21-1 fixed-income active management: credit strategies
2 invesment-grade and
high-yield corporate
bond protfolios
3 credit
spreads
credit
spread
measures
excess
return
credit
risk
credit
migration
risk and
spread risk
interest
rate risk
liquidity
and trading
investment-grade corporate bond
higher credit ratings / lower credit and default risk / lower yields
four Cs of
credit
analysis
capacity
collateral
covenants
character
extended -
capital
evaluate credit
worthiness
-credit models
losse caused by a counterparty's or debtor's failure to make a promised payment
two
components
default risk - the probability that defaults or fails to meet obligation
loss severity / loss given default - amount of loss if a default occurs
credit
loss rate
represent the persentage of par value lost to default for a group of bonds
= default rate * loss severity
on high-yield bonds is substantially higher and more variable
risk consideration
high-yield: credit risk - most important
investment-garde: credit migraton / spread / interest rate risk
credit migration risk
deterioration in credti quality
riskier - credit spreads typically widen / increase
forced sales - losses to a portfolio
spread
duration
measure for sensitivity to change in credit spreads
approximate percentage increase in price expected for 1% decrease in credit spread
non-callale fixed-rate corporate bonds -
spread duration generally very close to modified duration
floating-rate bonds - spread duration can differ substantially from modified duration
emphasis on postition's market value
market value-based risk measures
do experience meaningful spread chagnes even in absence of default
credit spreads tend to negative correlated with risk-free interest rates
-key macro factors ususally have opposite effects on each other
the price hehavior with high credit risk often more closely resembles that of equities
empirical
duration
-to run a regression
a measure of interest rate sensitivity determined from market data
smaller than theoretically based effective duration
negative - when risk-free interest rates fall, credit spread rise by more than the magnitude of change in interest rates
investment -grade: manage portfolio durations and yield curve exposure closely
high-yield: focus on credit risk
highly rated bonds - lower credit spreads - greater empirical duration
liquidity: ability to purchase or sell an asset quickly and easily at price close to fair market value
referenced measure - bid-ask spread
tend to positively correlated
with issue size and traded size
bond dealers - another factor
investment-grade - quoted as spreads over benchmark government bonds
high-yield - usually quoted in price terms
function of
several
factors
likelihood of default
probable loss given default
credit migration risk
market liquidity risk
benchmark
spread and
G-spread
benchmark - on-the-run government bond:
the most recently issued benchmark-size security of a particular maturity
problem - potential maturity mismatch
I-spread
G-spread - when benchmark is government bond
simolicity - a key advantage
useful for
indicate a way hedge credit interest rate risk
estimating yield and price changes for fixed-rate credit securities that not have optionality
normally uses swap rate that the same denominated currency
a key advantages - swap curves may smoother than government bond yield curves
a benchmark rate usually most helpful when represent a credit risk-free rate
credit investor sometimes hedge interest rate exposure using benchmark bonds
hedging instrument - spread measure used
Z-spread /
zero-volatility
spread
the yield spread must added to each point of implied spot yield curve to make the PV of bond cash flow equal its current market price
good measure of credit spread for bonds without embedded options
option-adjusted
spread OAS
more generalized version of Z-spread
the constant spread added to all the one-period forward rate on interest rate tree, make arbitrage-free value of bond equal to its market price
most useful for conparing bonds with different features - embedded options
main shortcoming - depends on assumptions regarding future interest rate volatility
the realized spread will different from OAS depend on whether option actually exercised
the most widely accepted measure of credit spread
in a portfolio
context
each bond's OAS is weighted by its market value
the return of a bond after interest rate risk has been hedged
the compensation a investro receives for assuming credi-related risks
XR ≈ (s × t) – (Δs × SD)
SD: spread duration
t: holding period
incorporated possibility
of future default losses
EXR ≈
(s × t) – (Δs × SD) – (t × p × L)