Credit

Question 1

Credit

Answer 1

One of the broadest categories as what we mean by credit is essentially any form of debt instrument not issued by a government (or guaranteed by the government in some way, as is the case for many MBS products).

Question 2

Types of Credit

Answer 2

The major forms of credit-based products traded on a floor will be investment grade debt, high yield debt, distressed debt, and CLOs.

Each of these areas will have their own desk. Further, you’ll often have a few “cross-market” desks that will deal with more esoteric forms of credit that don’t neatly fit into any one of the categories above.

Question 3

What is Investment Grade

Answer 3

Investment grade refers to the quality of a company’s credit. To be considered an investment grade issue, the company must be rated at ‘BBB’ or higher by Standard and Poor’s or ‘Baa” or higher by Moody’s.

Question 4

What does the Investment Grade Desk Do?

Answer 4

focuses on trading investment grade bonds in the secondary market – is a bit more flow based as the issuance sizes are large, bonds are liquid, and a wider set of clients will be interested in them (given that they have high credit ratings so a wider swath of clients will be able to hold them).

Question 5

Outline Everything below investment grade (at least 3)

Answer 5

Everything below investment grade includes desks such as high yield, distressed, and CLO trading (although some tranches of CLOs will be AAA, of course).

Question 6

Tranches

Answer 6

Tranches are segments created from a pool of securities—usually debt instruments such as bonds or mortgages—that are divided up by risk, time to maturity, or other characteristics in order to be marketable to different investors.

Question 7

Primary vs Secondary Market

Answer 7

The primary market is where new securities (stocks, bonds, etc.) are issued and sold for the first time, typically through initial public offerings (IPOs). The secondary market, on the other hand, is where already issued securities are bought and sold by investors.

Question 8

CLO

Answer 8

Collateralized loan obligations (CLO) are securities that are backed by a pool of loans. In other words, CLOs are repackaged loans that are sold to investors.

Question 9

CMO’s

Answer 9

Collateralized mortgage obligations (CMO) are securities that are backed by a pool of mortgages. In other words, CLOs are repackaged mortgages that are sold to investors.

Question 10

High Yield Debt

Answer 10

High-yield bonds (also called junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds.

Question 11

Name a key trait of sales roles in credit

Answer 11

1. It is more common for sales people in credit roles to be tied less to the specific product, and more to specific clients and work with them on trades across the credit spectrum.

Question 12

Future of Credit? Is it going to be last to go and why? 4 reasons.

Answer 12

credit will be one of the last places to be automated in any meaningful way (if at all).

1. As you get into more distressed areas of credit – spreads become wide and markets become illiquid. 
2. One has to make a lot of judgement calls on where to price trades, what securities to hold in inventory, and how to hedge your overall exposure.
3. Even in investment grade credit – where things are most liquid – the pace is much slower than in rates trading, for example. More discretion is needed, one has to keep abreast to what is happening with specific credits (meaning specific companies), and 
4. Clients often want more contact (or what some sales people might call hand holding).

Question 13

Issues in Credit. Regulation.

Answer 13

1. Post financial crisis regulations have made it more costly to hold “riskier”, illiquid debt (due to enhanced risk-weighted-asset requirements.
2. traders not being able to have as large of books in areas like distressed debt as they previously had, which has constrained their profitability to a certain degree.

Question 14

What are weighted asset requirements? 3 reasons.

Answer 14

1. determine the minimum amount of capital a bank must hold in relation to the risk profile of its lending activities and other assets.
2. This is done in order to reduce the risk of insolvency and protect depositors.
   The more risk a bank has, the more capital it needs on hand.

Question 15

Corporate Bonds

Answer 15

Bonds Issued by companies rather than governments. Investor lends money to a company for a set period of time, in exchange for regular interest payments.

Question 16

How long are maturities of corporate bonds?

Answer 16

Generally have maturities between 1-20 years (rarely sometimes longer) that have fixed coupons. Coupons are paid semi-annually on a 30/360 day-count convention.

Question 17

Credit Risk

Answer 17

Credit risk is the possibility of loss due to a borrower’s defaulting on a loan or not meeting contractual obligations.

