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READING 25: FIXED-INCOME ACTIVE MANAGEMENT: CREDIT STRATEGIES (MODULE…

- - - - risk-free rates and spread often move in opposite directions (negatively correlated)
        i.e. stronger economic conditions often lead to
        increasing risk-free rates but decreasing risk of default, increasing credit ratings,and lower spreads and vice versa.
    - - modified duration measures its change to general interest rate movement
        
        spread duration measures its price change if only spread (due to credit risk) has changed
        
        For most bonds, modified duration and spread duration are the same, except floating rate securities
        
        For fixed-rate bond,
        the effect of modified duration and spread duration are the same because future cash flows of the bond are fixed, regardless of why the yield changed.
        
        For floating rate bond,
        
        The price is insensitive to the rate change (decline less when yield up) because the future coupons adjust upward with the rate increase.
        
        The price will decline more ( when spread up), The reason is the coupons only adjust for general change in rates and not for specific spread change related to this issuer.
        
        Because spread reflects compensation for taking credit risk, the much higher credit risk in HY is reflected in much higher spread.
  - - - Benchmark G- Spread: is the difference in YTM of a bond and a similar duration credit risk-free
        benchmark bond (ie on-the-run government bond)
        G-spead = YTM normal bond- YTM G.bond
        
        a limited number of such government bonds >> a straight line interpolation of YTM is made between the two closest bracketing duration government bonds >> used as the benchmark and the resulting spread is called the G-spread
      - I-spread: the same way as the G-spread but is based on swap fixed rates as the benchmark yields
        I-spead = YTM normal bond- SFR of high quality bond
        
        Advantages are a smoother yield curve
        
        Disadvantages: SFRs normally reflect very high quality (but not fully credit risk free) rates. In periods of crisis this may not hold
        
        Disadvantages: SFRs are not the same as government bond yields and so I- and G-spread are not identical
      - Z- spread: (Zero-volatility spread) is a trial and error calculation to determine a single spread that if added to the implied initial spot rate curve of credit risk-free bonds could then be used to discount the bond's future cash flows to its current market value.
        (implied initial spot rate G-bond + Z-spread) = discount rate (i.e. YTM)
        
        Does not consider embedded option features. If there are no embedded options, Z-spread will closely approximate the other nominal spread measures.
      - OAS (option adjusted spread) : is a more complex derivative of Z-spread and does reflect the impact of options on expected return.
        (implied initial spot rate G-bond + OAS ) = discount rate to arrive at current market value (i.e. YTM).
        
        requires an assumption of interest rate volatility to build interest rate tree of possible forward interest rates.
        
        OAS, a trial and error calculation, to determine a single spread that if added to every node of the interest rate tree of credit-risk-free bonds would discount the bond's future cash flows to its current market value.
        
        it can be misleading because it measures a
        simulated average result
        
        In any one time period, rates will follow a single path, the option will or will not be exercised, and actual results can be considerably) higher or lower than the OAS (average).
      - further expanded to incorporate loss in excess return due to probability of default (p) and severity of loss (L) during the time period
        XR or EXR = (spread x time) − (Delta spread x Spread Duration) − (t x p x L)
        s= spread , t = projected time period,
- - - - Final credit portfolio construction involves identifying the optimal risk exposures and best relative value holdings, and is likely to involve compromise.
        
        when default is not expected to be a significant factor, sensitivity of the portfolio to spread change is the most relevant measure of spread risk.
        
        HY and bonds where default risk is high, market value allocation is the more relevant measure of credit risk
    - - Spread curves are another useful bottoms up tool. (https://bit.ly/2DW6ryv)
  - - - focuses on macro factors that are likely to affect the credit portfolio
      - Top-down may focus on historical patterns such as the credit cycle and credit spread change.
      - default rate and spreads are also highly correlated so the manager must generally be able to anticipate the next change in economic conditions to add value
      - top-down manager would likely vary the portfolio's average credit rating upward to a higher (or downward to a lower) rating in anticipation of weaker (or stronger) than consensus expectations for economic growth
        
        “non-arithmetic1 scales assign a number that increases much more rapidly than 1, 2, 3, 4 as credit rating declines (e.g., 1, 10, 20, 40 is used by Moody's) =>> to show that exposure to credit risk increases at a faster than linear rate, as bond rating declines
      - Portfolio average OAS (or other spread)
        
        Spread duration
        
        duration times spread (DTS) provides a more comprehensive indication of credit risk that either alone.
      - use historical spread between credit risky sectors to assess relative attractiveness.
        
