R25 Fixed Income Credit Strategies Flashcards
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Advantages of MBS
- Portfolio diversification
- Liquidity - Agency MBS (better returns and liquidity than high quality corp bonds.
- Investment in real estate - can express more targeted or levered investment views than REITS
- Exposure to expected changes in interest rate volatility [note prepayment risk and extension risk]. If interest rate volatility will decrease, buy agency MBS.
- Credit cycle and the real estate cycle often behave differently
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Features of CDO
- Do not provide much diversification benefit compared with corporate bonds, and they do not offer unique exposure to a sector or market factor
- The valuation of CDOs may vary from the valuation of their underlying collateral
- Correlation of expected defaults on the collateral of a CDO affects the relative value between the senior and subordinated tranches of the CDO: As correlations increase, the value of mezzanine tranches usually increases relative to the value of senior and equity tranches.
- Leveraged Exposure to Credit. Can gain additional return but also suffer large losses.
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Emerging Market Credit Market Features
- Concentration in commodities and banking
- Government ownership. Recovery rates lower
- Credit quality. Concentration in both the lower portion of the investment-grade rating spectrum and the upper portion of high yield - “sovereign ceiling”
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Components of Credit Risk
- Default Risk
- Loss Severity (Loss given default)
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4 ‘Cs’ of Credit Analysis
- Capacity
- Collateral
- Covenants
- Character
(+ 5. Capital)
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What is Credit Loss Rate?
Represents the percentage of par value lost to default for a group of bonds.
Default Rate x Loss Severity
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Spread Duration
- A measure used in determining a portfolio’s sensitivity to changes in credit spreads.
- Spread duration measures the effect of a change in spread on a bond’s price
- For non-callable, fixed-rate corporate bonds, spread duration is generally very close to modified duration.
- For floating-rate bonds (also called floaters) and some other types of bonds, however, the spread duration can differ substantially from the modified duration.
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Empirical duration
- A measure of interest rate sensitivity that is determined from market data
- To calculate a bond’s empirical duration, run a regression of its price returns on changes in a benchmark interest rate.
- Corporate bonds with low credit spreads tend to have greater empirical duration
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What is Benchmark Spread
The yield on a credit security over the yield on a security with little or no credit risk (benchmark bond) and with a similar duration.
A problem with benchmark spread is the potential maturity mismatch between the credit security and the benchmark bond
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What is G Spread
The yield on a credit security over the yield of an actual or interpolated government bond.
It is easy to calculate and understand, and different investors usually calculate it the same way.
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What is I Spread
The yield on a credit security over the swap rate (denominated in the same currency as the credit security). Also known as interpolated spread.
A key advantage of using swap rates over yields on government bonds is that swap curves may be “smoother” (less disjointed) than government bond yield curves
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What is Z spread
The yield spread that must be added to each point of the implied spot yield curve to make the present value of a bond’s cash flows equal its current market price. Also known as zero-volatility spread.
A good measure of the bond’s credit spread.
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What is OAS
The constant spread that, when added to all the one-period forward rates on the interest rate tree, makes the arbitrage-free value of the bond equal to its market price.
Theoretical measure of credit spread.
Most useful for comparing bonds with different features, such as embedded options
Main shortcoming of OAS is that it depends on assumptions regarding future interest rate volatility
The most appropriate measure for a portfolio-level spread is the OAS
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Measures of Secondary Market Liquidity in Credit (3)
- Trading Volume
- Spread Sensitivity to Fund Outflows. Increase in spread relative to percentage outflow [from funds] greatest during the global financial crisis.
- Bid–Ask Spreads. High-yield bonds are usually quoted in price terms, whereas investment-grade bonds are usually quoted as a spread over a benchmark government bond.
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Management of Liquidity Risk
- Holding cash
- Managing position sizes. More-liquid credit securities are given greater portfolio weight. Holding greater weights of liquid credit securities and cash may decrease expected credit portfolio returns,
- Holding liquid, non-benchmark bonds
- Credit default swap (CDS) index derivatives
- Exchange-traded funds (ETFs). ETFs are easy to trade so the funds may experience unusual market movements during periods of high credit volatility, and their prices may deviate from their net asset values.
