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Shifting language from past disappointments to new opportunities is the hallmark of people with a high Partnering Intelligence, and you will be amazed at how infectious it can be as it spreads throughout your organization.

Organizations that want to change their orientation need to assess their various relationships, both internal and external. Like other forms of life, they experience pain as a warning that something is wrong. It is the people who work in these organizations that manifest the pain. The symptoms include low morale, unethical behavior, isolation, resistance to change, and a feeling of being ignored. Recognizing this pain is the first step in helping an organization begin the change process. Before an organization that does not value collaboration can transform into one that embraces the partnering process, it must first acknowledge the problem.

Try an experiment: On a sheet of paper, write down a list of words that represent the past to you. On another piece of paper, write down words that represent the future. Try to avoid simply inverting the word, such as “old–new” but rather think of fresh words for each of these two orientations. Then, read the lists out loud to yourself or others in the room.What do you notice? Any difference? When we’ve used this exercise in our training sessions, we’ve discovered that the past-oriented words seem dull and humdrum with low energy and are spoken in a monotone voice, while futureoriented words are exciting and full of energy and are spoken with enthusiasm and optimism. The language of the future is full of hope and opportunity, while the language of the past seems tired and lacks hope.

“Can’t teach an old dog new tricks.” “He’s always been that way, what did you expect?”“I should have known better than to depend on her!”Do any of those expressions sound familiar? These are the types of past-oriented statements that send powerful messages to our partners about our expectations of them.When you hear yourself reverting back to past messages, you might want to try shifting your language to future-oriented statements such as “Show me how!” “I love learning new things,” “I know it’s a new procedure, how can I help?” or “What do you need from me to help you succeed?”

How did your organization rate? The higher the total score, the more you see your organization oriented toward the future. Just as with individual evaluations, the importance of understanding the present reality leads to a decision: Are the people in the organization comfortable where they are? If they are, they won’t see a need for change or make any efforts toward that end. What impact might this choice have on future partnerships? And if people do want to change, how can they go about it?

The most successful leaders live in the future. While they have also learned from history and acknowledge the current situation, they know that they must offer a compelling vision to help people move forward. Partners must live in the future, too. The whole purpose of establishing an alliance is to learn, grow, and do something different. If we continue to revert to the past, our former mental maps weigh us down. Our language becomes the reinforcing dynamic that spreads our past orientation throughout the culture.

High Need for Control vs. Empowering Others. In order to form a partnership, we need to release some control over events. If an organization is intent on controlling every aspect of the partnership (past orientation), the partnership will fail. Partnerships must be mutually beneficial for each partner; it is up to both partners to make sure they are benefiting. This does not mean domination of the partnership. Rather, it means empowering others so participants can work collaboratively toward a mutually satisfying result (future orientation). How would you rate your organization on this scale?

Making Decisions Based on Past Experience vs. Negotiating a Plan and Agreeing on Outcomes.When organizations continue to make decisions based on past experiences, they limit themselves by not being open to new possibilities (past orientation). Companies wanting to form partnerships need to be willing to negotiate expectations and then hold people accountable for doing what they say they’ll do (future orientation). If you continue to hear statements such as “They’ll never do that” or “That’s not possible,” you probably work in an organization that has a past orientation.

If the issuer does not default, which is, measured by historical standards, extremely unlikely for an A-rated company, an investor earns an incremental coupon income of 100 bp over a 1-year horizon. Conditional on the fact that the bond receives a downgrade to Baa during the course of the year, a price depreciation of 50 bp times the duration of the bond at the end of the year, that is approximately 3.5, would have to be expected. Since Baa-rated US corporate bonds on average traded at 150 bp over treasuries, 50 bp represents the spread widening that has to be expected as a consequence of the downgrade. Consequently the investor expects a negative excess return of 100 – 3.5x 50= -75 bp, if the rating is downgraded from A to Baa.

Next post details the same computation for the other potential rating changes.

As mentioned before, from an active portfolio manager’s perspective a major concern is migration risk. Investors who do not hold a bond until maturity have to be compensated for a possible deterioration in credit quality, a potentially resulting downgrade and increased volatility. This becomes even more important if the downgrade triggers investment restrictions. For a specific corporate bond the expected excess return over duration-matched government bonds can be estimated in three steps:

The probability of rating changes are derived from a rating transition matrix;
Spread and price changes for up- and downgraded bonds have to be estimated.