        Plotting the historical spread for other relationships: tracking the spread difference between 15- and 5-year A-rated bonds to gain perspective on the past relationship and as a starting point for developing a view on how the spread may change
    - - top-down managers are more likely to also actively manage interest rate risk
        
        bottom-up managers will generally just match interest rate exposure to that of their benchmark in order to focus
        on security selection issues.
        
        Increase (or decrease) duration if interest rates are expected to decrease (or increase).
        
        Adjust key rate duration exposures to profit from expectations regarding nonparallel yield curve shifts.
        
        Adjust exposure to option features, increasing long (or short) call option positions if volatility is expected to increase (or decrease).
        
        Increase (or decrease) convexity before large increases (or decreases) in volatility
        
        It can be difficult to simultaneously manage interest rate and credit risk without derivatives
- - - - Trading vol down
        
        Credit spread is sensitive to flows of funds in the credit markets
        
        The difference in bid-ask is often used as an indicator of liquidity but has become less reliable.
        
        Solutions
        
        Hold larger % in cash/ more liquid assets ( accept lower return)
        
        Trade CDS
        
        Use IG or HY ETFs as a temporary investment to gain market exposure and diversification
  - - - Tail risk: returns experiences more large declines than
        consistent with their standard deviation.
        
        Should try to quantify the potential losses with the following
        
        Scenario analysis /
        Historical analysis /
        Hypothethical scenarios
        
        Hold adequate top quality securities
        Diversify the portfolio
        Use tail risk hedges (CDS)
  - - - bond issuers in that country may generate significant
        revenue and profit in other countries, exposing the investor to global risks
        
        The size of the emerging market (EM) bond sector has been increasing and is now similar in size to the U.S. high-yield (HY) sector
        
        EM
        
        The size of the emerging market (EM) bond sector has been increasing and is now similar in size to the U.S. high-yield (HY) sector
        
        Direct government ownership or stakes in companies is high.
        
        The rating on EM non-government bonds may in some cases understate true quality
        
        Global bond portfolio
        
        Liquidity is a greater concern
        
        Currency risk
        
        Legal risk can be greater with less familiar or less developed legal protections and bankruptcy law
- - - - Higher yield and expected return
        
        Tailored risk exposure through multiple tranches with varying levels of risk ranging from first tranche (often AAA) to me''anine last tranche
        
        Exposure to specific market sectors such as real estate, consumer credit, or bank loans
        
        A diversification benefit. Adding structured finance instruments to a credit portfolio may leave returns unaffected but lower portfolio standard deviation.
      - multiple types of structured finance
        
        Mortgage-backed securities (MBSs) are pools of mortgage-backed loans
        
        a. Government agency backed MBSs (higher liquidity)
        b. MBSs have tailored exposure to specific segments of the real estate market
        c. MBSs are a means of adjusting portfolio exposure to interest rate volatility (the borrower the right to prepay the loan) MBSs offer a different exposure to credit risk from that of the corporate bond market.
        
        Suppose OAS on CMBS is higher than normal compared to corporate bonds, and an investor believes real estate prices are likely to improve but corporate profits may be under pressure, it should be profitable to shift out of corporates and into CMBS
        
        Asset-backed securities (ABSs) are backed by non-mortgage (generally consumer) debt
        
        Collateralized debt obligations (CDOs) are backed by various forms of debt obligations. CDOs are normally structured in tranches.
        
        potential benefits include
        
        Opportunities to identify relative value
        
        Opportunities to express a view on correlation within the underlying collateral
        
        Leveraged exposure to credit risk )(i.e..
        
        The bottom tier tranches of a CDO are akin to a highly leveraged investment in the collateral. If everything works, the return will be high, but if there are losses in the collateral, they may have no value
        
        Covered bonds are bonds that are typically issued by a financial entity such as a bank. They are a form of collateralized debt (backed by specifically identified assets of the issuer) and also general obligations of the issuer.