Editor's Letter

The subprime meltdown and the great recession have portfolio managers and their clients engaged in risk management issues. What happened, what have we learned, and what are we doing to make sure we are not exposed the next time? In this issue of The Journal of Fixed Income, we begin with articles exploring portfolio insurance alternatives. Stefan Ehlers and Marc Gürtler provide empirical evidence supporting the use of constant and time-invariant proportion portfolio insurance strategies for ABS and CDS indices. Furthermore, the time-invariant (floor adjustment feature) provides significant additional downside protection. However, Meng-Lan Yueh examines the performance of constant proportion portfolio insurance for credit index tranches with high leverage, in high volatility circumstances and for the failure to implement rule adjustments in the presence of rapid downward price movements.

A continuing major concern highlighted by the Lehman Bankruptcy and the AIG bailout is counterparty risk. A central clearing house for credit derivatives is a likely policy outcome. In the next article, Hans Byström employs extreme value theory to compute more accurate margin requirements in the presence of non-normal distributions. This is accomplished by focusing on the tails of the distribution and testing the methodology on the highly skewed and fat-tailed iTraxx credit default swap index.

Another dimension of the recent crisis was liquidity risk. How much of the spread we observe is compensation for liquidity risk and how much is compensation for fundamental risk? In the next article, Ugur Küçük isolates the non-default component of sovereign emerging market yield spreads and finds that bond liquidity has a significant and positive effect on the CDS-bond basis of investment grade bonds. However, the evidence for speculative grade bonds is counter-intuitive.

The mortgage market is still dealing with unprecedented delinquencies, defaults and foreclosures. Understanding the economic drivers of defaults is crucial for designing effective policies to stabilize and revive this market. In the next article, Laurie Goodman, Roger Ashworth, Brian Landy and Ke Yin present clear evidence that negative equity is the more important predictor of defaults than unemployment.

Finally, Naomi Boyd and Jeffrey Mercer demonstrate that excess returns can be earned with observable macroeconomic data related to the business cycle.

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

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