Larry “The Liquidator” Groves was a lot of things to an even bigger lot of people. Good-humored uncle, avid chess-player, devoted husband of 50+ years, scout leader, dad, rescuer of troubled boys, changer of lives. Adopter of kids left at his doorstep. Navy veteran. Patriot. Corporate climber. Banker. Good friend.
He passed on just before Christmas. He always had time for talking about new ways of thinking about credit, though he didn’t love the new place. He had no place for “tail risk” and the black swans in vogue right now. You throw high-impact outliers and derivative hedging at him, and he would come back with a twist on Bagehot: “that’s what equity is for, and a well-run bank needs no equity anyway.” He was a “bond” guy.
Bond guys are different from credit guys. They have a completely different approach often eschew the term credit to make the distinction. Bond guys are balance-sheet centric and they think like bankers. Their asset class is a set of cashflows, and their goal is loss avoidance. They usually fit in a typical bank, insurance company, and/or mutual fund. Bond guys prize a common sense-approach to credit analysis, with the chief weakness that they rely on rating agencies (quintessential bond guys) too much.
Credit guys trade cash instruments as well as credit default swaps, and they think like engineers or maybe mathematicians. Their outlook is absolutely shaped and steeped in mathematics. Price for a credit guy implies a market view of some risk overlaid on top of other risks on top of a base reference rate. Thus they believe credit risk can be isolated and traded for profit. They believe in risk-adjusted returns, and all these layers of risk can be peeled away to do this via arbitrage.
The derivative guys largely view bond guys as unsophisticated old-timers that don’t understand risk and the management of it. The bond guys, in turn, see the other camp as naive academics who apply spurious machinery that leads to microscopically precise methods but macroscopically wrong conclusions. Of course this is a simplification. They don’t hate each other, but there is a kind of British versus the French vibe going on pretty much all the time.
It is to Larry’s credit that we found common ground. What fixed income needs is a bit of both the bond guy and the credit guy mentalities. Bill Gross once said: “the ideal bond manager should be 1/3 economist, 1/3 mathematician, and 1/3 horse trader.” He anticipated and made his career establishing the link between being and bond guy and exploiting the growing importance of the credit guys.
Fixed income needs the robust logic of the derivatives guys and their awareness of the value of hedging. Firms do not operate in isolation and company defaults are not independent. In reality a whole network of links exists between companies in related businesses, industries and markets and the impact of individual credit events can ripple through the market as a form of contagion. It also needs an appreciation that credit investing is also about using intuition and trying to imagine unseen risks.
Times and fashions change, what is meaningful always endures. What is meaningful is both return and loss avoidance, done by getting the price right.
Loss avoidance means keeping an eye on credit weakness, corporate default, and correlation. Default can occur in three main ways. A company may be adversely affected for reasons specific to that company alone (e.g. poor financial management). Credit weakness may occur due to a factor or factors impacting multiple companies – whether in the form of a cyclical influence related to the economy, or a market-wide shock such as an earthquake or September 11th. Finally companies are related through ties, quantified as correlations. Some of which are real (e.g. a trade-creditor agreement), others of which are purely a matter of perception – for example the fear of accounting fraud. Credit dependence then occurs primarily through two mechanisms – either as a direct consequence of a common driving factor, or due to inter-company ties. The latter can be thought of as a form of contagion.
Credit is not only about understanding the drivers of credit risk at an individual company, but also the dependence structure between related companies. Whether accounting for counterparty risk in the price of a single-name credit derivative, or considering credit risk in a portfolio context, an understanding of credit dependence is essential to accurate risk evaluation and pricing.
Credit guys are much more attuned to the latter—systemic risk. Indeed, this is the primary driver behind correlation trading. They just didn’t realize how unstable correlations are. So you get credit guys using derivatives to squeeze all the juice there is to be had from a very, very overbought asset class. This presumes a degree of liquidity in credit that simply wasn’t there, even in the good times. It makes sense to buy out of the money options, exploit the volatility risk premium, or put on straddles to control systemic risk.
Bond guys are more attuned to the former driver of credit risk. And they are right to right in that not all risks are quantifiable or well-worn. And Larry was right to tell me that tail risk is why equity exists in the first place.