26th March 2009

The Credit Conundrum

Session 4: Credit Manager Selection – An Essential Guide

Credit Manager Selection

Contents

2

Page

Introduction 3

Why it Matters 4

Current Environment Consideration 7

Designing a Mandate 10

Choosing a Manager 16

Summary 21

Contents

• Popular market views on Credit is “new equity”, “free lunch”, “once in a life time opportunity”.

• But there are Risks: • When consensus say one thing, market often does the opposite; • We have seen significant credit deterioration already with more to come; • Defaults will increase and recovery rates are likely to collapse; • Refinancing will be difficult as little credit liquidity is available to corporates.

• Nevertheless, there are outstanding opportunities in the credit universe……

3

Credit Manager Selection

Introduction

Credit Manager Selection

Why it Matters

4

• This chart shows the monthly return dispersion between Oct 2005 and June 2007.

• This chart shows the monthly return dispersion between Oct 2005 and Jan 2009. (Note that only 14 managers

reported their January return.)

• Monthly return dispersion between managers has widened significantly since July 2007.

5

Credit Manager Selection

Why Manager Selection Is So Important?

Why Manager Selection Is So Important?

• In the past, all that mattered was getting asset allocation correct, equities, bonds, properties, etc.

• Now manager selection is vital.

Source: CAMRADATA/iBoxx

6

Credit Manager Selection

Executive Summary

• There are a few terms that need clarification.

Executive Summary

Like any other asset class – Does the manager have the necessary skill set to produce attractive returns in the sector in which he or she operates in the current environment?

• These are needed for mandate design

• This is needed for manager selection. What is the necessary skill set?

What is the current environment?

What is an attractive return?

What is the sector?

• We will discuss the pitfalls in manager selection.

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Credit Manager Selection

Current Environment Consideration

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02/01/2003 02/01/2004 02/01/2005 02/01/2006 02/01/2007 02/01/2008 02/01/2009

Spre

ad

Benchmark Spread

iBoxx Sterling Non-Gilts iBoxx Sterling Non-Gilts A iBoxx Sterling Non-Gilts BBB

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Credit Manager Selection

Current Environment Consideration

• In stable environments with no defaults (2003-2007) the skills required will be different from the skills needed now. i.e. now managers need a deep understanding of every issuer and every bond

• The spreads now are extremely wide on a historic basis but expected defaults are expected to increase significantly.

• The rating agencies have not proved to be particularly helpful.

Choosing a Manager – The Current Environment Matters……

Source: Barclays Capital

9

Credit Manager Selection

Current Environment Consideration

• Downgrade/transition risk: • Note: the implied “cost” of downgrade is

substantial, and prices may anticipate downgrade

Choosing a Manager – The Current Environment Matters……

The ongoing banking crisis and global economic downturn make it almost certain that default rates will continue to climb sharply during 2009. Because the impact of the current economic downturn on corporate debt issuers is likely to be more severe than for the two most recent credit cycles of the early 1990s and 2000s, Moody’s expects that the speculative-grade default rate will exceed the peaks of 11.9% and 10.4% reached in those cycles, respectively.

(Source: Corporate default and recovery rates, 1920-2008, Moody’s Global Credit Policy, Feb 2009)

Source: Barclays Capital

Credit Manager Selection

Designing a Mandate

10

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Credit Manager Selection

Designing a Mandate

• Opportunity • We feel that the current environment makes credit look attractive. • Target return: We would be happy with LIBOR + 250 • Achievable by investing in a diversified portfolio of Investment Grade Credit.

• Clarity needed around the sector:

Designing a Mandate – The Sector

High grade credit?

Sterling high grade credit?

Should it include any

Gilts?

Should it include Quasi-

government EIB, KFW

etc.?

High yield? Currency

considerations?

• PITFALL NUMBER 1: Not being specific around the sector will give you unwanted risks.

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Credit Manager Selection

Designing a Mandate

• We think that the iBoxx 10 year sterling corporate index is a good proxy for credit.

• Tracking error • We will allow a reasonable tracking error. • This has been the traditional method used for investing in credit

• But is it right for March 2009? • There is a bias in credit that one should be aware of (unlike Government benchmarks?) • The more a borrower issues the larger a percentage they are in the index. • The index may not contain the right amount of risk (either too much or too little).

Designing a Mandate – The Benchmark

• PITFALL NUMBER 2: Using an index that does not contain the appropriate securities is unlikely to lead to a portfolio you thought you would get.

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Credit Manager Selection

Designing a Mandate

• Behavioural finance • How will the manager behave if we give him this benchmark? • How will the benchmark affect his decision making?