Expected return is computed as the weighted sum of the price changes. Consider a portfolio of 5-year A-rated US corporate bonds. Between 1989 and 2003 they traded on average at a premium of about 100 bp over durationmatched government bonds which is roughly the level that was reached in August 2003. Evidence shows that 91.20 percent of these bonds maintain their rating and hence can be expected to earn an excess return of 100 bp over a 1-year time-horizon. Of the bonds rated A at the beginning of the year 2.66 percent can be expected to receive an upgrade in the course of the year.

Investors would expect to benefit from a subsequent spread tightening to an average of 55 bp if upgraded to Aaa or 70 bp if the bonds are upgraded to Aa. Conversely, downgrades below A would result in widening credit spreads and consequently negative excess returns versus duration-matched government
bonds. Differences in accrued interest between corporate bonds and government bonds can be considered at this stage.

Experience shows that a spread level of merely 25 bp was never achieved between 1989 and 2003 for Baa rated US corporate bonds. One reason is that from an economic perspective the default probabilities and recovery rates that were assumed to calculate the required spreads were too optimistic for this period. Especially between 1997 and 2002 the fundamental environment for corporate bonds was unfavorable. New technologies, company takeovers and equity buyback programs were primarily financed by the issuance of corporate bonds, resulting in an increased level of leverage in the corporate sector. Investors consequently required higher risk premia to invest in corporate bonds. One way to obtain more adequate estimates of required spreads is to use default probabilities and recovery rates that are typical for the current stage of the business cycle. Modern models for credit risk management and the pricing of credit derivatives account for the current economic environment. In particular, they differentiate between periods of expansion and contraction, because historically default rates increased and recovery rates fell during economic downturns, thus leading to a higher risk for credit investors. Additionally, a worst-case-scenario can be constructed assuming a zero per cent recovery value. A fair spread of 0.46 percent will be computed for Baa rated corporate bonds with a maturity of 5 years which is again a lot lower than the actually observed spreads.

For a corporate bond investor who is willing to hold a corporate bond to maturity the credit spread has to compensate fully for the loss if the company defaults during the lifetime of the bond. The expected loss is given  by the product of the probability of default, pD, and loss severity, which is defined as 100 percent minus the recovery rate, R. On the other hand, if the company does not default, the investor earns an excess return equivalent to the spread, S, times maturity of the bond, T. The effect of interest on interest is ignored in this calculation. Based on the Moody’s data depicted above, it provides an overview of the spreads that are required to compensate investors for default risk associated with holding corporate bonds of a certain rating class. Even if the general approach is buy-and-hold investment restrictions with respect to ratings may cause investors to be forced sellers when the bonds of an issuer are downgraded, for example, below investment grade.

This effect is not considered in the computed spreads, because this is rather the perspective of an active investor, which is laid out below.

The credit loss is the loss in total return of a fixed income portfolio due to defaults. Moody’s finds the following average annual credit losses for portfolios constructed primarily on the basis of Moody’s ratings for the 1982–2002 period.

The level of default rates is a good indicator for the state of the credit market. The default risk premium should rise or fall in accordance with the prevailing probability of default. More importantly, the expected default rates set the tone for the future development of the credit market. The expectations about future default rates depend on several factors:

GDP growth, because slower economic growth is accompanied by lower corporate earnings expectations and hence less companies will generate necessary cash flows to serve their debt obligations. Default rates move inversely with economic strength. Periods of high GDP growth go along with declining default rates.

The distribution of all outstanding issues on the rating spectrum. The default probability increases with proportionally more lower rated (B and worse) issues than better rated issues in the corporate bond market.

Distressed debt totals.

Financing alternatives during an economic downturn can have severe implications on the credit market. Deteriorating credit statistics in the credit market will force the banks to tighten their lending policies (more security = higher risk premiums) resulting in less available liquidity for the corporate sector. The lower rated companies (e.g. B- and C-rated) are the first to be impacted. Lending policies of commercial banks can be an indicator for future default rates in the corporate sector.

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The recovery rate is another important figure when evaluating corporate bonds. This is the amount that the bondholders will get after a company defaults and all debt obligations are restructured. Depending on the ranking in the capital structure (senior secured, senior unsecured, junior) and the industry and economic cycle, the recovery rate can vary substantially as shown.

Recovery rates and default rates tend to be inversely correlated. Moody’s finds a statistically significant relationship for high-yield default rates and recovery rates between 1983 and 2002. About 56 percent (R2) of the variance in recovery rates can be explained by default rates. If two outliers are removed the R2 statistics increases to 88 percent. This finding is consistent with the hypothesis that a higher volume of distressed bonds leads to lower recovery rates and vice versa.