Question 18

Credit Derivatives

Answer 18

• Usually more closely isolate, splice up, amplify, or diminish credit risk in some way.

Question 19

CDS? And how is it agreed?

Answer 19

A credit default swap (CDS) is a type of derivative that transfers the credit exposure of fixed income products.

In a credit default swap contract, the buyer pays an ongoing premium similar to the payments on an insurance policy. In exchange, the seller agrees to pay the security’s value and interest payments if a default occurs.

Question 20

What drives pricing of corporate bonds?

Answer 20

• The credit rating given to the bond (from Moody’s or S&P)
• The historical performance and credit worthiness of the corporation in question
• Where the bond resides in the capital structure
• Is it secured? Unsecured?
• How much debt (bonds, loans, revolvers) are ahead of the bond in question
  What comparable bonds are trading at (or were issued at)

Question 21

How large is the corporate debt market? What kind of credit worthiness do most of these securities have?

Answer 21

• The total corporate debt market – including bonds, loans, and revolvers – is approximately $10 trillion in 2020. S&P has compiled the distribution of ratings below:
• Issuers skewed towards B rates bonds.
  Issue amount peaks at BBB bell curve.

Question 22

What industries are the biggest issuers of corporate debt?

Answer 22

Financials are by far. For the non-financials industry, it is led by utilities, telecom, and tech.

Question 23

How are corporate bonds brought to market?

Answer 23

• Debt Capital Markets (DCM) divisions of an investment bank – that are not part of S&T due to their access to private, confidential information – bring bonds to market.
• These bonds are underwritten by a Lead Manager and a syndicate that will determine the best price the company can get (the lowest coupon they’ll have to offer) and build up a book of investors who will buy the bonds at issuance.

Investment grade, high yield, and distressed debt desks on the trading floor deal with trading these bonds – once issued – in the secondary market. In other words, they provide liquidity to the market so those who buy a bond at issuance do not need to hold them indefinitely and those who weren’t able to buy at issuance can now buy them.

Question 24

Why do companies issue bonds to begin with?

Answer 24

• Bonds are issued primarily due to funding needs surrounding expansions, acquisitions, or a re-balancing of their existing balance sheet.

Question 25

Who buys Corporate Bonds?

Answer 25

• Hedge funds
• Banks (trading desks or internal funds)
• (Very) High net worth individuals
• Pension fund managers
• Endowment funds
• Mutual funds
  Individuals can kind of through ETFs

Question 26

Is everyone who buys investment grade debt as likely to buy high yield debt?

Answer 26

• Almost all market participants who have raised money from outside investors have mandates that constrain them on what they can and cannot do. For example, pension funds have a mandate – in their founding documents – that outlines the amount of risk they are allowed to take on given that funds must be routinely available to pay pension holders.
• Therefore, most pension funds will have very little or no interest in distressed debt – given how risky it can be – but will routinely buy AAA-rated CLO tranches, investment grade debt, etc.

Distressed debt hedge funds have a mandate – from those who have put money into them – to buy high yield and distressed assets. However, investors would likely look unfavourably on a distressed fund having lots of their assets in investment grade bonds.

Question 27

What’s credit spread?

Answer 27

The credit spread is the difference between the yield of a corporate bond and the yield of the underlying government bond (treasury, in the U.S.) of the same duration.

For example, T+250 on a 10-year corporate bond would mean it trades at the ten-year treasury note, plus 2.5% (250 basis points).

Question 28

Do Credit Spreads move?

Answer 28

Credit spreads will widen due to general economic downturns, the company performing poorly, or general pessimism in the credit markets.

Credit spreads will tighten if the economy is healthy, the company is doing well, or credit markets are very active (lots of new issuance, new issuance pricing tight to treasuries, etc.)

Question 29

What credit ratings correspond to investment grade or high yield?

Answer 29

BBB or above.

Question 30

What goes into the credit rating process?

Answer 30

• Business risk: how likely the company is to continue to expand, grow, and be profitable
• Unique financial risks surrounding its capital structure
  Current debt payments
  Likely default rate etc

“Comparable universe” of similar companies and how they’re performing and where their debt is rated.

