We compare the efficacy of index credit default swaps to a synthetic overlay using equity index futures in hedging the systematic risk of high yield portfolios in the U.S. and Euro markets. Since 2004, the equity overlay was more effective than the swaps in both markets in reducing risk, irrespective of the measure used to represent risk or hedge ratio. While the two instruments exhibited almost the exact same correlation with the high-yield portfolios over the entire period, their behaviors diverged considerably in certain market environments. Credit default swaps mimicked cash market dynamics in calm periods, but during episodes of stress the cash and synthetic high yield markets diverged due to spikes in illiquidity and breakdown of the cash-CDS arbitrage. In contrast, equity futures performed well during such periods, when hedging was most needed. Despite the improved risk profile of the portfolios hedged with equity futures, deploying the overlay passively resulted in significantly lower performance. To reduce hedging costs, we investigate the benefit of combining equity futures with “writing” OTM put options on the underlying index. We find that hedging the high yield portfolios with a combination of futures and options improved their risk-adjusted performance for a large range of hedge ratios in both markets. We also examine whether our results change if overlays are deployed on a tactical basis, by representing managers’ skill in making discretionary calls with a simulation framework. We find that for the range of skill levels that can reasonably be expected from a portfolio manager, the combined futures and option overlay continued to dominate the other overlays in terms of both absolute and risk-adjusted performance irrespective of the hedge ratio. Furthermore, we demonstrate that the return predictability of the high-yield market resulting from its relative illiquidity allows even a simple spread-based indicator to be the basis for an active hedging strategy that generates consistent outperformance versus the unhedged index. Deploying the combined futures and options overlay based on this signal increased performance by 1.5% and 2.5% per year on average in the U.S. and Euro markets respectively since 2004 compared with using credit default swaps. <b>TOPICS:</b>Credit default swaps, performance measurement, developed

This study recalibrates corporate bond idiosyncratic risks in an international context. By applying a statistically powerful risk decomposition scheme, the authors show that diversification is significantly improved by the addition of a global risk benchmark. They construct a long-run stationary yield spread decomposition scheme that further provides a better diversification effect. In addition to global liquidity and default risk factors, a country-specific default risk component is included, and all of them are free of measurement or availability issues. The idiosyncratic risk component is estimated as a fixed effect along with all the parameter estimates, rather than separately from an exogenous generating process. The linear model is simple, yet it can be easily and promptly applied by practitioners.

In this article, the authors propose an alternative approach for pricing bond options and swaptions under the one-factor Hull–White model. Their proposal differs from the existing models used to evaluate these type of instruments when the evolution of the term structure of interest rates is modeled by short-rate models. Assuming that the forward price of a coupon bond is a martingale under the forward risk-neutral measure, the proposed model involves deriving the volatility of the coupon bond as a function of its stochastic duration. Once the volatility function is defined, the price of options on coupon bonds can be derived by simply applying the standard no-arbitrage pricing theory in the context of the one-factor Hull–White model. Given the equivalence between the price of a coupon bond and the price of the corresponding swaptions, this approach can be adopted to calibrate the parameters of the one-factor Hull–White model using swaptions quoted in the market. The new solution proposed for the calibration can be considered as an alternative with respect to the existing approaches proposed in the literature and used currently by practitioners. Numerical results are provided in order to analyze the features of the proposed model for calibration purposes. <b>TOPICS:</b>Fixed income and structured finance, derivatives applications, quantitative methods

Very little is known about how bond market participants react to insider stock trades. Our study attempts to fill this gap in the literature by analyzing the bond market reactions around insider transactions in U.S. firms during the period from 2002 to 2009. Our dataset covers 993 stock purchases and 6,562 stock sales by corporate insiders. We employ event study methodology to determine the cumulative abnormal bond price returns in a number of predetermined subperiods around the publication date and find that insider purchases negatively influence corporate bond prices, whereas insider sales appear to convey a positive signal to the bond market. The results for purchases are most obvious for financial firms and for investment-grade firms. The results for sales are larger in the subsamples including non-financial firms and non-investment-grade firms. For both purchases and sales, the effect is largest when the transactions are executed by insiders who are both corporate executive officers and chairmen or during the crisis period. The results of our regression analysis support the findings from the event study and reveal that purchases related to benefit plans transmit a less negative signal to the market than other purchases.

We analyze the sovereign credit default swap (CDS) market for 57 countries, using a novel dataset comprising weekly positions and turnover data. We document that CDS markets—measured relative to a country’s debt—are larger for smaller countries, countries with a rating just above the investment-grade cutoff, and countries with weaker creditor rights. Analyzing changes in credit risk, we find that rating changes matter but only for negative rating events (downgrades and negative outlooks). In particular, weeks with downgrades and negative outlooks are associated with a significantly higher turnover in the sovereign CDS market, even after controlling for changes in sovereign CDS spreads. We conclude that agencies’ ratings are a major determinant of the size of the sovereign CDS market.

For the euro debt crisis, we assess the relevance of financial contagion from an investor perspective. We find that contagion, which we identify through the joint occurrence of extremely negative bond returns, has only small and transitory effects on broad government bond portfolios. For portfolios with concentrated country exposures, the frequency of contagious events does not add information to a standard analysis of risk. Hence, contagion in the euro debt crisis appears to bear little relevance for market timing and country selection alike. <b>TOPICS:</b>Fixed income and structured finance, financial crises and financial market history, developed

In this article, we analyze new loan-level data recently released by Freddie Mac on more than 17 million single-family mortgages to reveal a range of new and useful insights into the ultimate financial losses associated with a loan after it experiences a credit event. We conclude that mortgage insurance significantly lowers loss severities. We show that actual loss severities are higher than the preset severity schedule for loans with a loan-to-value (LTV) ratio of 60–80, relatively accurate for higher-LTV loans. We also find that small loans have higher severity than larger loans, that real-estate-owned (REO) sales have higher severity than short sales, and that there is no stable relationship between the state of origination and severity. Finally, we review the components of loss—liquidation value, direct expenses, and lost interest—and find that direct expenses and loss interest contribute significantly to the ultimate loss.

Stock market sentiment is an important driver of corporate bond valuations. Using transactions from the Trading and Compliance Engine (TRACE), the authors find that sentiment is negatively related to bond yield spreads, with the impact being stronger after the onset of the recent financial crisis. The negative effect of sentiment on yields is stronger when fundamental risk and liquidity frictions are higher, which points to a direct role of sentiment in the bond market whereby rational bond investors are unable in these high-risk/high-friction scenarios to correct the mispricing generated by other bond investors. The authors also find that the sentiment effect is stronger when the returns to capital structure arbitrage are higher, suggesting that sentiment also spills over to the bond market through the activity of invesinvestors dedicated to correcting relative stock and bond value mispricings within the same firm. They further provide evidence that after the onset of the crisis, sentiment also helps explain the extent to which the corporate bond market and the equity market are integrated.

1. Stanley J. Kon 1. Editor The Federal Reserve responded to the financial crisis of 2008 with extraordinary monetary intervention and policy measures that have resulted in persistently low interest rates. We begin this issue of The Journal of Fixed Income with an article by J. Benson Durham