I have commented on this in the past

http://www.noelwatson.com/blog/PermaLink,guid,2060fb25-5d11-4a30-93b1-9c257651b104.aspx

Stephen Bland no longer writes for the Motley Fool and instead writes a subscription newsletter for MoneyWeek

http://www.moneyweek.com/about-us/the-moneyweek-team/stephen-bland.aspx

Before he left Fool, he gave an example portfolio for troubled times

http://www.fool.co.uk/news/investing/high-yield/2007/11/20/high-yield-picks-in-a-troubled-market.aspx

Bland's belief was that the best time to invest is now, and you shouldn't think you know what the future holds. Furthermore, the portfolio should be held indefinitely, as you are unable to predict the future. The portfolio is now almost a year old, so I thought I would do a little analysis. The HYP has fallen slightly more than the FTSE (-39.76% vs -38.14%). Certain shares have fallen more than others. For example, Taylor Wimpey is worth 5% of purchase price.

Were there any warning signs that could have told us that maybe we should sell? I decided to look at the CDS spreads (credit markets are notoriously slow to react). Unfortunately, Taylor Wimpey doesn't have an active CDS market, so onto another big faller.

I didn't pick RBS as its spread has been influenced by the BOE bail out, so instead will pick DSGI. Downgraded by Moody to speculative grade in May, by this point the stock had almost halved. So what did the CDS market show us? Soon after Christmas, DSGI started to move out, from around 100bps to 450 in mid Feb.

compared with the ITRAXX Europe which jumpled from 50bps to 160bps in the same period

So the first question could be, "Should be have a ratio of single name spread change to index spread change, and if our entity breaches it, we sell?"

I'm not sure it is as simple as this, as Rexam's CDS spread has gone from 60bps to 380bps, yet its share price has outperformed the market

and even Glaxo's CDS spread (the best performer) has gone from 27 to 110. So maybe we could have a rule that says if spread > MIN (500, ITRAXX Europe*2.5) sell. Furthermore, we could exclude names for which there is no CDS spread. of course, we cannot get excess return without taking risk, but maybe we can mitigate some of the risk by applying mechanical rules.

Here are my initial suggestions

Purchase

• Entity must be BBB rated or above when purchased
• Entity must have liquid CDS spread (tricky in current market!), and this must be no greater than 1.5*ITRAXX Europe
• Entity must not be in ITRAXX XOver (DSGI is in this list)

Reasons to sell

• Entity gets downgraded below BBB (probably too late to save majority of the fall in share price)
• CDS spread is greater than 2.5 times ITRAXX, or spreads goes above 500bps.
• Entity gets included in XOver on index roll

Research has been done into the link between credit spreads and stock prices

http://thesis.haverford.edu/dspace/bitstream/10066/1447/1/2008HaferS.pdf

but no link was found between the two that could be used to make excess return.

Attcahed is spreadsheet with working

HYP.xls (26 KB)

Will update at a future date