FIXED-INCOME ACTIVE MANAGEMENT: CREDIT STRATEGIES

Question 1

Identify the two crucial components of credit risk

Answer 1

Loss given default (loss severity)

Probability of default

Question 2

Contrast IG bonds and HY bonds in terms of sensitivity of risk.

Answer 2

IG Bonds are more sensitive to Credit migration. The risk that the bonds get downgraded.

HY bonds are more sensitive to default risk.

Question 3

Contrast corporate defaults, credit spread level and credit spread slope in Early expansion vs Peak

Answer 3

Corp Defaults : Rising vs stable
Credit Spread level : stable vs rising
Credit slope level : IG - stable, HY - Inverted vs IG and HY Upward

Question 4

Contrast empirical duration vs analytical duration

Answer 4

Empirical duration will take into consideration actual bond price returns and benchmark rate change to assess the duration of a bond. Since bonds fluctuation is based on rates changes and credit, duration will be lower to reflect the impact of spreads. Analytical duration is the basis modified duration that we use.

Question 5

Define the i-spread and give one advantage

Answer 5

YTM of the bond minus the interpolated swap fixed rate.

One advantage : based on tradeable derivative that can be used to hedge duration or measure carry returns.

Question 6

Define Asset swap spread

Answer 6

Bond coupon minus the interpolated swap fixed rate. It indicate the spread that the bond is offering over the fixed leg of the swap (MRR)

Question 7

What is the CDS basis ?

Answer 7

Difference between the CDS spread and the Z-spread.

Question 8

Identify one drawback of the discount margin in floating rate note spread mesure and explain how this can be address

Answer 8

Drawback : Discount margin assume that the MRR curve is flat. Zero-discount margin address this by incorporating the term structure of interest rate into its calculation.

Question 9

Whats the formula of duration time spread and what does it exhibit

Answer 9

DTS = EffectiveSpreadDuration * spread.

It explain the relationship that a bond with a higher spread will see higher fluctuation than a bond that has lower spread.

Question 10

Whats the formula of Expected excess spread?

Answer 10

Spread - (POD * LGD) - (fluctuation in spread * EffecSpreadDuration)

Question 11

What’s credit loss rate

Answer 11

the historical percentage value loss due to default.

Question 12

For a bottom-up credit strategies, what are the factors to consider when we are analyzing the likelihood of the issuer making the promised payments.

Answer 12

1. Operating history and competitive position in the industry.
2. Financial ratio : EBITDA/Assets, Debt/Equity, EBITDA/Interest

Question 13

Identify and explain the two major categories of credit risk models.

Answer 13

Structural models : Assume that POD is driven by the likelihood that the issuers’ future asset value falls below a threshold level. It measures how far away the issuer is of defaulting related to the volatility of their assets. That volatility metrics is often taken from equity data such as market cap.

Reduced Form : Look for relationship between macroeconomic data and individual characteristics of the issuer to analyse the default intensity (POD) of the bond issuer. Can be done with Financial ratio.

Question 14

Whats the purpose of the Altman z-scores.

Answer 14

Uses a bunch of multiple associated with financial ratio. If the results is above 3, there a low chance to default. If between 3 and 1.8, might have some risk. Below 1.8 is high chance that issuer default.

Question 15

In a factor-based credit strategies, what are the four factors that has been identified to offer a risk premium for corporate bonds.

Answer 15

1. Carry : Expected return if condition remains unchanged, measured by OAS.
2. Defensive : Empirical observations that lower risk assets offers higher risk-adjusted returns than higher risk assets.
3. Momentum :Bonds that have recently outperformed tend to outperformed in the future.
4. Value : Low market value versus fundamental value.

Question 16

How can a manager measure the transaction cost of his investment.

Answer 16

With effective spread :

Buy order = Trade size * (Trade price - mid quote)

Sell order = Trade size * (midquote - trade price)

Question 17

What are the methods a fixed income manager can do to manage liquidity risk

Answer 17

1. Buy liquid assets short term and illiquid assets long term.
2. ETF
3. CDS
4. Assets swaps to hedge exposure on illiquid bonds the time it takes to transact.

Question 18

Define Tail risk

Answer 18

Losses due to unfrequent but high negative impact events.

Question 19

Identify the most common approach used to derive the return distribution from which VAR is estimated

Answer 19

Parametric methods : Assumes returns are normal and uses standard deviation and mean to calculate the loss at a given percentile of the distribution. Drawbacks : Assume returns are normal so doesnt perform well for non normal distribution like options.

Historical simulation : Takes historical risk factor (spread movement, rates) to generate a return distribution. Good because we can take in considerations bonds with embedded options but is really dependant that the past will predict the future (which is not always the case)

Monte Carlo Simulation : Generates return distribution though random simulations from a user defined model. Good since we can incorporate non-normal distribution. Really dependant that the model is well specified.

Question 20

Drawbacks of VAR

Answer 20

1. Tail event tend to be more frequent and more severe than estimated by VAR
2. Fails to capture correlation and liquidity during market stress
3. Fails to quantify expected loss during a tail event.

Question 21

Whats the formula to estimate the CDS price

Answer 21

CDS price = 1 + (fixed rate - CDS spread) * EffSpreadDur cds

Question 22

How can a manager make a profit from his view that the credit spread curve will remain unchanged.

Answer 22

1. Reduce the credit quality of the portfolio to profit from a higher yield carry.
2. Take a position in longer dated bond to profit from higher yield.

Question 23

Explain what are structured credit instruments

Answer 23

Allow investors to invest in securities that are backed by debt-based collateral such as pool of mortgages or commercial loans.

Question 24

Identify the two primary reasons an investor would want to invest in structured credit

Answer 24

1. Structured credit offers tranches with different risk profile that would not be available by investing directly in the collateral. Investor can take different exposure by investing in the different tranches.
2. Structured instrument offers exposure to collateral that investor would not have access directly (exemple, mortg backed securities, asset backed securities, covered bonds.)