4 - Credit Flashcards
What does it mean to default?
Company borrows money
Lender writes a contract with “covenants”
(iii) Covenant violation → technical default
(iv) Can’t negotiate with lender → file for bankruptcy
Approaches to forecasting defaults
- Accounting based (ratio analysis)
- Credit ratings
- Market based (limited to larger listed securities)
- Structural models
Primary determinants of defaults in credit?
Seniority and industry
What drives credit spreads?
CS = Prob. Default * (1 – Recovery)
Moody’s/KMV model
Observe value and volatility for equity and assets. Calculate distance to default based on Black-Scholes option pricing.
How can you use the comparison between model implied spread (CS*) and actual spread (CS)?
If CS* > CS, then short, if the other way around, then long.
How to go long on credit?
Buy bond or sell CDS protection.
How to go short on credit?
Sell bond or buy CDS protection.
What are the two steps in Excess Spread to Peers (ESP)?
- Calculate excess spread for each bond over its rating/industry/maturity group peers average
- Correct excess spreads for differences in issuer fundamentals and characteristics using a regression
In the second step of Excess Spread to Peers (ESP) -> correct excess spreads for differences in issuer fundamentals, what are the fundamental ratios used?
Financial leverage (Debt/Assets), net debt to EBITDA, and interest coverage (EBIT/Interest)
Is leverage correlated with credit ratings?
Yes
What does SPiDER stand for
Spread per unit of debt/earnings ratio
SPiDER formula
Option Adjusted Spread / (Debt / Sustainable EBITDA)
Sustainable EBITDA is EBITDA 10-yr average.
Factors in Credit
Value
Momentum
Carry
Defensive
How is credit momentum defined?
Trailling 6-month bond excess returns
Carry in Credit
High yield assets outperform low yield assets
Defensive assets in credit?
D/D+E (Low Debt -> Low Risk)
Profitability of issuer
Low duration
Portfolio construction in credit
Rank and standardize measures (DTS to make portfolios closer to beta neutral) (Duration times spread)
Volatility-adjust
Form composites by placing equal risk in each factor
Form model by placing equal risk in each style
Form composites by placing equal risk in each factor
Aims to create a diversified portfolio across different sources of risk (factors)
Form model by placing equal risk in each style
Value-oriented or a growth-oriented approach. By placing equal risk in each style, the portfolio manager can ensure that the final portfolio is balanced across different investment styles.
Equity Momentum in Credit (EMC)
Differentiate credit issuers based on past equity returns.
PEAD – Post Earnings Announcement Drift in Credit
Tells us to form portfolios with a tilt towards issuers with positive earnings surprises
Proportion of HY market that is Fallen Angels
15 to 25%
Fallen Angels performance
Tend to underperform in the first couple months (specially first month) and follow with a reversal lasting up to two years.
The more they underperform initially, the more they are expected to overperform subsequentially.
New issuance factor in Credit
6-month net issuance / debt outstanding
Excess returns lower for aggressive borrowers.
Is there a clear definition of size in credit?
No (debt outstanding?)
