Reading 21: Fixed Inc: Rel Val for Credit

Question 1

relative value

Answer 1

• the ranking of fixed income investments by sectors, structures, issuers, and issues in terms of their expected performance during some future period of time
• the future period of time will vary => for a day trader it may be for a few min vs. for a large ensurer it may be multi year.

Question 2

total return analysis (relative value methodology)

Answer 2

begins with a detailed analysis of past returns and projection of expected returns to understand how sectors have done and determinants of returns especially since macro determinants may cause credit markets to display regular patterns

Question 3

when does credit underperform treasuries

Answer 3

during recessions, default risk increases which widens spreads and causes credit to underperform treasuries

Question 4

primary market analysis (relative value methodology)

Answer 4

• primary focuses on new issue supply and demand

- heavy supply actually leads to spread contractions which leads to strong returns

Question 5

MTN

Answer 5

medium term notes

Question 6

what kind of decision making do market dynamics have more an effect on

Answer 6

market dynamics effect long term strategy more than short term strategy

Question 7

the effect of product structure (relative value methodology)

Answer 7

• credit market has become more homogeneous bc bullet and intermediate maturity structures have come to dominate the credit market
• 3 portfolio implications from structural evolutions: 1) bullet popularity has caused securities w/ embedded options to be rare and demand a premium (which may not be priced in by models) 2)20+ yr bonds have become a small % of mkt 3)use of credit derivatives has skyrocketed

Question 8

liquidity and trading analysis (relative value methodology)

Answer 8

credit markets are becoming more liquid as there is pressure to go from “over the counter” to electronic platforms

Question 9

Why execute secondary trades

Answer 9

1) Yield/Spread Pickup
2) credit upside trades (especially popular when people try to determine what will go from HY to inv grade)
3) credit defense trades (when credits are downgraded)
4) new issue swaps
5) sector rotation trades
6) curve adjustment trades (duration tilts)
7) structure trades (going into preferable structures ex: callables, bullets, etc)
8) cash flow reinvestment (there aren’t enough issues in the primary market relative to all the coupons, maturities and partial redemption which forces ppl to go to secondary)

Question 10

which is a better framework for assessing potential trade performance

Answer 10

total return framework (not yield measures)

Question 11

examples of portfolio constraints

Answer 11

• rules that have asset managers sell a bond when it gets downgraded to speculative ratings. But selling it immediately is usually the worst time to sell
• being confined to local currency markets. Some issuers will trade at different spreads across markets

Question 12

shortfall risk

Answer 12

probability that the outcome will have a value less than the target return

Question 13

trading constraints

Answer 13

1. portfolio constraints
2. “story” disagreement
3. buy and hold
4. seasonality

Question 14

what is the main unit via which relative value analysis is done for the credit market

Answer 14

nominal spread (yield dif b/t corporate and govie bonds of similar maturities)

Question 15

valuing credit using OAS

Answer 15

• some prefer it so they can compare credit to vol sectors like MBS
• but given the reduction of credit structures with embedded options since 1990, it’s not used too often

Question 16

what is the european credit market like

Answer 16

• it’s been consistently homogeneous

- most issuance is : high quality and of intermediate maturity

Question 17

which valuation benchmark does Europe and Asia commonly use?

Answer 17

They commonly use swap spreads. Europe’s homogeneous credit market and having most issuers be financials makes them more willing to use swap spreads

Question 18

what is the swap spread valuation methodology?

Answer 18

it’s looking at what a credit bond yields and then essentially assuming you enter a swap where you pay that yield and you see what you receive from the swap. It’s a way of taking that fixed bond yield and converting it to receiving libor + something. This could be valuable since getting floating could be good if you think rates will rise.

Question 19

benefits of the swap spread framework

Answer 19

allows managers to more easily compare securities in fixed and floating markets

Question 20

drawbacks of the swap spread framework

Answer 20

• less relevant for speculative securities where default risk become more impt
• individual investors not comfortable with bond valuation using swap spread