Category Archives: bond pricing

8/5/16: Leverage and Management: Twin Risks or Separate Risks?


A new paper “How Management Risk Affects Corporate Debt” by Yihui Pan, Tracy Yue Wang, and Michael S. Weisbach (NBER Working Paper No. 22091 March 2016) looks at the role management risk (uncertainty about future managerial decisions) plays in increasing overall firm-wide default risk.

Specifically, the paper argues that “management risk is an important yet unexplored determinant of a firm’s default risk and the pricing of its debt. CDS spreads, loan spreads and bond yield spreads all increase at the time of CEO turnover, when management risk is highest, and decline over the first three years of CEO tenure, regardless of the reason for the turnover.”


The authors also show that a “similar pattern but of smaller magnitude occurs around CFO turnovers.”

Overall, “the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of prior uncertainty about the new management.”

Which means that leverage risk and management turnover risk can be paired.


In some detail, as authors note, “firm’s default risk reflects not only the likelihood that it will have bad luck, but also the risk that the firm’s managerial decisions will lead the firm to default”. In other words, while leverage risk matters on its own (co-determining overall firm risk), it also runs coincident and is possibly correlated with management turnover risk. “Management risk occurs when the impact of management on firm value is uncertain, and, in principle, could meaningfully affect the firm’s overall risk.”

This is not new. Empirically, we know that management risk is “an important factor affecting a firm’s risk. However, the academic literature on corporate default risk and the pricing of corporate debt has largely ignored management risk. This paper evaluates the extent to which uncertainty about management is a factor that affects a firm’s default risk and the pricing of its debt.”

Using a sample of primarily S&P 1500 firms between 1987 and 2012, the authors “characterize the way that the risk of a firm’s corporate debt varies with the uncertainty the market likely has about its management. The basic pattern is depicted in [the chart above]… The announcement of a CEO’s departure is associated with an increase in the firm’s CDS spread, reflecting an increased market assessment of the firm’s default risk. The CDS spread declines at the announcement of the successor, and further declines during the new CEO’s time in office, approximately back to the pre-turnover level after about three years.”

Quantitatively, the effect is sizeable: “the 5-year CDS spread is about 35 basis points (22% relative to the sample mean) higher when a new CEO takes office than three years into his tenure. Spreads on shorter-term CDS contracts exhibit an even larger sensitivity to CEO turnover and tenure. Spreads on loans and bond yield spreads also decline following CEO turnovers. These patterns occur regardless of the reason for the turnover; changes in spreads following turnovers that occur because of the death or illness of the outgoing CEO are not economically or statistically significantly different from changes in spreads in the entire sample.”

Dynamically, the results are also interesting: the process of risk pricing post-CEO exits is consistent with information updating / learning by markets. “The observed decline in default risk over tenure potentially reflects the resolution of uncertainty about management and hence a decline in management risk. …Bayesian learning models imply that if the changes in spreads around CEO turnover occur because of changes in management risk, then when ex ante uncertainty about management is higher, spreads should increase more around management turnover and decline faster subsequently. Consistent with this prediction, our estimates suggest that the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of uncertainty there is about the new management. For example, the increase in CDS spreads at the announcement of a CEO departure when the firm does not have a presumptive replacement is almost three times as high as when there is such an “heir apparent.” The revelation of the new CEO’s identity leads to smaller declines in spreads prior to the time when he takes over if the new CEO is younger than if he is older; presumably less is known about the young CEOs ex ante so less uncertainty is resolved when they are appointed. But once a younger CEO does take over, the market learns more about his ability from observing his performance, so the spreads decline faster.”

Fundamentals that may signal CEO quality ex ante also matter: “…when the CEO has an existing relationship with a lender before he takes his current job, the lender is likely to know more about the CEO’s ability and future actions, leading to lower management risk. Consistent with this argument, we find that the sensitivity of interest rates to the CEO’s time in office is 39-57% lower for loans in which the CEO has a prior relationship with the lender compared to those without such a relationship. This relation holds even if the CEO is an outsider and the relationship was built while he worked at a different firm, so the existence of the relationship is exogenous to the credit condition of the current firm.”

What about cost of debt and risk pricing? Some nice result here too: “Since uncertainty about management is likely to be idiosyncratic rather than systematic, it theoretically should not affect a firm’s cost of debt (i.e., the expected return on debt). Accordingly, firms should not adjust the cost of capital they use for capital budgeting purposes because of management-related uncertainty. In addition, since variation in management risk appears to be relatively short-term, it is unlikely to affect firms’ long-term capital structure targets. However, since management risk increases the volatility of cash flows, it should increase the demand for precautionary savings. Consistent with this idea, we find that firms facing higher management risk tend to have higher cash holdings. In particular, cash holdings decline with executive tenure, but only for firms for which management risk is likely to be high.”


