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8 September 2017 Financial Analysts Journal Book Review

Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives (a review)

  1. Martin S. Fridson, CFA

This book covers the cash, structured, and synthetic markets and includes chapters on credit analysis, basic trading, and default correlation. It is filled with practical knowledge backed up with meticulous research.

Editor’s Note: A short passage in this book addresses work of the reviewer.

Like most investors, buyers of collateralized loan obligations (CLOs) strive for diversification. To avoid excessive concentration in the underlying debt of any single issuer, they spread their holdings across different vintages. That is, they hold tranches of CLOs created in different years.

This approach to division of risk turns out to be less effective than some investors imagine. Many companies (“names”) are frequent borrowers, which leads to their loans showing up in several different vintages. An analysis in Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives finds a 46 percent average overlap of names among CLOs of different vintages, slightly higher than the overlap within CLOs of the same vintage. More important than diversifying across vintages is spreading exposure across CLOs managed by different managers. Name overlap among CLOs of a single manager averages 81 percent.

This is one of many findings of considerable practical value obtained through original research by Stephen J. Antczak, CFA, of UBS, Douglas J. Lucas of Moody’s Investors Service, and Frank J. Fabozzi, CFA, of the Yale School of Management. Another example is the light shed by the authors on average rates of recovery of principal on defaulted debt. Practitioners commonly assume a 70 percent recovery rate on loans versus only 40 percent on bonds—ratios that are generally consistent with the historical averages. The averages, however, understate the advantage of loans over bonds. Antczak, Lucas, and Fabozzi find substantial skewing in the statistics, with 45 percent of defaulted loans generating recoveries of 80 percent or more and 45 percent of defaulted bonds generating recoveries of less than 20 percent.

Leveraged Finance is impressive in both its breadth and its depth. The authors cover the cash, structured, and synthetic markets, with chapters on credit analysis and basic trading. They also provide two chapters on default correlation that are rich in both theory and evidence.

Readers should note two caveats, however. First, the authors finished writing the text while the recent financial crisis remained in an acute phase. As normal conditions return, the leveraged finance market may differ in certain ways from the market described by the authors. Second, some of the findings depend on sparse data, necessitating caution with respect to the conclusions. For example, the authors report a lower incidence of defaults on leveraged loans than on senior bonds rated BB to B based on just one annual cohort of issuance. Similarly, the authors admit that their study of bond performance by rating category in and around recessions is inconclusive because the requisite data are available for only two business cycles and the results are inconsistent across those periods.

This volume is part of John Wiley & Sons’ Frank J. Fabozzi Series and upholds Fabozzi’s reputation for communicating technical material in clear, comprehensible prose. The copyediting is good, although not perfect. For instance, the authors allude to the heretofore unheralded economic indicator “gross disposable product” (the “D” in GDP actually stands for “domestic”). Notwithstanding the book’s title, the authors seemingly cannot make up their minds between “leverage buyouts” and the more conventional “leveraged buyouts” or, in the same vein, “leverage loans” and “leveraged loans.” They also use two different spellings of “Merrill Lynch” within a single exhibit.

These flaws do not detract from the fact that Leveraged Finance contains a wealth of information directly applicable to the investment process. Readers will learn, for example, that CDX, a swap index based on high-yield bonds, has a lower beta in bear markets than in bull markets whereas the reverse is true for LCDX, an index based on leveraged loans. Also useful is the finding that bid–ask spreads in the credit default swap market widen as the tenor diverges—in either direction—from the benchmark tenor of five years. In short, Antczak, Lucas, and Fabozzi have packed an immense quantity of practical knowledge into this book and have backed it up with meticulous research.


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