19 June - FI Active Mgt: Credit Strategies

Which of the following statements best describes empirical duration?

Solution

A is correct. A bond’s empirical duration is often estimated by running a regression of its price returns on changes in a benchmark interest rate.

A junior analyst considers a 10-year high-yield bond issued by EKN Corporation (EKN) position in a high-yield portfolio.

The bond has a price of 91.82, a modified duration of 8.47, and a spread duration of 8.47. The analyst speculates on the effects of an interest rate increase of 20 bps and, because of a change in its credit risk, an increase in the EKN bond’s credit spread of 20 bps.

The analyst comments that because the modified duration and the credit spread duration of the EKN bond are equal, the bond’s price will not change (all else being equal) in response to the interest rate and credit spread changes.

Is the analyst’s prediction correct that the EKN bond price will not change in response to the interest rate and credit spread changes, all else being equal?

Solution

B is correct. An increase in interest rates results in a decrease in the bond price. An increase in the credit spread also results in a decrease in the bond price. For the EKN bond, its modified duration shows the effect of the 20 bp increase in interest rates. The approximate percentage price change resulting from the increase in interest rates is –8.47 × 0.0020 = –1.694%. The spread duration shows the effect of the 20 bp increase in the credit spread. The approximate percentage price change resulting from the increase in the credit spread is –8.47 × 0.0020 = –1.694%. The combined effect is a total change of –3.388%, or a price decrease of roughly 3.4%.

ChatGPT (Absolutely correct)

Which of the following outcomes is most likely if the junior analyst revises the bond’s original recovery rate higher?

A.An increase in the bond’s POD
B.A decrease in the bond’s POD
C.A decrease in the bond’s credit spread

Solution

C is correct. An increase in a bond’s recovery rate will lower the loss severity, or LGD, because LGD = (1 – RR). Recall the simple one-period relationship between credit spreads, LGD, and the POD as Spread ≈ LGD × POD. A lower LGD will result in a lower spread.

ChatGPT (Correct)

Recovery rate higher -> Lower credit spread

Recovery Rate: Imagine you lend money to someone and worry they might not pay you back. The recovery rate is how much money you expect to get back if they can't repay everything. For example, if you lend $100 and expect to get back $40 if they default, the recovery rate is 40%.

Which of the following observations on the risks of spread-based fixed-income portfolios is the most accurate?

A.Because credit spreads equal the product of the LGD and the POD, distinguishing between the credit risk and liquidity risk components of yield spread across all market scenarios is straightforward.
B.Given that frequent issuers with many bonds outstanding across maturities have their own issuer-specific credit curve, distinguishing between the credit spread and liquidity spread of all bonds for these issuers is straightforward.
C.The yield spread of a particular bond comprises both credit and liquidity risk and depends on market conditions and the specific supply-and-demand dynamics of each fixed-income security.

Solution

C is correct. A bond’s yield spread includes both credit and liquidity risk. Liquidity risk depends on both market conditions and the specific supply-and-demand dynamics of each fixed-income security.

it's not straightforward to distinguish liquidity spread, but straightforward for credit spread

Which of the following statements about credit spread measures is most accurate?

A.The DM is the yield spread over the MRR established upon issuance to compensate investors for assuming an issuer’s credit risk.
B.The Z-DM will be above the DM if the MRR is expected to remain constant over time.
C.The yield spread for a corporate bond will be equal to the G-spread if the government benchmark yield curve is flat.

Solution

C is correct. The yield spread is the simple difference between a bond’s all-in YTM and a current on-the-run government bond of similar maturity, while the G-spread is an interpolation of government benchmark yields. If the government bond yield curve is flat, these two measures will equal one another.

ChatGPT (Correct)

The most accurate statement about credit spread measures is:

C. The yield spread for a corporate bond will be equal to the G-spread if the government benchmark yield curve is flat.

Here’s an explanation for each option:

A. The DM (Discount Margin) is not the yield spread over the MRR (Minimum Required Rate); it is the yield spread over the reference rate (often a benchmark such as LIBOR) for a floating rate note, accounting for the discounting of future cash flows.

B. The Z-DM (Zero-Discount Margin) does not exist as a standard term. The Zero-Volatility Spread (Z-spread) will be above the DM if the benchmark yield curve (often the government or swap curve) is expected to rise over time. This option appears to mix up terms and is incorrect.

C. The G-spread is the yield spread over the government bond yield. If the government benchmark yield curve is flat, then the yield spread for a corporate bond will indeed be equal to the G-spread, as there would be no curvature to account for in the spread calculation. This statement is correct.

DM is about the extra yield for floating rate bonds over a reference rate.
Z-spread is a more complex measure over the entire yield curve.
G-spread is the difference between a corporate bond and a government bond yield, and if the government yield curve is flat, the G-spread equals the yield spread.

An active manager is considering the senior bonds of one of several corporate issuers. Holding other factors constant, which of the following key financial ratio changes would lead the manager to expect a decrease in the POD for that issuer?

A.An increase in the issuer’s coverage ratio
B.An increase in the issuer’s stock price volatility
C.An increase in the issuer’s leverage ratio

Solution

A is correct. The coverage ratio measures cash flow available to service debt, with a higher ratio indicating a lower probability of financial distress.

ChatGPT (Correct)

A. An increase in the issuer’s coverage ratio

An increase in the issuer’s coverage ratio indicates that the company is better able to meet its interest payments, which reduces the risk of default. Therefore, an increase in the coverage ratio would likely lead the manager to expect a decrease in the Probability of Default (POD) for that issuer.

