Revenue Rise with Loans

Mean–variance analysis, made popular by Markowitz and Sharpe, has been the basis for the process of portfolio optimization since the 1990s. Yet, the method itself suffers from various pitfalls. Among others it ignores deviations of the return distributions from normality. The asymmetric risk profile of corporate bonds and the illiquidity of certain segments of the international corporate bond markets make great demand on the process of portfolio construction. Merton (1974) clarified that corporate bonds can be replicated by the combination of a riskless bond and a short put on the assets of the company. This shows that the return potential of corporate bonds is somewhat constrained whereas the possible loss in the event of default is only limited by the recovery. Between 2000 and 2002, spectacular defaults like Enron and WorldCom heightened the sensitivity of investors to the risks associated with credits. In general the following relation holds: the higher the leverage of an issuer, the higher the credit risk. Remember that the short-put option on the assets of a highly leveraged issuer is much closer at-the-money than that of a conservatively financed company. And the closer the short put option is at-the-money the more asymmetric becomes the risk profile of a corporate bond. For those issuers small changes in credit quality such as, for example, due to increased dividend payments, can lead to significant volatility of spreads and corporate bond prices.