Reading 21: Fixed-Income Active Management: Credit

Question 1

Effective Duration

Answer 1

The effective duration of a bond is greater than its empirical duration in absolute terms. This is true for both investment-grade and high-yield bonds. Empirical duration is usually found by running a regression of its price returns on changes in a benchmark interest rate.

Question 2

Credit Spreads

Answer 2

Bonds with larger credit spreads (e.g., high-yield bonds) tend to have less sensitivity to interest rate changes than bonds with smaller credit spreads (e.g., investment-grade bonds). This is because as interest rates increase, credit spreads tend to decrease for HY bonds. However, when defaults are low and credit spreads are narrow (e.g., when economic conditions are strong) high-yield bonds behave more like investment-grade bonds, with higher sensitivity to interest rate changes.

Question 3

Investment Grade Bonds

Answer 3

Interest rate risk, spread risk, and credit migration risk are typically more relevant considerations than credit risk when analyzing investment-grade bonds.

Question 4

Floating Rate Bond

Answer 4

The modified duration and spread duration of option-free, fixed rate investment-grade bonds are generally the same. For floating-rate bonds, these duration measures can be significantly different, modified duration will be lower and spread duration will be higher.

Question 5

Tail Risk

Answer 5

Tail risk in a credit portfolio is the risk that there are more actual tail events than would be predicted by a probability distribution, such as the normal distribution (i.e., the probability distribution is likely to underestimate the actual number of tail observations). Diversification cannot eliminate this completely because they are impossible to predict in advance. Increasing correlations in a model can increase estimated tail risk (unusual outcomes).

Question 6

Emerging Market Bonds

Answer 6

Many are government owned, as govt could have significant stake in company. The credit rating will reflect the sovereign rating of the emerging market country, rating agencies will typically not give a rate any higher.

Question 7

OAS

Answer 7

If the Option Adjusted Spread is close to the bond’s other spread level (not exactly the same but close) it indicates that there it little embedded optionality and is likely not callable.

Question 8

Spread Sensitivity

Answer 8

Effect on credit spreads of large withdrawals by investors from credit funds. Measured as spread widening divided by percentage outflow from high yield funds. A decrease in spread sensitivity would indicate increased liquidity.

Question 9

G-Spread

Answer 9

Spread over actual or interpolated benchmark (usually govt bond). The opportunity of interpolation reduces the issue of maturity mis match.

Question 10

Bottom Up

Answer 10

Typically will focus on excess expected return of bonds based on similarities and differences in risk characteristics and if the expected excess return compensates for the risks appropriately.

Question 11

High Yield Bonds

Answer 11

Typically managers will focus on credit risk than interest rate and yield curve dynamics. When default losses are low and credit spreads are relatively tight, however, high-yield bonds tend to behave more like investment-grade bonds and focus more on interest rate sensitivity.

Question 12

CDOs

Answer 12

Have tranches with different credit quality, with lower tranches compensated with higher returns. If the tranches have positive correlation to default it is best to invest in the mezzanine as it offers higher expected return for the same default risk.

Question 13

Spreads

Answer 13

I-Spread is on swap fixed rates as benchmarks, many maturities and smoother yield curve. SFR can exhibit more risk than G-Spread.

Question 14

MBS

Answer 14

If interest rate volatility is expected to decrease, increase exposure to MBS securities.