworthy bonds for portfolios because when interest rates decrease a capital gain can
be realized when prices go up and bonds are sold in the secondary market.
Junk Bonds
Junk bonds will be used in a non-risk adverse portfolio for an above average return. It is a better idea
to incorporate junk bonds in a bond portfolio in a more stable economy than this one because of their
high default risk. With more defaults, in the current economic crisis, as a result of failing institutions it
is a bad time to invest in junk bonds. They should only be bought for an extremely steep discount and
provide a means of high return when taking a high risk.
CDOs
Investors use CDOs to find durations and maturities that back their liabilities and can choose a level of
risk based on which traunche the investor puts their money into. Until there is increased regulation on
assets backing a CDO, investors should be cautious on using CDOs in their portfolio because the assets
in the underlying security may not be properly rated. Corporations issue CDOs as a means of packaging
up cash flows and selling them off in order to receive money in the present. In the past they have been
a way to obtain liquidity in a portfolio. However, more recently the growth of the market has been
negative. After regulation is implemented, CDO demand will return and portfolios will again have a way
of acquiring liquidity.
CDSs
Credit Default Swaps are used by corporations in portfolios to hedge against default risk. There is
legislation in progress about having a working CDS clearinghouse by the end of 2008 to move some of
the lagging CDSs through the market. Institutions use this instrument in their portfolios often to
compliment a CDO or debt of another institution. In the past this instrument was able to provide
security for risky investments. More recently, the market is still in operation, but the costs of CDSs
have made it increasingly expensive to purchase, which will reduce liquidity. Also, an investor needs to
be cautious of the party who sells the CDS because many of those firms are also failing. The CDS
market is good to invest in if there are investments on the books that are worth the extra capital; in
the future with new regulation the market will be a useful hedge once more.
Executive Summary: Corporate Debt Sector
Corporate debt is a fundamental financial tool for conducting business in the corporate world. The tool
is divided up into five sections, which are investment grade bonds, junk bonds, collateralized debt
obligations, commercial paper, and credit default swaps. Each section of corporate debt is unique and
provides a different purpose for both institutions and investors to actively manage portfolios and
balance sheets. The risks and economic conditions that impact these instruments include:
reinvestment risk, price risk, default risk duration, unemployment, interest rate risk, inflation
expectations, and our current economic crisis. Even though the risks involved with using these financial
instruments are the same, the way in which the risks affect portfolios containing these instruments is
what defines the purpose of the instruments and why corporations need them to avoid risk and
maximize shareholder wealth.
Investment grade bonds usually have low yields and high liquidity providing an efficient market for
investors to do business. However, the economic crisis changed that by making investment grade look
more like junk bonds. Junk bonds are similar to investment grade bonds except that they involve
higher risk. These bonds are bought a deep discount and should be used in portfolios with great
caution. Commercial paper is used by corporations to raise funds for everyday operations and for its
investors to acquire a means of supporting short-term liabilities in a portfolio. Its security is similar to
investment grade bonds as a result of its short life span and issuance. However, Commercial paper has
also been greatly affected because its greater default risk and corporations are having a harder time
financing. CDOs are arguably the most effected by current conditions to the point that they were the
most popular tool less than a year ago and now they are hardly used. Underlying assets were unclear
and defaults happened at an unprecedented rate. The securities that were used to protect against
default risk, CDSs, are now being defaulted on by the issuing companies. There is significant
speculation that many of the strongest companies are going to default, making this instrument in the
current market more expensive.
After reviewing the current economic conditions and how each instrument is affected, along with
predictions for future interest rates, we decided that in a portfolio each instrument has a specific
purpose. Investment grade and junk bonds have the similar purpose of balancing long-term assets
except for the fact that junk bonds are higher risk and are less likely to be used. Commercial paper is
like a bond but is used for short term financing and will match short-term investment horizons.
Furthermore, CDO’s are used best when they are matched with an investment’s risk, horizon, and
provide liquidity as desired for each participant. Lastly, CDSs are used to ensure that the debt the
investor is holding will not default, and if it does the investor will still receive payment. This will protect
against default and allow the investor to more accurately immunize their balance sheet or portfolio.
Corporate debt has a verity of tools and each one is distinguished by how it can provide the greatest
return for specific investment requirements.