The Credit Crisis and
Discount Rate Determination
Presentation to the Canadian Institute of Actuaries
April 15, 2009
Marlene K. Puffer, Ph.D., CFA
www.twistfinancial.com
marlene.puffer@twistfinancial.com
Agenda
Corporate Bond
Market
Spreads
Issuance
Opportunities
Market Structure
Discount Rate
Determination
Long Term
Corporate AA
Various
Approaches
Canadian 10-year Corporate Spreads
600
550
500
450
AA
Credit Spreads (bps)
400
A
BBB
350
300
250
200
150
100
50
0
2000
2001
2002
2003
2004
2005
2006
2007
Source: RBC Capital Markets
2008
2009
Canadian Net New Bond Issuance
Federal, Provincial, Municipal
Corporate
(Bln. C$)
50
40
30
20
10
0
Source: Standard&Poor’s
08
20
06
20
04
20
02
20
00
20
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
19
19
80
-10
Opportunities
Canadian corporates
Significant new issue supply
Mainly investment grade, heavy in financials.
Global investment grade
credit
Liquidity and diversification
Detailed credit research required
High yield
U.S./Europe
Equity-like risk characteristics
Mainly < 10 year term
Emerging markets
Good diversifier
Growing corporate market
Credit derivatives
Pure credit exposure
Limited currency risk
Liquid individual names and indices
Increased standardization and central clearing to
reduce counterparty risk
Market Structure - Trading
Source: IIAC
Average daily corporate bond trading
$580m in 2008 vs. $885m in 2007
Market Structure
Corporate Issuance and trading
Market Structure
Sector
Typical trade
“Large” trade
Typical new
issue size
Canada
$10-25 m
>$100 m
$1 to $4 b
Provincial
$10-25 m
>$100 m
$300 - $600 m
Short/mid
Corporate
$5-25 m
>$50 m
$300 - $600 m
Long Corporate
$5-10 m
>$10 m
$200 - $300 m
Gov t of Canada
Inflation Linked (RRB)
$5-10 m
>$25 m
$300 - $400 m
Provincial RRB
Very limited
Very limited
$ 100 m +
Canadian Bond Market - Sectors
Percent of Bond Market Value by Sector
60%
3.1%
50%
40%
<10y
>10y
30%
53.3%
20%
10%
0%
5.0%
5.1%
3.5%
4.6%
2.8%
5.0%
1.2%
3.1%
0.0%
0.8%
1.3%
7.4%
0.5%
2.9%
0.1%
0.1%
0.0%
0.1%
Source: CIBC World Markets, ForethoughtRisk
Canadian Bond Market - Rating
2% of all
corps are
over 10
years and
rated AA or
higher
Percent of Bond Market Value by Rating
50%
45%
40%
<10y
35%
11.6%
>10y
1.2%
30%
25%
20%
15%
33.1%
0.5%
26.6%
3.7%
10%
5%
12.4%
$3.5b vs.
$32b rated A
or lower
10.9%
0%
AAA
AA
A
BBB
Source: CIBC World Markets, ForethoughtRisk
Discount Rate Methodology
Methodology
Discount liability cash flows using
corresponding spot rate that reflects
corporate AA spot yields.
Term
Need full curve, and in particular need to
extrapolate beyond 30 year maturity.
Potential confusion
With a normal upward sloping yield
curve, semi-annual yield < annual yield
< spot yield. Beware of mixing them up.
Long term Government of Canada yield
plus “AA” spread
Data
Bank of Canada long term bond yield available
daily. Dealers publish daily indicative yields on
select corporate bonds by maturity for both
secondary market trades and theoretical new
issues. Important to understand source data.
Methodology
Distinction between secondary trading and
indicative new issue levels. Selection of
bonds to use is discretionary. “Bootstrap” a
spot curve from raw semi-annual yields.
Term
Maximum 30 year maturity. Data more
reliable 10 years and shorter.
Usefulness
Discretion involved may lead to very different
derived discount rates. Standardization is
desirable, but some discretion is important in
extreme market conditions.
CIBC Spot Curve – cash flow matching
Data
Long vs short
term
Single dealer
New issue
concession
Theoretical new issue bank spreads (“offered side”).
Not a diversified portfolio.
Differential between financial and other spreads has
increased dramatically recently.
Active market in financials under 10 year maturity.
Little to no issuance or trading over 10 years.
CIBC data only. May differ from other dealers,
especially when spreads are wide and volatile.
Spreads reflect new issue concession relative to
secondary spreads. Wider when spreads are wide
and markets are volatile.
PC BOND AA Yield Curves
Data
Bid yields (vs. index mid market ; CIBC spot curve offered).
Intended to reflect representative AA rated bond yields at
each maturity point. Month end only.; semi-annual and
annual yields. Data can very by month i f a new bond is
selected at a specific maturity point. Highly dependent on
specific bond spread.
Long vs short
term
Active market in corporates under 10 year maturity, but
mainly financials. Little to no issuance over 10 years, and
tend to use utilities or industrials which may not compare to
financials. May use govt yield plus indicative spread in long
end. Inconsistent data approach.
Single dealer
Scotia data only. May differ from other dealers, especially
when spreads are wide and volatile.
Comparison to
CIBC spot curve
Derived spot curve can have irregular shape. Derived
spot rates have typically been close to CIBC spot curve
historically, but have diverged in the past year.
DEX long-term AA/AAA bond index yields
Data
Market value weighted average of all AAA and
AA corporate bonds. Long index is > 10 year
maturities. Only 5 issuers with these ratings!
Semi-annual yield calculation.
Term
Yields are available for all corporates, or
broken down by rating, and/or maturity , or
sector.
Multiple Dealer
Since early 2008, uses all major Canadian
dealer data. Gives weight to some dealers
who trade very little in the quoted bonds. But
omits high and low quotes.
Usefulness
Long term Index yield data is a useful crosscheck to guage curve movement over time.
Not directly comparable yield level to derived
30-year rates.
Conclusion
Data source
CIBC spot curve most consistent and no need to
“bootstrap” to derive spot curve. Judgment still required
due to single dealer, financials, and new issue concession,
especially in volatile markets.
Need for new standard based on multi-dealer
data and transparent process?
Term
Extrapolation beyond 30 years subject to subtleties of
shape or long end (higher yields around 25 year area vs.
30-years).
Judgment
Compare to peers, changes in index yields, changes in
yields based on Govt bonds plus spread.
Biography
Dr. Marlene K. Puffer, CFA, Managing Director of Twist Financial Corp., provides
strategic advice, analytics, education, litigation support and expert witness
testimony, and financing and investment solutions in all areas of fixed
income and institutional investment. She was recently appointed to the
board of the Hospitals of Ontario Pension Plan (HOOPP). Current projects
include pension Liability Driven Investment strategies, mortgage markets,
and Asset-Backed Commercial Paper restructuring. Recently, she was an
expert witness in the BCE vs. Bondholders case in the context of the BCE
leveraged buyout. She has 18 years of capital markets experience, including
13 years on Bay Street and 5 years as a professor of finance at the
University of Toronto.
Dr. Puffer holds a Ph.D. in Finance and Applied Statistics and a M.Sc. in
Business Administration from the University of Rochester William E. Simon
Graduate School of Business Administration, and master's and bachelor's
degrees in Economics from the University of Toronto. She is a CFA
charterholder. Dr. Puffer sits on numerous boards and committees at the
University of Toronto, the Toronto CFA Society, and the Canadian
Investment Review.