Fixed Income Active management Flashcards
What are the “C” of credit analysis ?
Capacity Collateral Covenant Character Capital
What are the components of the credit risk ?
Default risk
Loss severity
What are the prime considerations for High yield and Investment grade PM ?
High yield PM are more concerned with credit risk while Investment grade are more concerned with interest rate risk
What is spread duration ?
Spread duration provides the approximate percentage increase in bond price for a % increase in credit spread
New price = Old price [1 + (-spread duration(end spread -beg spread)
For fixed coupon bond, spread duration is approximately equal to modified duration. For floater, it is rather different.
Elaborate on risk exposure for High Yield and Investment Grade
Investment Grade have higher sensitivity to interest rate risk while High Yield have more sensitivity to credit risk. Thus PMs in High Yield manage credit risk and PMs in Investment grade manage duration.
However during good time with narrow spread, High Yield behave like Investment grade and become more sensitive to interest rate risk.
Elaborate on risk for High Yield and Investment Grade
Investment grade market is larger than High yield. Bond in Investment grade are quoted in term of benchmark + spread and high yield which behave like equities are quoted by price
What are the main factors affecting credit spreads
- PD
- LGD
- Credit migration
- Market liquidity
Elaborate on Benchmark spread and G-spread
Benchmark spread is the difference between the yield of the credit security and the riskless security.
The G-spread is the difference between the credit security and the interpolated or actual government bond. The main advantage of the G-spread is its simplicity.
Elaborate on G-Spread extrapolation
1)
[longest maturity G-bond-Corporate bond maturity]/[longest maturity G-bond-smaller maturity G-bond]
2)
the ration found corresponds to the x% attributable to the smaller maturity G-bond and the (1-x)% is attributable longest maturity G-bond
3)
The linear interpolation is found my multiplying the x by the attributable bond yield.
Elaborate on I-Spread
The I-Spread is quite similar to G-spread except that it uses swap rate as its base. If G-spread or I-spread entails some credit risk, then it is not a good representation of risk free rate. For investor hedging interest rate exposure, the choice of the hedging instrument should correspond to the choice of spread measure used.
Elaborate on Z-Spread and AOS
I-Spread and G-Spread are good for pricing credit securities. However investors use Z-spread and AOS to compare relative value across credit securities.
Z-spread is the the spread that must be added to the implied spot yield curve to make the present value of a bond CF equals its current price. For bond without embedded options, Z-spread is a good measure of bond’s credit spread.
AOS is the spread which when added to all the one-period forward rates on interest rate tree, makes the arbitrage-free value of the bond equal to its market price.
Excess return (XR)
XR = (st)-(Δs * sd)-(pd*t)
How to construct a bottom-up portfolio ?
Start by dividing along sector line then pick your weighting scheme. another approach is to use spread duration. The main advantage of bottom-up is the informational advantage.
Example
Assume a benchmark with 8% mcap retail sector.
The benchmark spread duration is 4. The retail sector spread duration is 5. Measured by spread duration, the retailer weight will be (5*8)/4=10%
Elaborate on sizing.
If default losses are the most sanguine concern, then market value is the right metrics, if spread risk is the right key risk, then spread duration is appropriate.
Elaborate the construct a top-down portfolio ?
Cluster into Investment grade and high yield.
Real GDP growth rate and default rates are fairly correlated. The correlation between default rates and spread are even higher. The main advantage of top-down approach is that portion of the credit return can be attributed to macro factors.