POD == Prob of Default

so coverage ratio would decrease POD, simple;

the rests will increase POD

Which of the following statements about statistical credit analysis models is most accurate?

Solution

C is correct. Structural credit models use market-based variables to estimate an issuer’s asset value and asset value volatility, defining the likelihood of default as the probability of the asset value falling below that of liabilities, with zero net assets defined as the default threshold.

ChatGPT (Correct)

Summary

Structural Credit Models (C): Focus on the company's asset value vs. liabilities to assess default risk.
Reduced-form Credit Models (B): Use market data to statistically estimate the likelihood of default without focusing on the company's specific assets and liabilities.
Statement A is incorrect because structural models don't primarily use financial ratios or macroeconomic variables; they focus on the balance between assets and liabilities.

QuestionQ.

Which of the following strategies best addresses the liquidity risk of a less frequently traded bond position in an active manager’s portfolio?

Solution

C is correct. Both A and B represent “long” risk positions that would increase rather than offset the benchmark yield and credit spread risk to the portfolio manager related to the illiquid bond.

ChatGPT (Correct)

Strategy C is straightforward and directly reduces the pressure to sell the bond quickly.
Strategies A and B involve complex financial instruments that don't directly solve the liquidity problem and can introduce additional risks and costs.

Why buy-and-hold?

Buy-and-Hold: By putting the bond in a part of the portfolio where you don't plan to sell it soon, you avoid the need to sell it quickly.
Less Pressure: You can wait for a better time to sell it or just hold it until it matures (when the bond issuer pays back the principal amount).
Reduced Risk: This approach reduces the risk of having to sell the bond at a low price just because it's hard to find buyers quickly.

An active portfolio manager observes the following market information related to an outstanding corporate bond and two on-the-run government bonds that pay annual coupons:

Issuer

Term

Coupon

Yield

ModDur

Corporate

12y

3.00%

2.80%

9.99

Government

10y

1.75%

1.85%

9.09

Government

20y

2.25%

2.30%

15.94

The portfolio manager also observes 10-year and 20-year swap spreads of 0.20% and 0.25%, respectively.

QuestionQ.

Calculate the G-spread of the corporate bond.

Solution

A is correct. The G-spread is the difference between the corporate bond YTM and a linear interpolation of the 10-year and 20-year government bond YTMs. To calculate the approximate 12-year government rate, solve for the weights of the 10-year bond as 80% (= (20 – 12)/(20 – 10)) and the 20-year bond as 20% (or (1 – 80%), noting that (80% × 10) + (20% × 20) = 12). The 12-year government rate is 1.94% (or (80% × 1.85%) + (20% × 2.30%)), and the difference between the corporate bond YTM and the 12-year interpolated government rate is 0.860%.

ChatGPT (Absolutely Correct)

Calculate the I-spread of the corporate bond.

Solution

B is correct. The I-spread is an estimate of the corporate bond’s spread over an interpolated swap benchmark. We can solve for the 10-year and 20-year swap rates as 2.05% (=0.20% + 1.85%) and 2.55% (=0.25% + 2.30%), respectively, by adding the swap spread to the respective government bond. The 12-year swap rate is 2.15% (or (80% × 2.05%) + (20% × 2.55%)), and the difference between the corporate bond YTM and the 12-year interpolated government rate is 0.65%.

An active portfolio manager observes the following market information related to an outstanding corporate bond and two on-the-run government bonds that pay annual coupons:

Issuer

Term

Coupon

Yield

ModDur

Corporate

12y

3.00%

2.80%

9.99

Government

10y

1.75%

1.85%

9.09

Government

20y

2.25%

2.30%

15.94

The portfolio manager also observes 10-year and 20-year swap spreads of 0.20% and 0.25%, respectively.

QuestionQ.

Calculate the ASW of the corporate bond.

A.0.65%
B.0.95%
C.0.85%

Solution

C is correct. The ASW is an estimate of the spread over MRR versus the bond’s original coupon rate to maturity, which is equal to the difference between the corporate bond coupon of 3.00% and the 12-year swap rate of 2.15%, or 0.85%.

Solution

A is correct. The 20 bp increase in the 20-year government YTM causes the 12-year interpolated government YTM to rise 4 bps to 1.98% (or (80% × 1.85%) + (20% × 2.50%)). The corporate bond percentage price change can be estimated based on the YTM change multiplied by modified duration (–ModDur × ΔYield) familiar from earlier lessons. This percentage price change can be calculated as –0.4% (=–9.99 × 0.04%).

ChatGPT (Correct)

Which of the following is the most accurate statement related to international credit markets?

Solution

B is correct.

Fixed exchange rate regimes in A usually result in greater instability and a higher probability of financial distress,

while higher domestic currency YTMs in emerging economies in C are a sign of expected currency depreciation, not appreciation, over time.

ChatGPT (Correct)

B. Although many emerging economies have domestic bond markets that include sovereign, financial, and corporate issuers, investments across these bonds offer less diversification than similar investments in developed markets.

Explanation:

Option A is not necessarily true because fixed exchange-rate regimes can sometimes lead to financial distress if the country is unable to maintain the peg due to economic pressures, which can lead to currency crises.
Option C is incorrect because higher domestic currency yields to maturity (YTMs) in emerging markets are generally due to higher perceived risks and inflation expectations, not necessarily expected currency appreciatio

Which of the following statements about the role of structured products in an active credit portfolio is most accurate?

Solution

A is correct. Covered bonds perform relatively well in a downturn versus other fixed-income bonds with real estate exposure because the investor also has recourse to the issuer.

