19 June - FI Active mgt summary
SUMMARY
📍 Yield spreads compensate investors for the risk that they will not receive expected interest and principal cash flows and for the bid–offer cost of buying or selling a bond under current market conditions.
💡 Two key components of a bond’s credit risk are the POD (probability of default) and the LGD (loss given default).
💡 Credit spread changes are driven by the credit cycle, or the expansion and contraction of credit over the business cycle, which causes asset prices to change based on default and recovery expectations.
💡 High-yield issuers experience greater changes in the POD over the credit cycle than investment-grade issuers, with bond prices approaching the recovery rate for distressed debt.
📍 While fixed-rate bond yield spread measures use actual, interpolated, or zero curve–based benchmark rates to capture relative credit risk, OAS (option-adjusted spreads) allow comparison between risky option-free bonds and bonds with embedded options.
📍 FRNs (floating rate notes) pay periodic interest based on an MRR (market reference rate) plus a yield spread.
📍 Spread duration measures the change in a bond’s price for a given change in yield spread, while spread changes for lower-rated bonds tend to be proportional on a percentage rather than an absolute basis.
💡 Bottom-up credit strategies include the use of financial ratio analysis, reduced form credit models (such as the Z-score model), and structural credit models, including Bloomberg’s DRSK model.
💡 Top-down credit strategies are often based on macro factors and group investment choices by credit rating and industry sector categories.
💡 Fixed-income factor investing incorporates such factors as size, value, and momentum to target active returns and also increasingly include ESG factors.
💡 Liquidity risk in credit markets is higher than in equities because of market structure differences and is often addressed using liquid bonds for short-term tactical positioning, less liquid positions for buy-and-hold strategies, and liquid alternatives where active management adds little value.
💡 Credit market tail risk is usually quantified using VaR (value at risk) or expected shortfall measures and is frequently managed using position limits, risk budgeting, or derivative strategies.
💡 Credit derivative strategies offer a synthetic liquid alternative to active portfolio managers as a means of over- or underweighting issuers, sectors, and/or maturities across the credit spectrum.
💡 Credit spread levels and curve slopes change over the credit cycle, with credit curve steepening usually indicating low near-term default expectations and higher growth expectations, while curve flattening, or inversion, suggests rising default expectations and lower future growth.
💡 Active credit managers can benefit under a stable credit curve scenario by adding spread duration for existing exposures and/or increasing average portfolio credit risk and can capitalize on divergent market views using cash- or derivative-based strategies related to specific issuers, sectors, or the overall credit market.
💡 Investors in international credit markets distinguish between developed and emerging markets. Developed markets face common macro factors, with market and credit cycle differences affecting relative interest rates, foreign exchange rates, and credit spreads. Emerging markets usually exhibit higher growth combined with greater sovereign and geopolitical risk, currency restrictions, and capital controls.
💡 Structured financial instruments offer active credit managers access to liquid bond portfolios, fixed-income cash flows derived from real estate and consumer loans, and enhanced returns by adding volatility and/or debt exposure via tranching across the credit spectrum.
💡 Key considerations for fixed-income analytical tools include the accuracy of model inputs and assumptions as well as alignment between model outputs and fixed-income manager objectives.
Asset swap spread (ASW)
The spread over MRR on an interest rate swap for the remaining life of the bond that is equivalent to the bond’s fixed coupon.
Asset swaps
Convert a bond’s fixed coupon to MRR plus (or minus) a spread.
Authorized participants
(APs) A special group of institutional investors who are authorized by the ETF issuer to participate in the creation/redemption process. APs are large broker/dealers, often market makers.
CDS curve
Plot of CDS spreads across maturities for a single reference entity or group of reference entities in an index.
Conditional value at risk
(CVaR) Also known as expected loss The average portfolio loss over a specific time period conditional on that loss exceeding the value at risk (VaR) threshold.
Credit default swap (CDS) basis
Yield spread on a bond, as compared to CDS spread of same tenor.
Credit loss rate
The realized percentage of par value lost to default for a group of bonds equal to the bonds’ default rate multiplied by the loss severity.
Credit valuation adjustment (CVA)
The present value of credit risk for a loan, bond, or derivative obligation.
Default intensity
POD over a specified time period in a reduced form credit model.
Default risk
Credit Risk: The risk that a fixed-income investor may not receive contractual interest and principal cash flows as expected, which is comprised of default risk and loss given default.
Discount margin
The discount (or required) margin is the yield spread versus the MRR such that the FRN is priced at par on a rate reset date.
Duration Times Spread (DTS)
Weighting of spread duration by credit spread to incorporate the empirical observation that spread changes for lower-rated bonds tend to be consistent on a percentage rather than absolute basis.
Empirical duration
The use of statistical methods and historical bond prices to estimate the price–yield relationship for a specific bond or portfolio of bonds.
Excess spread
Credit spread return measure that incorporates both changes in spread and expected credit losses for a given period.
G-spread
The yield spread in basis points over an actual or interpolated government bond.
I-spread (interpolated spread)
Yield spread measure using swaps or constant maturity Treasury YTMs as a benchmark.
Incremental VaR (or partial VaR)
The change in the minimum portfolio loss expected to occur over a given time period at a specific confidence level resulting from increasing or decreasing a portfolio position.
Option-adjusted spread (OAS)
A generalization of the Z-spread yield spread calculation that incorporates bond option pricing based on assumed interest rate volatility.
Last updated