Spread that solely mirrors credit risk
Based on historical data on defaults we can derive the fraction of the spread over riskless bonds for different rating classes and maturities, that is solely due to the probability of default and loss given default. The expected loss rate is derived from these two factors. Market participants who have a buy-and-hold perspective must decide on whether the current spread of a corporate bond sufficiently compensates for default and migration risk.
This is rather the perspective of a private than an institutional investor, because the latter in general has a short- to medium-term investment horizon and rarely holds a bond to maturity. In general, the institutional investor tries to achieve an excess return against a benchmark with a trading oriented management approach.
However, for the calculation of the required spread from a buy-and-hold perspective reliable default probabilities and recovery rates have to be used. If the issuer has an agency rating, Moody’s historical database is a good starting point. This database compiles expected default probabilities on a historical basis which is updated annually and also average recovery rates depending on the seniority of a bond. Those values allow to calculate a “fair” spread that solely mirrors credit risk.
The actual credit spread is explained by credit risk
One typical reason for spread differentials between bonds of the same rating are liquidity considerations, particularly with respect to stress situations. enerally, bonds with a large issue size, issued recently and actively traded by several market makers tend to be the most liquid. Sometimes old bonds with a small issue size, too, trade at rather tight levels. This is often the case for typical “CDO (Collateralized debt obligations) names”, that is bonds that are often included when CDOs are set up. Another reason for wide spread differentials between issuers with similar credit quality is that many market participants are concerned with potential mark-to-market losses. Therefore, rather illiquid and more volatile bonds require a higher spread, even if spread volatility is rather due to market technicals than uncertainty regarding company fundamentals. Consequently, it is natural that credit spreads differ even for bonds and issuers with the same rating.
But more importantly, only a fraction of the actual credit spread is explained by credit risk, which in turn is reflected by the rating.
How to view the credit risk
One example from the automotive sector is the large spread differential between Ford and Renault bonds with similar coupon and maturity.
Although the rating agencies assign approximately the same credit risk to both issuers, investors view the risk that is related to owning Ford bonds as significantly higher. It clearly outlines that Ford bonds have been much more volatile than Renault bonds between September 2003 and February 2004. When S&P put Ford on credit watch negative on October 21, 2003, spreads widened massively. Even if only very few investors feared a multiple notch downgrade of Ford from the then BBB rating, a 1 notch downgrade to BBB coupled with a negative outlook would have caused concerns about a later downgrade of Ford into high-yield. There were fears that the high-yield market would not be able to absorb the large volume of outstanding Ford bonds, and from a fundamental perspective that the company’s financing costs would rise, thus limiting the company’s financial flexibility massively. This example highlights that market technicals at least temporarily can be the dominant driver of credit spreads.
Average spread increasing as credit quality decreases
Despite the wide dispersion of credit spreads within the rating buckets the general link between credit spreads and ratings is clear, with average spread increasing as credit quality decreases. However, as it illustrates there are large overlaps between individual rating distributions. Myriad examples can be found to show that market participants often perceive the risk of one company in comparison to another to be completely different, even if both have the same rating. It should be noted that it includes bonds with rather different maturities and coupons.
Altman (1989) and Taylor and Perraudin (2001) have shown the presence of
highly persistent inconsistencies between credit ratings and bond spreads,
even after adjusting for liquidity and potential tax effects.
Some more key credit questions
- Do people in your organisation view sales from the customers’ perspective?
- How well do people in your organisation know each individual customer? Could more data be gathered and assessed?
- Do people in your organisation share information and insights about customers?
- Are product benefits (not simply product features) highlighted?
- Could you sell more to existing customers?
- Do people in your organisation act decisively and swiftly to reassure and impress customers?
- Do you take a co-ordinated approach to selling online?
- Is buying online an easy and worthwhile experience for the customer? How could it be improved?
- Is the website attractive, practical and relevant, learning from the lessons of the early years of website design?
- Are you ready for the changes that may result from greater internet sales?
Key credit questions you should ask
Sales, marketing and brand management decisions can be as difficult as they are important. Below are some of the issues that may need to be considered on a regular basis.
- How elastic are product prices? Could prices be increased without reducing revenue?
- When is the next price rise planned? Could it happen sooner?
- Are forces driving down prices in your market? What are they and how can you counter them?
- Who fixes prices in your organisation? How do they do it and could the process be improved?
- Are discounts targeted at the right sectors, or are they needlessly eroding profitability?
- Could pricing be used more aggressively?
- What are the barriers to entry in your market? How much of a barrier are they? Could you make it even harder for competitors to enter the market?
- When is the best time to enter or leave the market? Can action be taken to discourage and reduce the effectiveness of competitors entering?
- If you are planning to enter a new market, what makes your offer distinctive and likely to succeed?
- Are other firms entering the market? If not, why?
Ways to build credit loyalty
If you build trust and rapport with customers by listening to, understanding and helping them, they are more likely to be loyal. And the more you are able to tailor information and special offer promotions to individual customers the more likely they are to remain loyal. The Holy Grail of marketing has long been the ability to meet the needs of individual customers to drive revenue and profit; this is now easier to achieve, especially online.
Try to build on the initial purchase so that it is not simply a once-only transaction but provides an opportunity to make further offers that will be attractive to the customer.
Focus on credit generating the most profit growth
This means identifying customers with the greatest profit potential, rather than the ones who are most profitable now. Businesses often try to be all things to all people, disregarding the need to retain a focus on the most profitable parts of the market. Customer loyalty may be important, but if the cost of ensuring a customer’s loyalty outweighs the benefits
and revenue of that customer, why bother? Maintaining market share for its own sake is often an unwise approach. If a customer cannot be retained without losing money, then it is better to lose that customer and focus on those that will help improve profitability.
Harley Davidson reveals their credit strategy
Harley-Davidson used several methods to bond with its customers, and each one combines knowledge of individual customer’s needs with a cleverly judged appeal to their emotions. For example, the company’s managers regularly meet customers at rallies, where new models can be sampled with free demonstration rides. Advertising reinforces the image and perception of owning a Harley, persuading existing customers to stay loyal as much as attracting new ones. The Harley Owner’s Group (HOG) activities are central to binding customers to the company, and rather than providing trite or cheap benefits Harley devotes considerable resources to ensuring that its customers receive benefits that they value. Membership of HOG is free for the first year for new Harley owners and then a membership fee of approximately $40 is payable; over two-thirds of customers renew. It might seem easy to sell a product as exciting and appealing as a motorbike, but Harley-Davidson also manages to persuade tens of thousands of customers to keep on buying its machines, as well as paying to attend rallies where they enjoy themselves, make friends and provide valuable customer feedback. Some even tattoo themselves with the name of the company. How many businesses achieve that?
Riding high: Harley-Davidson’s credit programme
From its beginnings in Milwaukee in 1909, Harley-Davidson has enjoyed a long history as America’s foremost motorbike manufacturer. However, by the early 1980s its reputation and business were in serious trouble following a sustained onslaught from affordable, high-quality Japanese machines produced by companies such as Honda and Kawasaki. Following a management buy-out, Harley-Davidson tackled its product-quality problems using the techniques of W. Edwards Deming (ironically, an American whose quality methods transformed Japanese manufacturing). The next challenge was to win back and maintain market share.
This the company achieved, once again becoming America’s leading motorbike manufacturer, with an amazing 90% of Harley-Davidson customers staying loyal to the company.