ChatGPT - Correct

A. Covered bonds perform relatively well in a downturn versus other fixed-income bonds with real estate exposure because a covered bond investor also has recourse to the issuer.

Covered bonds offer a dual recourse structure, providing additional security to investors by giving them recourse not only to the underlying pool of assets but also to the issuer's other assets. This feature generally makes covered bonds perform better in downturns compared to other fixed-income bonds with real estate exposure.

ChatGPT (Correct)

Imagine you are investing in different types of bonds, which are basically loans you give to companies or institutions, and they promise to pay you back with interest. Now, let's look at three different types of investments and how they behave in different situations:

Covered Bonds: These are like super-safe loans. When you invest in a covered bond, you're lending money to a company, but you also have an extra layer of safety. If the company can't pay you back, you can still get your money from a pool of assets (like real estate or mortgages) that the company owns. This extra security means that covered bonds tend to do better when the economy is struggling because you have a backup source to get your money from.
ABS Tranches (Asset-Backed Securities): These are more complex. Imagine you have a bunch of loans (like car loans or student loans) bundled together. Each piece of this bundle is called a tranche. Higher-rated tranches are considered safer because they get paid first. However, they are not usually chosen by active investors who want to take on more risk, especially when the economy is getting better. These investors might prefer lower-rated tranches that could offer higher returns.
CLO Tranches (Collateralized Loan Obligations): These are bundles of loans to businesses. They are similar to CDOs (Collateralized Debt Obligations), but they focus on loans to companies. In a slowing economy, CLO tranches can sometimes be better than CDO tranches with the same ratings because the loans in CLOs often have better protections and structures in place.

In summary, the safest bet during tough economic times is usually covered bonds because you have more ways to get your money back. This makes them a reliable choice for investors who want to protect their investments when things aren't looking great economically.

An active fixed-income manager is evaluating the relative performance of an investment-grade corporate versus a high-yield corporate debt allocation in a fixed-income portfolio. Which of the following analytical model assumption changes is most likely to reduce the future value of the high-yield portfolio relative to the investment-grade holdings?

Solution

C is correct. Under a “flight to quality” scenario, macroeconomic factors driving government bond YTMs lower cause high-yield bond credit spreads to rise because of an increased likelihood of and expected higher severity of financial distress. This relationship is captured in the difference between empirical and analytical duration measures.

ChatGPT (Correct)

C. Increased likelihood of a flight to quality associated with bullish benchmark yield curve flattening (long-term rates fall by more than short-term rates do)

Explanation:

Flight to Quality: In a flight to quality scenario, investors tend to move their investments from riskier assets, like high-yield bonds, to safer assets, like investment-grade bonds. This shift generally leads to a decrease in the demand for high-yield bonds, causing their prices to fall and yields to rise, which reduces their future value.
Benchmark Yield Curve Flattening: A bullish flattening of the yield curve means that long-term interest rates fall more than short-term rates. This environment is often associated with economic uncertainty or a slowdown, which can negatively impact the performance of high-yield bonds more than investment-grade bonds due to their higher risk profile.

On the other hand:

Steepening of the Benchmark Yield Volatility Curve (A): This generally indicates higher volatility at the longer end of the curve, which can affect both high-yield and investment-grade bonds. However, the direct impact on the relative performance is less clear compared to a flight to quality scenario.
Decreased Likelihood of an Economic Slowdown (B): This would typically be positive for high-yield bonds, as it reduces the risk of default and improves the outlook for corporate earnings, making them relatively more attractive compared to investment-grade bond

An investor is considering the portfolio impact of a new 12-year corporate bond position with a $75 million face value, a 3.25% coupon, current YTM of 2.85%, modified duration of 9.887, and a price of 104.0175 per 100 of face value.

QuestionQ.

Which of the following VaR measures is most appropriate for the portfolio manager to use to evaluate how this position would affect portfolio tail risk?

Solution

C is correct. The incremental VaR measures how the additional portfolio position would change the overall portfolio’s VaR measure.

ChatGPT (Correct)

When we talk about Value at Risk (VaR), we are essentially trying to measure how much money we could potentially lose in a worst-case scenario over a specific period of time. It's a way to assess the risk involved with investments.

CVaR (Conditional Value at Risk): Think of this as looking beyond the initial risk estimate. It tells you how bad the losses could get if things go worse than what VaR predicts. It looks at the "tail" of the risk distribution, the extreme losses.
Relative VaR: This compares the risk of your portfolio to a benchmark, like a standard or average portfolio. It tells you if your portfolio is riskier or safer compared to this benchmark.
Incremental VaR: This specifically measures how much additional risk the new bond will bring to your portfolio. It's like asking, "If I add this bond to my investments, how much more could I potentially lose?"When we talk about Value at Risk (VaR), we are essentially trying to measure how much money we could potentially lose in a worst-case scenario over a specific period of time. It's a way to assess the risk involved with investments.

(cal)

QuestionQ.

What is the approximate VaR for the bond position at a 99% confidence interval (equal to 2.33 standard deviations) for one month (with 21 trading days) if daily yield volatility is 1.50 bps and returns are normally distributed?

Solution

A is correct. The expected change in yield based on a 99% confidence interval for the bond and a 1.50 bps yield volatility over 21 trading days equals 16 bps = (1.50 bps × 2.33 standard deviations × √21). We can quantify the bond’s market value change by multiplying the familiar (–ModDur × ∆Yield) expression by bond price to get $1,234,105 = ($75 million × 1.040175 × (–9.887 × .0016)).

