Editor’s Letter

Hedging techniques are essential for risk management of fixed income portfolios. Great care must be taken, however, when the asset being hedged is illiquid. We begin this issue of The Journal of Fixed Income with an article by Arik Ben Dor and Jingling Guan that considers the alternatives of hedging a high yield corporate portfolio with index credit default swaps or equity index futures and options. Given periods of illiquidity in the cash market for high yield bonds, the cash-CDS divergence makes this hedge less effective than employing futures and options. In the next article, Jeroen Jansen and Frank Fabozzi provide an excellent review of bond credit ratings models and introduce an empirical implied rating model that incorporates the information in credit default swaps, macroeconomic variables, and a realized transition matrix.

Liquidity risk continues to be an important post financial crisis topic for investment professionals. In the next article, John Anthony, Paul Docherty, Doowon Lee, and Abul Shamsuddin find that loans with high liquidity risk experience lower returns during shocks to market liquidity, but in the absence of shocks there is limited evidence of a liquidity premium. Furthermore, the ongoing impact of liquidity and default shocks is consistent with momentum in the loan market. Next, Christian Hafner and Fabian Walders introduce heterogeneous nonlinear liquidity effects via a latent group structure. The empirical results indicate that groups differ in magnitude and the relative contribution between idiosyncratic and market illiquidity.

Special purpose vehicles contain potentially illiquid asset risk magnified by high leverage and rollover uncertainty. In the next article, Sanjiv Das and Seoyoung Kim provide a covenant-based optimization model that solves for the optimal capital structure of the deal. The model can also be used to solve for the maximum senior tranche size. Project finance also has a high proportion of senior debt used for investment in illiquid assets. Majid Hasan and Frédéric Blanc-Brude introduce a step-in option that creates extensive creditor rights to maximize recovery or payoff. They model the option effect on valuation and the risk characteristics of the senior unsecured project debt.

We hope you enjoy this issue of The Journal of Fixed Income. Your continued support of the Journal is greatly appreciated.

TOPICS: Fixed income and structured finance, fixed-income portfolio management, portfolio theory

Stanley J. Kon

Editor

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