How to effectively manage a credit

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.

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?