ChatGPT (Absolutely Correct)

but calculation method is bit lengthy and detailed; follow Solution for more straightforward thoughts

1) 99% confidence -> 2.33 z-score (95 -> 1.65; 90 -> 1.28)

2) Cal bps yield volatility per duration = bps x z-score x sqrt duration

3) -modD x change of yield x bond price / par x portfolio value

21 trading days; DAILY YIELD VOLATILITY

so cal monthly yield vol = 0.0015 * sqrt 21 = 0.00687386354

x 2.33 z-index = 0.016016

var = MV x price factor per face value x (- Mod x change of yield)

it's easy

get

change of yield - daily yield volatility x z-score x sqrt (duration)

MV x bond price per par x (- Mod D x change of yield)

(cal)

An active United States–based credit manager faces the following US and European investment-grade and high-yield corporate bond portfolio choices:

Rating Category

OAS

EffSpreadDur

Expected Loss

USD IG

1.25%

4.50

0.40%

USD HY

3.00%

5.50

2.25%

EUR IG

1.15%

4.75

0.50%

EUR HY

3.25%

6.00

2.50%

The EUR IG and EUR HY allocations are denominated in euros, and the euro is expected to depreciate by 2% versus the US dollar over the next year.

QuestionQ.

What is the expected unhedged excess return to the United States–based credit manager for an international credit portfolio index equally weighted across the four portfolio choices, assuming no change to spread duration and no changes to the expected loss occur?

A.–0.257%
B.–0.850%
C.0.750%

Solution

A is correct. We solve for the excess spread by subtracting Expected Loss from the respective OAS:

Rating Category

OAS

EffSpreadDur

Expected Loss

E(Excess Spread)

USD IG

1.25%

4.5

0.40%

0.85%

USD HY

3.00%

5.5

2.25%

0.75%

EUR IG

1.15%

4.75

0.50%

0.65%

EUR HY

3.25%

2.50%

0.75%

Recall that the United States–based investor must convert the euro return to US dollars using RDC = (1 + RFC) (1 + RFX) – 1, so the USD IG and USD HY positions comprising half the portfolio return an average 0.80%, while the EUR IG and EUR HY positions return –1.314% in US dollar terms (= ((1 + ((0.65% + 0.75%)/2)) × 0.98) – 1), so –0.257% = ((0.80% – 1.314%)/2).

Excess Spread = OAS - Expected Loss

Weighted avg = 0.85 + 0.75 -1.35 - 1.25 / 4 = -1/4 = -0.25

ChatGPT (Correct but Inaccurate calculation. It adds on currency appreciation instead of multiplying)

1) 0.85

2) 0.75

3) 1.0065 * 0.98 -1 = -1.363%

4) 1.0075 * 0.98 - 1 = -1.265%

avg = 0.85 + 0.75 -1.363 - 1.265 / 4 = -1.028 / 4 = - 0.257

An active United States–based credit manager faces the following US and European investment-grade and high-yield corporate bond portfolio choices:

Rating Category

OAS

EffSpreadDur

Expected Loss

USD IG

1.25%

4.50

0.40%

USD HY

3.00%

5.50

2.25%

EUR IG

1.15%

4.75

0.50%

EUR HY

3.25%

6.00

2.50%

The EUR IG and EUR HY allocations are denominated in euros, and the euro is expected to depreciate by 2% versus the US dollar over the next year.

QuestionQ.

Which of the following active portfolios is expected to have the highest excess return versus the index if European economies are expected to experience an earlier and much stronger credit cycle recovery than the United States?

A.EUR HY 50.0%, EUR IG 25.0%, USD IG 12.5%, USD HY 12.5%
B.EUR IG 50.0%, EUR HY 25.0%, USD IG 12.5%, USD HY 12.5%
C.EUR HY 33.3%, US HY 33.3%, EUR IG 16.7%, USD IG 16.7%

Solution

A is correct. Given that high-yield (HY) spreads are expected to fall the most in an economic recovery, the manager should choose the portfolio with the highest percentage of EUR HY credit exposure.

European economies are expected to experience an earlier and much stronger credit cycle recovery

-> EUR appreciation

-> narrowed High-Yield (HY) spread

--> highest excess returns = EUR HY > EUR IG > then USD

(cal)

An active portfolio manager seeking to purchase single-name CDS protection observes a 1.75% 10-year market credit spread for a private investment-grade issuer. The effective spread duration is 8.75 and CDS basis is close to zero.

QuestionQ.

What should the protection buyer expect to pay or receive to enter a new 10-year CDS contract?

A.The buyer should receive approximately 6.5625% of the notional.
B.The buyer should pay approximately 15.3125% of the notional.
C.The buyer should pay approximately 6.5625% of the notional.

Solution

C is correct. Because the market premium is 0.75% above the 1.00% standard investment-grade CDS coupon, the protection buyer must pay the protection seller 6.5625% (= EffSpreadDurCDS × ∆Spread, or 8.75 × 0.75%) of the fixed notional amount upon contract initiation; the initial CDS price is therefore 93.4375 per 100 of notional with a CDS spread of 175 bps.

Inputs

(The standard investment-grade CDS coupon is 1.00%. not explicitly stated)

1.75%, 10 year, 8.75 eff Dur;

standard 1% -> spread = 1.75-1 = 0.75%

8,75 x 0.75% = 6.5625%

I see... then it's 100 - 6.5625 = 93.4375%

CDS spread 175bps

ChatGPT (Wrong but explaning well after Solutio)

QuestionQ.

Once the manager purchases CDS protection, the issuer’s CDS spread immediately falls to 1.60%. What is the investor’s approximate mark-to-market gain or loss for a contract notional of €10,000,000?

