In the Bank of America/Exult case, the bank was looking to get out of the human resource transaction business. They looked to Exult to help them manage their 120,000 associates. To be successful at this, the bank needed an entire infrastructure including an 850-person call center, telecommunications network, and Web site to manage the volume. With the transfer of the bank’s HR call center to Exult, which had the infrastructure already in place, the bank could focus its energy on servicing its customers’ financial needs.

NASA is very capable of launching probes toward the sun. However, APL at Johns Hopkins has a track record of being able to launch targeted missions more economically than NASA. NASA’s real expertise lies in its ability to manage multiple missions while making sure taxpayers’ monies are being spent wisely. It makes sense that NASA, with its strong management competencies, provides mission oversight while others contribute based on their strengths.

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.

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.

Numerous empirical studies confirm that the economic cycle is an important determinant for the performance of credit and government bond markets. They find that credit spreads are negatively correlated with GDP growth.. Historically, spreads tightened during the early stages of economic expansions, and spreads widened during economic recessions. Crabbe and Fabozzi (2002) note that during the ten economic cycles since the end of the Second World War, the Baa–Aaa quality spread typically already widened in the months leading up to a recession. After a recession began, spreads usually continued to widen, peaking approximately 10–14 months into the cycle. The magnitude of the spread widening as well as the duration of the spread widening, however, varies from cycle to cycle, depending primarily on the duration of the recession period and the magnitude of the economic downturn. The fact that credit spreads tend to widen before the business cycle peaks indicates that corporate bond investors often anticipate future economic developments.

Focusing on macroeconomic activity variables, therefore, is not sufficient to predict changes in corporate bond spreads. Investors should carefully analyze leading economic indicators as well as any evidence that corporate profitability slows or leverage increases. Both factors result in a reduced ability to generate cash flows and weakens credit quality, resulting in a higher risk of default.