• Incentives

• Should we ask him to beat the benchmark and if so, by how much? • Target: iBoxx Corporate index + 50bp. • Environment: 2005/2006 with low default rates and low volatility • Strategies to achieve return without additional interest rate risk

• Trade the portfolio like a banshee and generate alpha by small bets • Very difficult: very few managers achieved this.

• Or perhaps simply underweight the lower yielding securities and overweight the higher yielding securities (e.g. tier 1 and upper tier 2).

Designing a Mandate – Other Benchmark Considerations

2004 2006 2009

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Credit Manager Selection

Designing a Mandate

Designing a Mandate – Other Benchmark Considerations • Suppose the manager underweight the lower yielding securities and overweight the higher yielding

securities. • Under current environment, value of high-yield securities shrink massively. • Overweighting high-yield securities results in significant underperformance of credit portfolio.

• PITFALL NUMBER 3: Beware of unintended consequences of setting inappropriate incentives.

Source: Redington Partners

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Credit Manager Selection

Designing a Mandate

• Last point on benchmarks • Can it ever be good to underperform the benchmark?

• Yes, if it leads to a better risk-adjusted return • Benchmark

Designing a Mandate – The Benchmark

Pro: provides framework for measuring performance

Con: may unnecessarily constrain the manager’s ability to act on his views or lead to the manager taking asymmetric risk

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Credit Manager Selection

Choosing a Manager

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Credit Manager Selection

Choosing a Manager

Choosing a Manager

Like any other asset class – Does the manager have the necessary skill set to produce attractive returns in the sector in which he or she operates in the current environment?

• If we have answered the first three questions we are more than half way there

• Let’s make some assumptions and then look at some pitfalls.

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Credit Manager Selection

Choosing a Manager

• Process • Define the criteria on which the

managers will be assessed (just a few examples):

Choosing a Manager

• What defines a good philosophy? • We need a framework

• If we have answered the first three questions we are more than half way there

• Let’s make some assumptions and then look at some pitfalls.

Assessing Managers

Size of the Firm

Client Quality

People

Philosophy

USP

Investment Process

Client Products

Risk Control

Performance

Street Relationship

Fantasy Football Meets Investment Management People

10/10

Criteria • Structure which covers Top-down

and bottom-up. • Balanced roles and geographical

distribution. • Significant experience in the

industry and the firm. • Senior new-joiner recently is also a

benefit.

John Maynard Keynes, 94 yrs experience.

Strategist

Sunzi, 2500 yrs experience.

Portfolio Managers

W. Buffet, 74 yrs experience.

Analysts

Meredith Whitney, 20 yrs experience.

Traders

Derek Trotter, 47 yrs experience.

Client Relationship

Macro

Credit Manager Selection

Choosing a Manager

19

• Define the standard of perfection e.g. what would a manager scoring 10 for People look like?

Brangelina

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Credit Manager Selection

Choosing a Manager

• Is it different from 2006-2008? • Could the best performing manager in this period be the best

performing manager in 2009 or do you need to look for something else?

• Example • In the previous period a manager could have got one bet

right – being long EIB and KFW. • Macroeconomic Team

• They have an excellent Macroeconomic team and accurately forecast the downturn in the economy.

• Strategists • Furthermore, the strategists could see what impact this would

have on spreads.

• Historical Performance • They will have outperformed both the index and the peer

group in 2008. • The skills needed for 2009 may well be different. What are you

trying to achieve? The index will give you LIBOR + 400 – more than you need.

Choosing a Manager – Skill Set needed in 2009

• Dispersion between the best and the worst credit managers have increased dramatically in 2008:

• Manager returns in 2008 range from 0% and -17%;

• While the difference was around 4-5% in 2007 and <3% in 2006.

• PITFALL NUMBER 4: Relying too heavily on performance when choosing a manager may ignore the skill set needed in the current environment

Source: CAMRADATA/iBoxx

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Credit Manager Selection

Summary

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Credit Manager Selection

Summary

Summary

Recapping a few pitfalls: • PITFALL 1: Not being specific around the sector will give you unwanted risks. • PITFALL 2: Using an index that does not contain the appropriate securities is unlikely to lead to a

portfolio you thought you would get. • PITFALL 3: Beware of unintended consequences of setting inappropriate incentives. • PITFALL 4: Relying too heavily on performance when choosing a manager may ignore the skill set

needed in the current environment.

• Selecting the right manager really matters.

Like any other asset class – Does the manager have the necessary skill set to produce attractive returns in the sector in which he or she operates in the current environment?

• Understand your objectives, and then determine the appropriate sector:

Consider the current environment – what

matters now

Design the mandate avoiding unintended risks

Now need a deep understanding of the managers in this area

Select the credit manger that best fits your risk return profile

and is most likely to deliver