As a consequence each of the mentioned types of bank capital represents its own risk class. Investors clearly have to be compensated to carry the additional risks compared with senior bank bonds. Figure 4.3 shows that on average the spread differentials between senior bonds and Lower Tier 2, Lower Tier 2 and Upper Tier 2, and Upper Tier 2 and Tier 1 tend to be roughly equal. But one should note that spread volatility also increases significantly when moving to more subordinated types of bank debt. Again, this can be explained by the Merton model. Since Tier 1 and Upper Tier 2 bonds are designed to absorb losses before holders of senior bonds and Lower Tier 2 suffer a loss, the strike price of their embedded short put option is closer at the money than that of senior and Lower Tier 2 bonds. Hence, in absolute terms the delta of the short put is higher, causing larger changes of the value of the option and consequently spreads, when fundamentals change.
The tactical asset allocation in credit portfolios combines top-down- and bottom-up analyses in order to arrive at medium- to short-term investment decisions. In this step of the investment process three major subjects are tackled:
- Spread class selection,
- Sector allocation, and
- Credit curve positioning.
When making a decision about the allocation of resources to different spread classes, elements of the top-down analysis clearly have a substantial impact, since the assessment of the fundamental and technical environment for credit and the valuation relative to other asset classes have significant influence on the positioning within the credit asset class. Conversely, credit curve decisions are usually implemented on a sector or, probably even more frequently, on a single issuer basis. Although elements of the bottomup analysis clearly influence the positioning on the credit curve, there are also some economy-wide indicators that have to be considered. Therefore, and with respect to the time horizon of investment decisions and their potential impact on active portfolio performance, the three abovementioned issues should constitute an own step in a structured investment process for credit portfolios.
The overall sentiment of investors towards the asset class corporate bonds is mirrored in mutual fund flows. Monthly and weekly statistics, for example, from Investment Company Institute, AIG and Trim Tabs, track the net flows into the major asset classes and their subcomponents. They also give an indication about the portion of cash held in mutual funds. The published numbers can help to explain movements in credit spreads that are not directly related to changes in the fundamental environment for credit. For example, they partly reflect risk appetite of investors. This is especially true, when looking at flows into high-yield bond funds. Major shifts in the asset allocation of institutional investors can also be observed from the data. Yet, published information on mutual fund flows tends to be behind the curve, in other words it is a lagging indicator for the activity of market participants and thus for credit spreads. But the analysis may help to spot long-term trends in the relative attractiveness of different asset classes.
Overwhelmed by the prospect of buying individual stocks, you may turn to mutual funds. Mutual funds are marketed as a simple way to own a diversified portfolio managed by a professional. Unfortunately, mutual funds are confusing and complex.
Confusion is rampant. There are as many mutual funds as there are individual stocks. Just when you think you have a fund picked out, the fund manager changes, the investment style is altered, and a load is imposed to purchase the former no-load fund. There are hundreds of styles and types of funds: micro cap, small cap, medium cap, and large cap, value, growth, blend, income, leveraged, unleveraged, closed-end, open-end, and so on.
Taxes are a mess. Those who buy the fund the day before the tax date have to pay taxes on capital gains that occurred before they owned the fund. Those who sell that day avoid the taxes even though they owned the fund while the gains occurred. Those who buy a day after the tax date have no taxes but a different cost basis even though they paid the same price for shares as those who bought before. Multiple systems can be used to declare your taxes and adjust your basis when you sell shares.
Calculating returns and comparing returns to other funds is equally complex. Unless you bought on January 1 and reinvested all dividends and capital gains, your returns and those in fund reports, the paper, and the magazines will be different. Ask yourself: How much complexity and confusion am I comfortable with? On these two criteria alone, mutual funds are outside the comfort zone of many investors.
When all of that is done, match the total amount of the checks against at least one control total to make sure everything balances. Those control totals may include the total amount paid for all checks, the amount subtracted from the checking account, and the total from the A/F subledger summary posted to the general ledger. If these amounts all balance, then the process has been successfully completed.
At some point your company will also likely find itself having to record vendor credits and adjustments. That system works the same in your ACCOUNTS PAYABLE system as it does in accounts receivable. Credits may occur for such things as returned merchandise, disputed accounts, and error correction.
Many companies have added automated A/13 files to their general ledger systems. Most systems automatically track and report payables and provide summaries of amounts owed each vendor.
All in all, life becomes much easier with an automated system—providing the accounting department:
- Sets up vendor files properly.
- Sets up the A/1′ subledger to default to the general ledger.
- Establishes default files that categorize and track specific types of amounts owed and payments due.
The automated system includes the same types of information listed in the manual file, such as date of transaction, name of vendor, description of purchase, amount owed, and terms of payment. Using that data, the automated system will send the necessary information to the A/1′ subledger, which then batches all payables by entry date and balances the batch to the general ledger account.
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