A.The manager realizes an approximate loss of €131,250.
B.The manager realizes an approximate gain of €131,250.
C.The manager realizes an approximate gain of €525,000.

Solution

A is correct. The CDS spread decline of 0.15% leads to a new CDS contract price of 94.75 per 100 face value (=1 – (EffSpreadDurCDS × ∆Spread) or (8.75 × 0.60%)). The protection buyer (short risk) position therefore realizes an approximate mark-to-market loss of €131,250 (=(94.75 – 93.4375)/100 × €10,000,000) because of the 0.15% decline in CDS spreads.

ChatGPT

Easy

1) change of spread

2) notional amt x spread duration x change of spread

An investor observes the following current CDS market information:

CDX Contract

Tenor (years)

CDS Spread

EffSpreadDurCDS

CDX IG Index

85 bps

4.9

CDX IG Index

135 bps

8.9

CDX HY Index

175 bps

4.7

CDX HY Index

275 bps

8.7

QuestionQ.

Select the most appropriate credit portfolio positioning strategy to capitalize on an expected steepening of the investment-grade credit spread curve.

A.Sell protection on the 10-year CDX IG index and purchase protection on the 5-year CDX IG index using contracts of equal notional value.
B.Sell protection on the 10-year CDX IG index and purchase protection on the 5-year CDX IG index using a contract with a notional amount equal to 1.82 times that of the 10-year contract.
C.Buy protection on the 10-year CDX IG index and sell protection on the 5-year CDX IG index using a contract with a notional amount equal to 1.82 times that of the 10-year contract.

Solution

C is correct. The investor benefits from a short risk (as protection buyer) on the 10-year CDX IG index and long risk (as protection seller) on the 5-year CDX IG index, duration matching the notional value by increasing 5-year notional 1.82 times (=8.9/4.9) versus the 10-year.

An investor observes the following current CDS market information:

CDX Contract

Tenor (years)

CDS Spread

EffSpreadDurCDS

CDX IG Index

85 bps

4.9

CDX IG Index

135 bps

8.9

CDX HY Index

175 bps

4.7

CDX HY Index

275 bps

8.7

QuestionQ.

Which of the following is the most appropriate credit portfolio positioning strategy to capitalize on an expected economic contraction?

A.Buy protection on the 5-year CDX HY index and sell protection on the 5-year CDX IG index in approximately equal notional amounts.
B.Buy protection on the 10-year CDX IG index and sell protection on the 5-year CDX IG index using a contract with a notional amount equal to 1.82 times that of the 10-year contract.
C.Buy protection on the 10-year CDX HY index and sell protection on the 5-year CDX HY index using a contract with a notional amount equal to 1.85 times that of the 10-year contract.

Solution

A is correct. Because an economic contraction is often associated with a sharp rise in shorter-term high-yield spreads and spread curve flattening in investment grade and inversion in high yield, the most appropriate choice is to take a short risk (purchase protection) in five-year high-yield spreads and a long position (sell protection) in five-year investment-grade spreads. Answers B and C position the investor to benefit from a steeper investment-grade and high-yield spread curve, respectively.

ChatGPT - wrong

McDown asks Larent to describe the risk considerations for investment-grade bonds. Larent responds by stating that the primary component of credit risk is loss severity. Furthermore, she states that credit rating migration can cause spread risk to become realized. Larent then states that interest rate risk reflects the positive correlation between risk-free interest rates and credit spreads.

With respect to investment-grade bonds, Larent is most likely correct with respect to which risk consideration?

Solution

B is correct. With respect to risk considerations for investment-grade bonds, Larent is most likely correct with respect to spread risk. Spread risk is a function of credit migration. For investment-grade bonds, the risk of credit rating migration (credit deterioration) is greater than the risk of actual credit loss. Accordingly, credit spread volatility, as opposed to outright credit default loss, is a more relevant consideration as it relates to investment-grade bonds. Spread duration measures the credit spread volatility risk in a portfolio of investment-grade bonds.

A is incorrect. Credit loss is a lesser consideration than credit migration for investment-grade bonds. Credit loss is a primary consideration for high-yield bonds.

C is incorrect. For investment-grade corporate bonds, the correlation between credit spreads and the risk-free interest rate is negative, not positive.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Describe risk considerations for spread-based fixed-income portfolios

Ronane asks Larent to disclose her methodology for credit security selection. Larent explains that she uses various credit spread measures to ensure that the securities she is considering for purchase are fairly priced. Larent illustrates by providing data for three $100 par value A rated corporate bonds that mature in five years and whose benchmark yield to maturity is 4.00%.
Exhibit 1
Data on Corporate Bonds

Credit Rating

Coupon

YTM

G-Spread

Z-Spread

OAS

Bond A

6.00%

5.00%

100 bps

112 bps

Bond B

Baa

6.50%

5.50%

150 bps

163 bps

152 bps

Bond C

7.00%

6.00%

200 bps

213 bps

Which bond from Exhibit 1 is most likely callable?

Solution

B is correct. Bond B is most likely callable because of the difference between its option-adjusted spread (OAS) and its Z-spread. The Z-spread is the yield spread that must be added to each point of the implied spot yield curve in order for the present value of the bond’s cash flows to equal its market price. The OAS considers the value of optionality in a bond’s cash flows. The theoretical value of a callable bond is less than that for an otherwise equivalent non-callable bond because of the value of the call option (the issuer’s right to retire the bond prior to maturity) being sold by the investor. The OAS is the constant spread that when added to all the one-period forward rates makes the arbitrage-free value of the bond equal to its market price.

A is incorrect because Bond A is likely a non-callable bond because its Z-spread and OAS are equal.

