Seven Frequently Asked Credit Process Questions

Introduction

In its most basic form, investing is all about understanding and managing risk. For fixed income securities, it’s more about managing credit and interest rate risk. And, understanding credit is of particular importance for corporate cash investors whose primary concerns are principal stability and liquidity, while attractive yield potential is often a secondary concern. Understandably, virtually every bond manager professes to be a conservative at heart when it comes to credit risk.
Regrettably, the subprime credit crisis has painted us a very different picture and revealed many false claims. It is now apparent that investment firms large or small, well-known or obscure, were investing in securities with credit quality that was inconsistent with the risk tolerance of their conservative claims of credit philosophy. In retrospect, it was quite clear that some firms had fallen into the all too familiar trap of investing in securities with unproven credit quality, having been temped by the lure of incremental yield.
Lately, the research department at Capital Advisors Group has been fielding a number of questions on our credit philosophy, process, and credit selection criteria. Of course, we cannot claim that “our mouse traps are better”, or that “we are smarter”. What we are committed to is choosing credits the old-fashioned way, even when it was out of fashion as the credit paradigm perilously shifted to structured finance, credit derivatives, and dynamic hedging.
Without further ado, below are the seven most asked questions we’ve seen in recent months:

Frequently Asked Questions

1. What are the objectives of the credit function?
The main credit objective at Capital Advisors is to look for credits with strong credit fundamentals compatible with corporate cash investors. Aside from evaluating an issuer’s fundamental credit metrics, we place greater emphasis on assessing its event risk and market risk.
In addition to avoiding credit defaults, we seek credits that provide effective headline risk management, enhanced portfolio liquidity, better risk diversification, minimized market-driven credit losses, and lastly, risk-adjusted yield potential.
Simply stated, “money good” is not good enough.
2. What is your overall credit process?
As “fundamental” credit investors, we use a bottom-up process to identify issuers with strong operating results and financial flexibility. We have a multi-faceted credit research process with an institutional “buy-side” focus, a robust risk management system, specialization in financial institutions, and an objective to manage separate accounts. This is in contrast to cash management units at major financial institutions that rely on credit functions elsewhere in the organization that serve investment banking, pension or money market fund needs.
The process starts with the construction of a strong “buy list” consisting of highly rated issuers which are market leaders with sound financial profiles. We proactively monitor and evaluate these credits through a variety of means that include an early warning system of stock alerts and corporate news, daily tracking of credit rating changes, periodic credit reviews, a maturity scoring system, and a formal committee that is made up of senior managers, traders and the Director of Research. Each corporate name must be recommended by a credit analyst and approved by the credit committee before being allowed in a portfolio. A weekly newsletter communicates to the portfolio managers and traders all relevant credit events in the previous week.
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