Question 31

What are the differences in how investment grade and high yield bonds trade?

Answer 31

• Investment grade bonds tend to be originated in larger size, by large companies (that are obviously healthier).
• This makes the market much more liquid; not only because of larger issuance size, but also because banks hold more of these bonds in inventory (because they are safer, thus require less balance sheet to be reserved to warehouse them).
• Investment grade bonds are often – but not always – quoted as a spread against treasuries of the same duration.
  However, high yield and distressed bonds are almost always quoted outright with much wider spreads.

Question 32

What are fallen angles?

Answer 32

• Fallen Angles are bonds that were issued as investment grade but have now fallen below investment grade. In 2020 Fallen Angles became a talking point given the rapid rise in them

Question 33

What happens to credit spreads as credit ratings decline?

Answer 33

• As credit ratings decline, credit spreads increase (denoting the greater risk of default potentially occurring).
• Note that credit spreads will compress when credit markets are hot (meaning when yields are falling and lots of new issuance is occurring, usually because of strong economic conditions).

Question 34

What kinds of debt are most common in capital structures by seniority?

Answer 34

Revolver (Revolving Credit Facility)
o Like a credit card; can be drawn and paid down over the maturity period with some restrictions
* Term Loans
o Can have Term Loan A or Term Loan B (TLBs are often syndicated and traded by a “bank loan desk” on the floor)
* Senior Notes
o Either secured or unsecured
* Subordinated Notes
* Mezzanine Debt
* Preferred Equity
* Common Equity

*

Question 35

How are corporate bonds often hedged (if you want to minimize exposure)?

Answer 35

Any trader will have to maintain an inventory and he or she may not like the direction of the markets or the kind of inventory being held. A common way to hedge is by taking an offsetting position in the underlying treasury (the treasury with the same maturity).

Shortselling, Credit default swaps, Inverse ETFs

Question 36

Inverse ETFs

Answer 36

ETFs that rise in value when the underlying securities fall in value.

Question 37

Convertible Bonds

Answer 37

A convertible bond is a hybrid fixed-income corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares.

The conversion from the bond to stock can be done at certain times during the bond’s life and is usually at the discretion of the bondholder.

Question 38

Why use convertible bonds? (owner)

Answer 38

Convertible bonds provide the capacity for the owner to convert into equity at a pre-set rate. For the issuer of convertible bonds, they have the benefit of allowing them to raise debt at favorable terms and potentially get rid of future interest payments (if their stock appreciates above the pre-set conversion rate).

Question 39

Why use convertible bonds? (Investor)

Answer 39

For the investor, buying provides a position higher in the capital structure than equity if the company ends up defaulting (so could have some level of recovery), but if the company does well it allows for the investor to have higher upside (compared to just getting the pre-set coupon payments of the bond) via converting to equity.

Question 40

Conversion Ratio

Answer 40

This bond’s conversion ratio determines how many shares of stock you can get from converting one bond. For example, a 5:1 ratio means that one bond would convert to five shares of common stock.

Question 42

Callable Bonds

Answer 42

Have gone from being a rarity to being the majority of corporate bonds issued. All callable bonds do is allow for the company to recall part or the entire issuance of bonds after a certain amount of time.

The reason why the company likes to have this feature is that in a declining rates environment, if the company is healthy, they may be able to call the bonds and reissue bonds with a lower coupon (thus saving money).
-
The callable price is above the issuance price.

Question 43

Why would investors ever want a bond that is callable?

Answer 43

If corporations can just call bonds when rates decline, then won’t investors get none of the benefits of yields going down (and thus prices on the bonds going up)? The answer is that the callable price – the price that corporations must pay to recall the bonds – is above the issuance price.

So, the corporation needs to make the determination if the price to retire the bonds early (paying the callable amount above par) is worthwhile given the lower interest rate they can get on a new bond issuance.

Question 44

Puttable Bonds

Answer 44

Puttable bonds just allow for the holder of a bond to redeem it early (get their principal back). They would obviously do this if they feel like new bonds being issued have higher coupons that are more favorable.