C is incorrect because Bond C is likely a non-callable bond because its Z-spread and OAS are equal.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Discuss the advantages and disadvantages of credit spread measures for spread-based fixed-income portfolios, and explain why option-adjusted spread is considered the most appropriate measure

ChatGPT (Absolutely Correct)

For a callable bond, the OAS is typically lower than the Z-spread because the Z-spread does not adjust for the option value, while the OAS does.

Bond A: OAS (112 bps) = Z-Spread (112 bps)
Bond B: OAS (152 bps) < Z-Spread (163 bps)
Bond C: OAS (213 bps) = Z-Spread (213 bps)

From this, Bond B is the only bond where the OAS is less than the Z-Spread, indicating that it is adjusting for an embedded option, likely a call option.

Thus, the bond most likely to be callable is:

B. Bond B

McDown expresses concern about the timing of the credit cycle as it relates to constructing a corporate bond portfolio for CCHC. Larent explains that she uses a bottom-up approach to determine which corporate bonds offer the best relative value should the credit cycle deteriorate. Larent then provides the data in Exhibit 2 for three corporate bonds in which the holding period is assumed to be one year.

Exhibit 2

Data on Corporate Bonds

Credit Rating

Probability of Default

Spread Duration

Z-Spread

Expected Change in Z-Spread

Loss Severity

Bond D

0.25%

3.0

0.75%

+0.25%

40%

Bond E

Baa

0.50%

3.5

1.00%

+0.25%

50%

Bond F

0.75%

4.0

1.25%

+0.25%

60%

The bond in Exhibit 2 with the best relative value is most likely:

Solution

A is correct. Bond D has the best relative value; its expected excess return (EXR) has the smallest loss given the expectation that credit spreads are going to widen by 25 bps (the change in the Z-spread). The expected excess return calculation is as follows:EXR = (s × t) – (∆s × SD) – (t × p × L)where

s = Z-spread

t = Holding period

SD = Spread duration

p = Probability of default

L = Loss severity

Calculations are as follows:

Holding Period

Bond

Credit Rating

Probability Default

Spread Duration

Z-Spread

Change Z-Spread

Loss Severity

Excess Return

EXR

1.0

0.25%

3.00

0.75%

0.250%

40%

–0.100%

1.0

Baa

0.50%

3.50

1.00%

0.250%

50%

–0.125%

1.0

0.75%

4.00

1.25%

0.250%

60%

–0.200%

B is incorrect because Bond D has the best expected excess return.

C is incorrect because Bond D has the best expected excess return.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Discuss bottom-up approaches to credit strategies

ChatGPT (Correct)

Key Terms:

Z-Spread: This is the extra yield (return) you get from the bond compared to a risk-free bond.
Probability of Default: The chance that the company issuing the bond will not be able to pay you back.
Loss Severity: If the company defaults, this is the percentage of your investment you might lose.
Spread Duration: This measures how sensitive the bond price is to changes in the spread (extra yield). A higher number means more sensitivity.

Expected Excess Return=Z-Spread−(Probability of Default×Loss Severity)−(Expected Change in Z-Spread×Spread Duration)

Larent explains that another approach to portfolio construction is top down. She says, “I believe that global economic conditions are going to improve. Credit portfolios that are overweight lower-quality bonds in industry sectors that are highly correlated with the economic cycle, such as industrial metals, will likely outperform a global benchmark. We can use effective duration to assess the impact of a likely steepening in the yield curve. Within credit rating categories, we can underweight longer-maturity bonds given my expectation that the relatively wide spread curve will flatten.”

In Larent’s discussion about the top-down approach to portfolio construction, she is most likely correct about:

Solution

C is correct. Larent’s comment about credit portfolios that are overweight lower-quality bonds likely outperforming a global benchmark whenever global economic conditions improve is correct.

A is incorrect. Effective duration is used to measure the impact of a parallel change in the yield curve, not a steepening in the yield curve.

B is incorrect. With respect to the spread curve, overweighting shorter-maturity bonds and underweighting longer-maturity bonds is not optimal whenever there is an expectation that a relatively wide spread curve will flatten. When a wide spread curve flattens, the yields of longer-maturity bonds decline by a magnitude that is greater than the magnitude of changes (up or down) in the yields of shorter-maturity bonds. Accordingly, the optimal portfolio construction strategy is to be underweight shorter-maturity bonds and overweight longer-maturity bonds.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Discuss top-down approaches to credit strategies

Ronane asks Larent to discuss the factors that CCHC should consider before investing in the bonds of international companies. Larent replies that the international bond universe consists of companies that are located in both developed markets and emerging markets. In term of factors to consider, Larent states that a company’s credit ratings are independent from the sovereign rating of its domicile and that bankruptcy laws apply equally to all investors of any particular company’s bond issuances. Larent adds that being able to accurately predict credit cycles is important because of regional differences across the global credit universe.

Which factors about investing in the bonds of international companies is Larent most likely correct about?

Solution

C is correct. Determining the timing and location of credit cycle weakening is an important top-down relative value consideration for global credit portfolio managers. Regional differences exist in credit cycles, credit quality, sector composition, and market factors.

A is incorrect. The ratings of emerging market debt issuers are typically concentrated in the low-investment-grade/high-non-investment-grade range, which reflect the sovereign ratings of the countries in which they are domiciled. Rating agencies typically apply a “sovereign ceiling” to corporate debt issuers, implying that any debt issuer is normally rated no higher than the sovereign rating of its domicile.

