P6 - Fixed Income active managment: Credit strategies

Question 1

Explain the concept of a spread

Answer 1

The excess return of a bond over comparable benchmark security, compensates investors from risks inherent in the bond that are not inherent in the benchmark

Question 2

Explaint the (2) main components of risk

Answer 2

POD - Probability of default - the chance that the issuer fails to make payments on its obligations when due
LGD - Loss given default - Proportion of investment lost if a default occurs. (1-RR)

RR = Recovery Rate

All credit loss from a credit risky security are equal to the sum of POD x LGD.

Question 3

When I say the first, second, third lien what’s the mean

Answer 3

Lien is a legal term to the ranking claim or collateral for a borrowing

Question 4

Explain how to plot a credit spread curve and the change in shape given the business cycle

Answer 4

Plot credit spread vs. maturity

Question 5

Explain the difference between empirical and analytical (eg. modified) duration

Answer 5

Based on regression of market data of actual bond returns and benchmark rate changes. For low quality securities empirical duration will be lower than analitical duration.

Question 6

Explain the concept of yield spread

Answer 6

Is the YTM minus YTM closest on the run gov bond.

Question 7

Explain the concept of g spread and formula

Answer 7

Bond YTM minus an interpolated YTM of the two adjacent maturity on the run gov bond

Question 8

Explain the concept of i spread and formula

Answer 8

Bond YTM minus the maturity interpolated swap fixed rate.

Question 9

Explain the concept of ASW spread and formula

Answer 9

Bond fixed coupon minus the maturity interpolated swap fixed rate.

Question 10

Explain the concept of Zero volatility spread (z-pread)

Answer 10

Uses trial and error calculation to determine the single spread that when added to RFR discounts bond’s future cash flow back to its current market value

Question 11

Explain the concept of Z
Option adjusted spread (OAS)

Answer 11

Only spread that measure appropriate for assessing credit/ liquidity bonds with embedded options.

Question 12

Explain the component of return of floating rate note (FRN).

Answer 12

Question 13

Explain the concept of discount margin of floating rate note (FRN).

Answer 13

Discount margin effective margin above/ below MMR+ QM.

Question 14

Formula for effective duration in FRN contracts

Answer 14

Question 15

Explain the meaning of MMR

Answer 15

MRR= market reference rate

Question 16

Explain the meaning of zero discount margin (Z-DM) and the difference for DM

Answer 16

DM assumes that MMR is flat. And Z-DM assumes that it’s a curve.

Question 17

Explain the difference between rolldonw return and change in yield

Answer 17

Question 18

Formula of efective duration and convexity

Answer 18

Question 19

Explain the formula of DTS - Duration times spreads (DTS)

Answer 19

Question 20

Explain the concept of excess spread

Answer 20

Excess spread from suffering credit losses

Question 21

Formula for price appreciation vs. depreciation vs. change in credity quality

Answer 21

Remenber the first part is the delta yield and second part (1+change)

Question 22

Explain the two models of credit risk models structural and reduced form models. Remember an example of reduced form model.

Answer 22

Structural models estimates the future POD this models mesure how far away from defauting an issuer currently is in term of volatility (come from market cap, equity price vol).

Reduced form models look for macro conditions and individual characteristcs of borrower.

Question 23

Explain the caracteristcs of top down credit strategies in context of macro analisys

Answer 23

The main difference of botton uo strategies is that top down focus on factors that are likely to affect the credit portifolio. (ex. strength of economic growth and corporate profits)

Question 24

Explain the (4) factors that are used in factor based strategies

Answer 24

(1) Carry - measure by OAS
(2) Defensive - lower risk assets has higher risk adjusted return than higher risk assets
(3) Momentum- Bonds that have recently outperformed/ underperformed
(4) Value - low market value vs. fundamental value.

Question 25

Explain the ESG factors that can be used for credit analisys.

Answer 25

Negative screening - excuding industries, sectors with poor ESG records ESG rating - favorable ESG characteristics Investing directly fund ESG - FAMA for example

Question 26

Formula explain the logic for comparing two bonds:

Answer 26

After calculate the excess spread. Values above 1 indicates that mantain the bond will give +x% incremental return. Otherwise is true.

Question 27

Explain the concept of tail risk, and considering VaR as principal mesure explain the main drawbacks.

Answer 27

Refers to risk of losses due to infrenquent but high negative impact events. The main drawbacks: - Tail events tend to be more frenquent and more severe - Fails to capture changes in correlation and liquidity during times of market stress - Fails to quantify the expected loss during tail event.

Question 28

Explain the concept of CDS

Answer 28

Derivative contract that involve two parties - a protection buyer and a protection seller. Protection buyer pays a regular fixed coupon to the protection seller for cover a potential losses upon credit event

Question 29

In a scenario of economic downturn explain wich bond will widen more HY vs IG (High yield vs. Investment Grade)

Answer 29

In this situation think about flight to quality. Hy tend to widen more than investment grade.

Question 30

In a scenario of economic downturn explain wich bond will widen more HY vs IG (High yield vs. Investment Grade) and the CDS positions that PM should allocato to profit in those scenario.

Answer 30

In this situation think about flight to quality. Should buy protection in HY bonds and sell protection in IG bonds.

Question 31

Formula os price change in CDS given change in CDS spread

Answer 31

Question 32

For questions of CDS remember the coupon for HY and IG.

Answer 32

HY = 5% IG = 1%

Question 33

In a scenario of stable credit curve what PM should do for enhance return.

Answer 33

- Sell long dated CDS - Or lower the portifolio credit

Question 34

Explain the structured debt instrument.

Answer 34

Are debt backed by debt based collateral, such pool of mortgages or commercial loans.

Question 35

Explain the main reasons (2) issuers invest in structured credit

Answer 35

1) issues different tranches of security, each with different risk profile, allowing investor to create a risk exposure not available though invest directy in collateral For exemple in a credit exposure situation junior tranches are affected first 2) This structures offer exposure to collaterals that cannot invest directily ex. Mortgage backed securities backed by mortgages Asset backed securities backed by credid card, cars, houses

Question 36

A manager expecting an economic recovery would sell/buy junior tranches and sell/buy senior tranches?

Answer 36

buy junior tranches and sell senior tranches. In economic recovery usually junior tranches widen more than others.