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various categories of corporate debt were –

loan stock,
preference shares.


In analysing corporate debt the key issue to be considered is, generally:

the security of the debt and
the risk of default.


the use of credit derivatives has

significantly deepened the market for corporate debt.
Associated with this have been the study of credit risk
and the allowance for risk of default in pricing.


use credit derivatives to

reduce their exposure to the risk of default.


one method of pricing corporate debt and assessing credit risk

based on the information about the credit risk
of the debt contained within the company’s equity.


Can Calculate expected default losses from bond prices :

a credit rating gives
an indication of the
creditworthiness of a bond.


A typical categorisation system of credit rating – such as that used by Standard & Poor’s:

grade of AAA to the most creditworthy bonds,
which are deemed to have
almost no chance of defaulting.
AA is then the next best rating,
then A,
then BBB,
then BB and so on.


Fundamental analysis of bonds entails

The process of credit rating


Zero-coupon yield curves are derived by

a process called bootstrapping – .


ZC Yield curves can be used to:

value other bonds.


Example of Bond risk

Historical evidence suggests that 
the average probability of default
within the next 5 years
by a corporate bond currently rated AAA by Standard & Poor’s is about 0.1%,
whereas for a bond rated BBB the corresponding probability is over 2%.
margin over risk-free rate
(% pa)


The higher yield on corporate bonds is entirely due to :

compensation for the additional risk
from investing in these instruments.


It is generally accepted that there are two primary additional risks associated with Corporate Bonds:

1. Default risk –
⁃ which is the risk that the issuer
⁃ will not be in a position to make payment
⁃ of the interest or redemption payments,
⁃ either on the due dates or at all. 

2. Liquidity risk (strictly marketability risk) –
⁃ which is the risk that a holder of the bond will not be able
⁃ to realise value for it
⁃ in certain market conditions.
⁃ This might be because
⁃ the bond has certain unusual terms or covenants,
⁃ or because the issue is small
⁃ and unlikely to be attractive to major investors. 

Default and liquidity risk are not necessarily independent.

For example
if a company is in financial difficulties,
not only may it be more likely to default on debt interest payments,
but the debt may also be less marketable.

market liquidity tends to be less
at times of economic distress
when overall defaults will tend to be higher.


Corporate bonds typically

yield more than comparable Treasury bonds.


Bond traders construct

zero-coupon yield curves
for bonds of different credit rating categories and
by comparing these
to comparable Treasury curves
we can see the magnitude of
this excess credit spread
for different maturities.


The credit spread typically is

significantly in excess of historic default losses,
so that an investor could expect significantly higher returns
from investing in corporate bonds
than from investing in Treasury bonds.


Actual default losses can be calculated

using historical data.


The excess of the yield on corporate bonds over Treasury bonds is typically 
decomposed into four components:

1. Compensation for
⁃ expected defaults. 

2. Investors may expect
⁃ future defaults to exceed historic levels. 

3. Compensation for
⁃ the risk of higher defaults, ie
⁃ a credit risk premium. 

4. A residual that includes
⁃ the compensation for the liquidity risk —
⁃ typically referred to as an illiquidity premium.

Techniques being considered include :

1. the use of option pricing models using equity volatility
⁃ to estimate the risk of default (see Chapter 12), and

2. the use of credit default swaps (see Section 2.4 below)
⁃ to estimate the market premium for credit risk.


Credit derivatives are

where the payoff depends partly upon
.the creditworthiness of
one (or more)
commercial (or sovereign)
bond issuers.


Credit derivatives are used for

managing credit risk


The two most common types of credit derivative are:

1. credit default swaps 

2. credit spread options.

third also :
.credit-linked notes in the discussion that follows.


Why is part of the higher yield on corporate bonds compensation for the risk of higher defaults over and above that indicated from historical data?

because bond investors are typically risk-averse.
So they will demand higher returns
from riskier bonds
even after allowing for the expected default losses
because of the greater uncertainty
regarding the returns provided.


A credit default swap is

a contract
that provides a payment
if a particular event occurs.
For example,
it may give Bank X
the right to sell a bond
issued by utility Company Y
to Bank Z
for the face value of the bond
should Company Y default on the bond.
The bond involved is sometimes referred to as
the reference bond.


Credit events are

Events that trigger payments under credit derivatives


Examples of credit events include:

  bankruptcy (
1. insolvency,
2. winding-up,
3. appointment of a receiver) 

  a rating downgrade 

  cross-default.
1. A cross-default clause on a bond means
2. that a credit event on another security of the issuing firm
3. will also be considered as a credit event on the bond in question.
4. In addition, it is important to note that
5. default does not necessarily mean that all the money loaned is lost.
6. usually possible to recover (eventually) at least some of the money loaned,
7. the proportion recovered being referred to as the recovery.


Buying a Credit Default swap

The party that buys the protection
pays a fee to the party that sells the protection.
If the credit event occurs within the term of the contract
a payment is made from the seller to the buyer.
If the credit event does not occur within the term of the contract,
the buyer receives no monetary payment
but has benefited from the protection during the tenure of the contract.
So, in the example above,
Bank X would pay a fee to Bank Z,
typically in the form of a regular premium over the term of the swap.
By doing so, it would effectively be purchasing insurance against the risk of the bond defaulting.


two ways to settle a claim under a credit default swap:

A pure cash payment,
representing the fall in the market price of the defaulted security.
the market value may be difficult to determine. 


two: The exchange of
both cash and a security
(physical settlement).
The protection seller pays the buyer
the full notional amount
and receives, in return, the defaulted security.


In practice, CDS settlement is often based on

the difference between the face value of the bond
and the value of the recovery, R.
So, in the first case, a cash payment based on 100 - R would be made,
whereas in the second case,
the bond (now worth R) would be handed over
and a cash payment of 100 made

the net payment to the buyer of protection in the event of default is based on
100 - R .


Banks and CDSs

Banks have historically been
the largest users of credit default swaps,
although institutional investors have
become significant participants in the market.


Using CDSs to Maintain credit relationships with a client

Lenders who have reached their internal credit limit with a particular client,
but wish to maintain their relationship with that client
can use credit default swaps to
reduce their aggregate exposure to the client.
Given the relationship need,
the main users of credit default swaps are banks.