B is incorrect. Global differences in regulations and laws, such as bankruptcy laws, are a source of risk for investors in international bonds. Non-domestic investors of a particular company’s bond issuances face contractual rights that are less certain than those for domestic investors in the event of debt restructurings.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Discuss considerations in constructing and managing portfolios across international credit markets

McDown asks whether structured financial instruments should be considered for CCHC’s portfolio. Larent replies yes and states, “The credit cycle is expected to improve. For purposes of diversification, both collateralized debt obligations (CDOs) and their underlying corporate bonds should be included in the portfolio. AA rated CDOs currently offer significant relative value for long-term investors as the yield spread reflects a BB default rate expectation for the underlying collateral. Moreover, the value of the senior tranches should increase by more than the value of the mezzanine tranches since default correlations are expected to increase.”

Question

Which of Larent’s statements about structured financial instruments is most likely correct? The statement about:

Solution

A is correct. Laurent’s statement about relative value is correct. CDOs are securities whose underlying cash flows are the interest and principal of the underlying debt instruments that are pledged as collateral. Whenever the value of a CDO is different from the value of its underlying collateral (in this example, the CDO value is lower as implied by the BB rating of its underlying debt instruments), an arbitrage opportunity exists. In this example, the trade opportunity is to (1) short (alternatively, purchase credit default swaps on) the underlying bonds and (2) purchase the undervalued CDO.

B is incorrect because the collateral for a CDO consists of its underlying corporate bonds. Accordingly, there is no diversification benefit.

C is incorrect because the mezzanine tranche of a CDO increases by more than the senior tranche whenever correlations increase.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Describe the use of structured financial instruments as an alternative to corporate bonds in credit p

Harlow Choate is the portfolio manager of the Credit Opportunities Fund (COF) at Ipswich Advisors, LLC. Choate navigates his fund with the same dexterity as his 46-foot sloop, scouring the markets for attractive credit securities. He describes his strategy approach as having “an objective to beat the Barclays US Investment-Grade Corporate Index by 100 basis points (bps) annually with a tracking error volatility of 200 bps. We evaluate the relative value of securities within countries and sectors using our own assessment of credit-related risks and use expected excess return as the measure to make relative value decisions. We consider overall corporate profitability, default rates, and industry trends to allocate to industry sectors and when adding an asset class, such as high-yield bonds. Investments are not restricted based on companies’ business practices.”

Based on Choate’s comments regarding the Credit Opportunities Fund, which strategy approach(es) does Ipswich most likely follow?

Solution

C is correct. Ipswich follows a top-down and bottom-up approach. The top-down approach involves the investor formulating a view on major macroeconomic trends, such as economic growth and corporate default rates, and then selecting the bonds that the investor expects to perform best in a given environment. The bottom-up approach involves selecting the individual bonds or issuers that the investor views as having the best relative value from among a set of bonds or issuers with similar characteristics (usually the same industry and often the same country of domicile).

A is incorrect because Ipswich follows a bottom-up approach but also applies top-down in asset allocation.

B is incorrect because while Ipswich follows a top-down approach, there is no mention of ESG considerations and the description actually states it doesn’t look at business practices.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Discuss top-down approaches to credit strategies

Choate elaborates on the different risk considerations he attributes to investment-grade bonds compared to high-yield bonds, “Relative to high-yield bonds, investment-grade bonds are more sensitive to interest rate changes and credit migration risk, resulting in credit spread volatility. High-yield bonds are not as sensitive to interest rates, and, given the potential for actual credit losses caused by default, monitoring outright market value of the position is more critical with high-yield bonds than with investment-grade bonds.

Solution

B is correct. Investment-grade bonds have lower credit and default risks than high-yield bonds and are more sensitive to interest rate changes and credit migration, which cause credit spread volatility. The much higher credit loss rate experienced with high-yield bonds results in an emphasis on credit risk and the market value of the position to evaluate high-yield risk.

A is incorrect because Choate is correct with respect to both investment grade and high yield bonds.

C is incorrect because Choate is correct with respect to both investment grade and high yield bonds.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Describe risk considerations for spread-based fixed-income portfolios

Choate is nimble with seafaring tools, such as the compass and sextant, so it is no wonder that he employs a number of specialized tools when investing in bonds. He shares his favorite measures to assess how much he is being compensated for the credit-related risks he takes, saying “There are a number of credit spread measures that can be used when evaluating risky bonds. My preference is to use a measure at the security level that uses a spread over a linear interpolation of the yields of two on-the-run government bonds. At the portfolio level, I prefer to use a measure that applies to a diversified group of securities, whether they have embedded options or not.”

The spread measures Choate refers to in evaluating credit at the security and portfolio levels, respectively, are most likely the:

Solution

A is correct. The most appropriate measure for the security level spread is the G-spread, which uses a linear interpolation of the yields of two on-the-run government bonds as the benchmark rate, weighted so that their weighted average duration matches the duration of the credit security. The most appropriate measure for a portfolio-level spread is the OAS because it is challenging to apply the G-spread, I-spread, or Z-spread to a diversified portfolio of credit securities because none of these spread measures would reflect optionality in the relevant bonds.

B is incorrect. Although OAS is appropriate for evaluating credit at the portfolio level, the I-spread is incorrect because it uses swap spreads rather than government bonds as the benchmark.

