Credit Strategies Flashcards
Spread duration
Provides the approximate percentage increase in bond price expected for a 1% decrease in credit spread (or vice versa)
The reason why credit spreads tend to be negatively correlated with risk-free interest rates
A better economic environment generally leads to higher risk-free rates and narrower credit spreads, whereas a weaker economic environment generally results in lower risk-free rates and wider credit spreads
Empirical duration
- A measure of interest rate sensitivity that is determined from market data
- Calculated by running a regression of a bond price returns against changes in a benchmark interest rate
- Tends to be smaller than effective duration
Benchmark spread
- = the yield on a credit security - the yield on a security with little or no credit risk (benchmark bond) with a similar duration
- There is sometimes a mitmatch in duration between the credit security and the benchmark security
G-spread
The spread over an actual or interpolated government bond (benchmark bond)
I-spread
The spread over an interpolated swap rate
Z-spread (zero-volatility 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
Option-adjusted spread (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
Excess return
EXR ≈ (s × t) – (Δs × SD) – (t × p × L)
- s is the spread at the beginning of the holding period in percentage (20 bps is 0.20)
- t is the holding period expressed in fractions of a year
- Δs is the change in the credit spread during the holding period
- SD is the spread duration of the bond
- p is the annualized expected probability of default
- L is the expected loss severity
Bond price change following a change in spread or modified duration
priceafter = pricebefore * [1 + (-duration * Δs)]
- Δs is the change in bps (20 bps is 0.0020)
Granularity of a benchmark classification
The investor typically wants each sector to contain a set of companies for which he expects company-level risks, rather than industry or macro risks, to be the dominant factors
Credit-related risks
- Credit spread risk
- Credit migration risk
- Default risk
- Liquidity risk
Principal considerations for bonds selection
- Liquidity
- Portfolio diversification
- Risk
Considerations in Bottom-Up Relative Value Analysis
- Bond structure
- Issuance date
- Supply
- Issue size
Primary macro factors important to credit investing
- Economic growth
- Overall corporate profitability
- Default rates
- Risk appetite
- Changes in expected market volatility
- Changes in credit spreads
- Interest rates
- Industry trends
- Currency movements