Overall, an interesting set of results - highly intuitive and empirically novel. One thing that is missing is control for quality of governance within the firms, e.g.
- CSR
- ERM
- Board and C-level quality metrics
Avenue for future extension of the study…

14/3/2016: Foreign Investors, Sovereign Risks & Regulatory Clowns


Over 2012-2013, sovereign and corporate bonds markets started showing sigs of QE-related fatigue within the system, most commonly associated with periodically volatile trading spreads, term premia and risk spreads. In 2013, following the onset of the Fed-related “taper tantrum” many emerging markets spreads on their sovereign bonds widen dramatically, especially in response to rapid devaluations of their domestic currencies.

“This prompted market analysts to identify five of the worst hit economies as the “fragile five,” attributing their vulnerability to economic fundamentals, particularly to current account deficits.” Which is fine - current account is a reasonably important signal of the overall external balance in the economy, but… the but bit is that current account alone means little. Take for example Russia: back in 2013, the economy enjoyed record current account surpluses - so was a picture of rude health by the analysts criteria. Yet, within the economy there was already an apparent and fully recognised on-going structural slowdown.

Bickering over indicators validity aside, however, it would be nice to know which indicators and which risk models do investors flow when they decide to buy or sell emerging market bonds?

Traditionally, we think about two types of factors: “push” and “pull” factors, determining whether the emerging economy experiences capital inflows or outflows.

- “The push factors often relate to economic or financial developments in the global economy as a whole or in the advanced economies, notably the United States.”
- “The pull factors often relate to country-specific economic fundamentals in emerging markets”

Both push and pull factors seem to be important.

In analyzing returns on sovereign CDS contracts, the BIS paper looks at CDS returns “for 18 emerging markets and 10 advanced countries over 11 years of monthly data from January 2004 to December 2014.”

Findings in a nutshell:

  • “Statistical tests for breaks in the movements of CDS returns suggest a break at the time of the eruption of the global subprime crisis in October 2008. This leads us to consider two subperiods separately, an “old normal” before the outbreak of the crisis and a “new normal” afterwards.”
  • “In both the old normal and new normal, we seek to explain the variation of these [principal factors] loadings [onto risk premia] in terms of such fundamentals as debt-to-GDP ratios, fiscal balances, current account balances, sovereign credit ratings, trade openness, GDP growth and depth of the domestic bond market.”
  • “In the old normal, the first risk factor alone explains about half of the variation in CDS returns…” 
  • “This factor becomes more dominant in the new normal, in which it explains over three-fifths of the variation in returns.”
  • “When it comes to how the different countries load on this factor, we find that that the commonly cited economic fundamentals have little influence on the country-specific loadings on the factor. Instead the single most important explanatory variable for the differences in loadings is a dummy variable that identifies whether or not a country is an emerging market.”


To summarise the BIS findings: “In the end, we find that CDS returns in the new normal move over time largely to reflect the movements of a single global risk factor, with the variation across sovereigns for the most part reflecting the designation of “emerging market”. There seems to be no “fragile five”; there are only emerging markets. While the emerging markets designation may serve to summarize many relevant features of sovereign borrowers, it is a designation that lacks the kind of granularity that we would have expected for a fundamental on which investors’ risk assessments are based. The importance of the emerging markets designation in the new normal suggests that index tracking behaviour by investors has become a powerful force in global bond markets.”

And the cherry on top of the proverbial pie? Why, here it goes: “Haldane (2014) has argued that in the world of international finance, the global subprime crisis and the regulations that followed made asset managers more important than banks. Miyajima and Shim (2014) show that even actively managed emerging market bond funds follow their benchmarks portfolios  quite closely. For the most part, when global investors invest in emerging markets, instead of picking and choosing based on country-specific fundamentals, they appear to simply replicate their benchmark portfolios, the constituents of which hardly change over time.”

Wait, what? All regulators are running around the world chasing the bad bankers (for their pre-2008 shenanigans), all the while the new threat has already migrated to asset management. The regulators and enforcers are busy bee-buzzing around courts and regulatory hearings chasing the elusive ‘signalling value’ of enforcing old rules onto the heads of the bankers. With little real outcome to show, I must add. … But the future culprits are not to be found amongst those who care to watch the fate of bankers unfolding in front of them.

In short, having exposed the farce of bond / CDS markets pricing risks based on a vague and vacuous designation of a country, the BIS paper inadvertently also exposed the massive futility of the financial regulators chasing their own tails trying to get past crises culprits to prevent new crises from happening, even though the future culprits don;t give a toss about the past culprits.

Dogs, tails, everything wagging everyone, and vice versa…


Full paper here: Amstad, Marlene and Remolona, Eli M. and Shek, Jimmy, “How Do Global Investors Differentiate between Sovereign Risks? The New Normal versus the Old” (January 2016). BIS Working Paper No. 541: http://ssrn.com/abstract=2722580