C is incorrect because the I-spread uses swap spreads rather than government bonds as the benchmark, and Z-spread cannot be used to compare bonds with and without options.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Discuss the advantages and disadvantages of credit spread measures for spread-based fixed-income portfolios, and explain why option-adjusted spread is considered the most appropriate measure

Similar to many fixed-income investors, Choate envisions the glass half empty. He is concerned about the challenging market environment, liquidity, and a number of black swan or tail risks that could potentially impact the performance of his investments. He outlines for Hale the precautions he can take in the portfolio and specifically outlines three key considerations:
Consideration 1: Liquidity risk has increased markedly for corporate bonds, particularly since the global financial crisis. We assess liquidity through a number of measures, such as the bid–ask spread, trading volumes, and the impact of funds flows. We manage liquidity through position sizes, the use of Treasuries, exchange-traded funds, and derivatives.
Consideration 2: Tail risk events are challenging to model or predict ahead of time. Scenario analysis can provide an indication of how a portfolio would perform under certain conditions, such as spreads widening by a certain amount across the credit curve. The positions in a portfolio can be stressed in scenario analysis assuming similar outcomes of a past crisis recur.
Consideration 3: It is difficult to hedge tail risks through portfolio diversification, and it can also prove too costly. We prefer to hedge using such derivatives as credit default swaps, which have a very low cost.

Which of Choate’s considerations regarding the precautions he can take in the portfolio is least likely correct?

Solution

C is correct. Consideration 3 is incorrect. Hedging tail risks through portfolio diversification is not difficult to implement and only has modest incremental cost. Hedging with derivatives, such as credit default swaps, is effective but costly.

A is incorrect because Consideration 2 is correct.

B is incorrect because Consideration 1 is correct.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Describe how to assess and manage tail risk in credit portfolios

Choate does not limit his investments strictly to domestic issuers. He prefers to traverse the global waters for opportunities. His rationale is fairly straightforward: “The credit market is global in nature. We evaluate opportunities across regions and countries, which include emerging markets. We are especially keen on emerging market credits, which can provide excess returns that outperform the domestic and global developed market indexes. Because the emerging market credits are not included in the performance benchmark, we limit the maximum exposure to this asset class and buy them in either USD or the local currency depending on the total expected return of the transaction.”
Choate’s final comments to Hale detail how he also looks for structured financial instruments that offer diversification benefits and attractive expected returns. These are listed in Exhibit 1, which shows recent COF portfolio positioning relative to the benchmark and reflects various opportunities Choate has uncovered across several markets.
Exhibit 1
COF Portfolio Holdings as of 12/31/xx

Portfolio (%)

Benchmark (%)

Investment-Grade Credit

100

Emerging Market Credit

High Yield

Collateralized Debt Obligations

Senior Tranche (Class A)

–10

Subordinated Tranche (Class B)

Mortgage-Backed Securities

Total

100

An implication of Choate’s investment strategy is that relative to the benchmark, the portfolio most likely would have:

Solution

A is correct. Emerging market credit is characterized by a concentration in commodities and banking and government ownership of some entities. Additionally, uncertainty in creditor rights can lead to lower recovery rates and lower credit quality. Even though Choate has a diversified portfolio, the emerging market credits are outside their performance benchmark, which would lead to lower credit quality and a higher concentration in commodities.

B is incorrect because emerging market debts face uncertainty in contractual rights and lower recovery rates.

C is incorrect because there are some differences across regions in the credit cycle providing diversification.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Discuss considerations in constructing and managing portfolios across international credit markets

Based on Choate’s final comments and the COF portfolio positions in Exhibit 1, Choate is most likely expecting:

Solution

B is correct. Choate expresses his belief that market expectations of interest rate volatility will decrease, so he buys agency MBS in the COF portfolio. The correlation of expected defaults on the collateral of a CDO affects the relative value between the senior and subordinated tranches; as default correlations increase, the value of mezzanine tranches usually increases relative to the value of senior tranches. Because he expects the correlation to be highly positive, he can try to profit by selling the lower yielding (or selling short) Class A and buying the higher yielding Class B.

A is incorrect because an investor buying MBS expects lower, not higher, volatility.

C is incorrect because an investor that expects higher correlations would short Class A and go long Class B.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Describe the use of structured financial instruments as an alternative to corporate bonds in credit portfolios

Ashley West is the Managing Director of Credit Strategies at Mt. Pleasant Advisers (MPA). She oversees a group of strategists, analysts, and traders who contribute to managing more than $50 billion in fixed-income securities. She has gathered her group for their weekly investment strategy meeting, where they are currently focused on higher expected volatility in the markets. West makes the following comments:

Comment 1

Relative to high-yield bonds, investment-grade bonds of the same duration are more sensitive to changes in interest rates.

Comment 2

Credit investors can use the four Cs of credit as a framework to assess both the probability of default and the estimated loss given default.

Comment 3

Spread duration is a measure of risk that is more useful for high-yield bonds than for investment-grade bonds.

Which of West’s comments regarding risk considerations in corporate bonds is least likely correct?

Solution

B is correct. West is incorrect in Comment 3. Spread duration is a useful measure for determining a portfolio’s sensitivity to changes in credit spreads. Because credit spread volatility—as opposed to outright credit default loss—is more relevant for investment-grade bonds than for high-yield bonds, the risk in a portfolio of investment-grade bonds is typically measured in terms of spread duration.

A is incorrect because Comment 1 is correct. Investment-grade bonds are quoted as a spread to Treasuries and move lockstep in price with changes in interest rates. High-yield bonds are typically quoted in dollar prices or yields and may not move with rates as frequently.

C is incorrect because Comment 2 is correct. The 4 Cs of credit are used to assess creditworthiness and, as a result, can be applied to determine the probability that a borrower will default and the severity of the loss.

Fixed-Income Active Management: Credit Strategies Learning Outcome

Describe risk considerations for spread-based fixed-income portfolios

ChatGPT (Correct)

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