Question 45

Why are puttable bonds less common?

Answer 45

However, corporate bonds being puttable is much less common than them being callable. Partly because of the low rates environment we have been in for the past few decades and partly because it creates quite a bit of cash flow uncertainty for a company (as rates rise they suddenly need to have lots of cash to pay back bond holders early).

Question 46

Expected Loss

Answer 46

Expected loss is the probability of the company defaulting multiplied by the loss that will be incurred as a result of defaulting.

Question 46

What are the two most common types of ratio used in credit?

Answer 46

Coverage ratios (ability to meet debt)
* EBITDA / Interest Expense

Leverage ratios (proportion of debt)
* Debt / EBITDA
* Net debt / EBITDA
Debt / (EBITDA – capex)

Question 47

Eurobonds

Answer 47

confusing name for a simple kind of bond: one issued outside the country that the company is based in and the currency most utilized by the company.

Question 48

What 6 qualities would an investment grade issuer (company) have financially?

Answer 48

Strong EBITDA margin
* Low current interest expenses
* Predictable revenue
* High current coverage ratio
* Low current leverage ratio
* Simple capital structure

Question 49

What are covenants

Answer 49

Covenants in finance most often relate to terms in a financial contract, such as a loan document or bond issue stating the limits at which the borrower can further lend.

Question 50

What types of covenants will you likely find in corporate debt (in particular, corporate bonds)?

Answer 50

1. Coverage ratio (min EBITDA / interest expense)
2. Leverage ratio (max debt / EBITDA)
3. Restricted cash (min amount of cash that must be kept aside at all times)
4. Negative pledge provisions (inability to pledge certain assets for new debt)
5. Restrictions on guarantees that can be offered to subsidiaries without prior consent
6. Payment priority in the event of asset sales
7. Additional covenants to protect priority of the debt (meaning the place in the capital structure) and under what conditions additional debt can be placed ahead of this debt

Question 51

What are credit default swaps?

Answer 51

In a credit default swap, there will be two sides: a credit protection buyer and a credit protection seller.

The protection buyer pays a fixed annual fee and will receive payment if a “credit event” occurs on the “reference entity”.

The protection seller on the other hand gets paid annually to provide this “insurance” and may never have to pay out anything, if a credit event occurs, or may have to pay much more than they’ve received in annual payments.

Question 52

What are the two ways CDS contracts can settle?

Answer 52

If a credit event occurs, then CDS contracts can be settled either physically or on a cash basis.

1. If the contact is settled physically, then the CDS buyer will deliver the reference asset (for example, certain eligible corporate bonds, which will obviously have a very low value) to the seller. Then the CDS seller will pay the par value in cash. 

To be clear, when the CDS buyer purchases the reference asset it will be at a very steep discount to par (given that a credit event has occurred, so the company is distressed), but once they deliver the assets to the CDS seller then the seller will pay par.  

If a contact is cash settled, then the physical delivery does not occur. Instead the CDS seller pays the difference between the par value of the reference asset and the auction settlement price.

Question 53

Why would a client buy CDS

Answer 53

1. Speculate on a credit that they think will become distressed and have a credit event. (These kinds of clients are generally distressed hedge funds).
2. Protect yourself from credit exposure to the company:
   ○ If you deal frequently with a company – perhaps they are a large customer of yours or you’ve extended them some kind of credit – you can mitigate your exposure to the company by buying CDS
   ○ Clients who buy CDS for this purpose are large corporations and banks
3. Reduce exposure to a sector
   ○ If you are a large fund you may have lots of exposure to a certain sector – like oil and gas – that you want to hedge
   ○ However, you don’t want to sell your current oil and gas holdings (perhaps because they’re illiquid or you like the particular asset)
   ○ In order to gain downside exposure to the industry, you can pick certain companies (in this example, oil and gas companies) and buy CDS against them
   ○ This rationale will often be that of large funds – like endowments or sovereign wealth funds – who want to buy downside exposure, but can’t entirely shift their portfolio around because it’s so large