4 - Credit

Question 1

What does it mean to default?

Answer 1

Company borrows money
Lender writes a contract with “covenants”
(iii) Covenant violation → technical default
(iv) Can’t negotiate with lender → file for bankruptcy

Question 2

Approaches to forecasting defaults

Answer 2

1. Accounting based (ratio analysis)
2. Credit ratings
3. Market based (limited to larger listed securities)
4. Structural models

Question 3

Primary determinants of defaults in credit?

Answer 3

Seniority and industry

Question 4

What drives credit spreads?

Answer 4

CS = Prob. Default * (1 – Recovery)

Question 5

Moody’s/KMV model

Answer 5

Observe value and volatility for equity and assets. Calculate distance to default based on Black-Scholes option pricing.

Question 6

How can you use the comparison between model implied spread (CS*) and actual spread (CS)?

Answer 6

If CS* > CS, then short, if the other way around, then long.

Question 7

How to go long on credit?

Answer 7

Buy bond or sell CDS protection.

Question 8

How to go short on credit?

Answer 8

Sell bond or buy CDS protection.

Question 9

What are the two steps in Excess Spread to Peers (ESP)?

Answer 9

1. Calculate excess spread for each bond over its rating/industry/maturity group peers average
2. Correct excess spreads for differences in issuer fundamentals and characteristics using a regression

Question 10

In the second step of Excess Spread to Peers (ESP) -> correct excess spreads for differences in issuer fundamentals, what are the fundamental ratios used?

Answer 10

Financial leverage (Debt/Assets), net debt to EBITDA, and interest coverage (EBIT/Interest)

Question 11

Is leverage correlated with credit ratings?

Answer 11

Yes

Question 12

What does SPiDER stand for

Answer 12

Spread per unit of debt/earnings ratio

Question 13

SPiDER formula

Answer 13

Option Adjusted Spread / (Debt / Sustainable EBITDA)

Sustainable EBITDA is EBITDA 10-yr average.

Question 14

Factors in Credit

Answer 14

Value
Momentum
Carry
Defensive

Question 15

How is credit momentum defined?

Answer 15

Trailling 6-month bond excess returns

Question 16

Carry in Credit

Answer 16

High yield assets outperform low yield assets

Question 17

Defensive assets in credit?

Answer 17

D/D+E (Low Debt -> Low Risk)

Profitability of issuer

Low duration

Question 18

Portfolio construction in credit

Answer 18

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

Question 19

Form composites by placing equal risk in each factor

Answer 19

Aims to create a diversified portfolio across different sources of risk (factors)

Question 19

Form model by placing equal risk in each style

Answer 19

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.

Question 20

Equity Momentum in Credit (EMC)

Answer 20

Differentiate credit issuers based on past equity returns.

Question 21

PEAD – Post Earnings Announcement Drift in Credit

Answer 21

Tells us to form portfolios with a tilt towards issuers with positive earnings surprises

Question 22

Proportion of HY market that is Fallen Angels

Answer 22

15 to 25%

Question 23

Fallen Angels performance

Answer 23

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.

Question 24

New issuance factor in Credit

Answer 24

6-month net issuance / debt outstanding

Excess returns lower for aggressive borrowers.

Question 25

Is there a clear definition of size in credit?

Answer 25

No (debt outstanding?)