The mortgage servicer company I worked with was frustrated with the custodian’s tracking system. Frequently the servicer company would inquire about where the documents were located and the custodian couldn’t tell them. The firm of mortgage custodians felt they had a good process for identifying and retrieving documents and didn’t want to hear complaints from the servicer. Nancy, the custodian CEO, told me, “Those mortgage servicers are never happy, no
matter what we do!” In time, however, this servicer got a bad reputation among closers and lenders. It seemed that every time there was a closing and this particular company was involved, documents arrived late—causing late closings, scheduling nightmares, and angry buyers and sellers.Gradually closers and lenders started to avoid this servicer.

When I discussed the issue with Bob, the servicer CEO, he said the custodian was trying to drive them out of business. I thought this was a bit paranoid—especially since Nancy, the custodian leader, had told me several times she had tried to improve the situation between the two groups. But, Nancy said, “mortgage servicers just aren’t interested in partnering to fix the process.”

So far we have described a rather intuitive way of combining individual views in a portfolio. Top-down and bottom-up analyses have determined the overall strategy for the portfolio, spread class and sector selection and finally issuer weightings. This qualitative methodology does not require estimates of returns, risks and correlations between the investments, and therefore is easy to implement. Yet, it is not able to capture the full benefits of diversification and to tailor the expected risk/return profile of the portfolio to the preferences of the investor. Since the seminal work of Markowitz (1952), diversification is a central tenet of modern investment theory. In the context of credit portfolios it plays a crucial role, because it helps to control downside risk arising from single issuer credit events. Since the mid-1990s debt-financed M&A activities, share buybacks, and the introduction of new technologies have fueled the new issue pipeline and broadened the corporate bond universe. Meanwhile, the European corporate bond market offers sufficient market breadth and depth for institutional investors to construct thoroughly diversified portfolios. If the portfolio manager is capable of quantifying the risk and return characteristics of his investment alternatives, portfolio optimization approaches present a formalized and thus objective way of deriving investment recommendations. This applies irrespective of the performance target of the investor. Portfolio optimization can be used with respect to portfolios that are managed in absolute risk/return terms as well as portfolios that are managed relative to a benchmark index. Various constraints can be included, for example a short sales restriction for real money investors, maximum concentration limits or esired duration ranges.

Similar to the level of interest rates itself the slope of the yield curve also is an indicator for the economic environment. Generally, the slope of the yield curve is seen as a good proxy for future economic growth and corporate profits.

Steep yield curves imply that future rates are expected to be higher than at present. Asteep 2s10s slope and a further steepening of the 2s10s slope in the past often have been followed by positive excess returns of corporate bonds. Usually, one observes a steepness in this part of the curve at the end of a recession and at the start of an expansion. When the expansion finally materializes the curve flattens, and inflation concerns cause central banks to raise interest rates. In this environment, credit usually suffers, and investors should be particularly cautious when overweighting cyclical credits.

While liquidity risk is primarily a function of the willingness and ability of banks and brokers to provide liquidity and of investors’ readiness to take on risk, in other words, risk appetite, the other two points are related to the economic environment. The companies’ ability to generate sufficient cash flows to service their liabilities is central for the probability of default and is reflected in ratings. In general slowing economic growth, usually coupled with lower private consumption due to weak growth of labor income and rising unemployment undermines the profitability of the corporate sector.

In this context, it is worth remembering the definition of a recession. Market participants often define recessions in terms of two consecutive quarters of decline in real GDP. The National Bureau of Economic Research (NBER) which is responsible for dating recession periods, however, claims that recessions are characterized by a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale–retail sales.