Credit Strategies Flashcards
Spread duration
Provides the approximate percentage increase in bond price expected for a 1% decrease in credit spread (or vice versa)
The reason why credit spreads tend to be negatively correlated with risk-free interest rates
A better economic environment generally leads to higher risk-free rates and narrower credit spreads, whereas a weaker economic environment generally results in lower risk-free rates and wider credit spreads
Empirical duration
- A measure of interest rate sensitivity that is determined from market data
- Calculated by running a regression of a bond price returns against changes in a benchmark interest rate
- Tends to be smaller than effective duration
Benchmark spread
- = the yield on a credit security - the yield on a security with little or no credit risk (benchmark bond) with a similar duration
- There is sometimes a mitmatch in duration between the credit security and the benchmark security
G-spread
The spread over an actual or interpolated government bond (benchmark bond)
I-spread
The spread over an interpolated swap rate
Z-spread (zero-volatility spread)
The yield spread that must be added to each point of the implied spot yield curve to make the present value of a bond’s cash flows equal its current market price
Option-adjusted spread (OAS)
The constant spread that, when added to all the one-period forward rates on the interest rate tree, makes the arbitrage-free value of the bond equal to its market price
Excess return
EXR ≈ (s × t) – (Δs × SD) – (t × p × L)
- s is the spread at the beginning of the holding period in percentage (20 bps is 0.20)
- t is the holding period expressed in fractions of a year
- Δs is the change in the credit spread during the holding period
- SD is the spread duration of the bond
- p is the annualized expected probability of default
- L is the expected loss severity
Bond price change following a change in spread or modified duration
priceafter = pricebefore * [1 + (-duration * Δs)]
- Δs is the change in bps (20 bps is 0.0020)
Granularity of a benchmark classification
The investor typically wants each sector to contain a set of companies for which he expects company-level risks, rather than industry or macro risks, to be the dominant factors
Credit-related risks
- Credit spread risk
- Credit migration risk
- Default risk
- Liquidity risk
Principal considerations for bonds selection
- Liquidity
- Portfolio diversification
- Risk
Considerations in Bottom-Up Relative Value Analysis
- Bond structure
- Issuance date
- Supply
- Issue size
Primary macro factors important to credit investing
- Economic growth
- Overall corporate profitability
- Default rates
- Risk appetite
- Changes in expected market volatility
- Changes in credit spreads
- Interest rates
- Industry trends
- Currency movements
Measuring Credit Quality in a Top-Down Approach
- Average credit rating
- Average OAS
- Average spread duration
- Duration times spread
Duration times spread (DTS)
- For a bond = duration * OAS
- For a portfolio = weighted average of individual bonds DTS
Most important risks for:
- High-yield portfolio
- Investment-grade portfolio
- Credit risk
- Interest rate risk, spread risk and credit migration (credit downgrade)
Liquidity management tools
- Cash
- Position sizing
- CDS index derivatives
- ETFs
- Liquid bonds outside the benchmark
Two principal tools that investors use to manage tail risk
- Portfolio diversification
- Tail risk hedges
Spread sensitivity
Measures the impact on credit spreads of large withdrawals by investors from credit funds
CDOs tranches
- Senior
- Mezzanine
- Subordinate/Equity
CDOs senior and subordinate tranches correlation impact
If the correlation of the expected defaults on the CDO collateral of the senior and subordinated tranches is positive, the relative value of the mezzanine tranche compared with the senior and equity tranches will increase
