Corporate bonds markets

A primary distinguishing feature of a bond is its issuer. The nature of the issuer will affect the way the bond is viewed in the market. There are four issuers of bonds sovereign governments and their agencies, local government authorities, supranational bodies such as the World Bank, and corporations. Within the corporate bond market there is a wide... 

So far we have focused on the issuers view of the market— why they want to access it, and what are the barriers to their doing so. How about investors What attractions does the European corporate bond market hold for them ... 

The gilts market is primarily a plain vanilla market, and the majority of gilt issues are conventional fixed interest bonds. Conventional gilts have a fixed coupon and maturity date. By volume they made up 82% of the market in June 2002. Coupon is paid on a semi-annual basis. The coupon rate is set in line with market interest rates at the time of issue, so the range of coupons in existence reflects the fluctuations in market interest rates. Unlike many government and corporate bond markets, gilts can be traded in the smallest unit of currency and sometimes nominal amounts change hands in amounts quoted down to one penny ( 0.01) nominal size. 

Ex post simulations are run with historical data in order to determine the optimal portfolio. This allows us to review which portfolio structure would have been optimal with the given data from an ex post perspective. Due to the less developed corporate bond market in the... 

Euroland as compared to the United States and the restricted availability of appropriate data, the focns was set on the US financial markets. The US market for government bonds is represented by the Salomon Brothers Treasnry indices. We focns on the Salomon Brothers corporate indices as a mirror image of the corporate bond market. 

Let us consider first the probability of default. One way to obtain default probabilities is to observe credit spreads in the corporate bond market. 

Wilson, R., and F. Faboza. 1990. The New Corporate Bond Market IfCh. 11). New York Probus Pubhshing. 

A credit default swap (CDS) price provides fundamental credit risk information of a specific reference entity or asset. As explained before, asset swaps are used to transform the cash flows of a corporate bond for interest rate hedging purpose. Since the asset swaps are priced at a spread over the interbank rate, the ASW spread is the credit risk of the same one. However, market evidence shows that credit default swaps trade at a different level to asset swaps due to technical... 

Central banks and market practitioners use interest rates prevailing in the government bond market to extract certain information, the most important of which is implied forward rates. These are an estimate of the market s expectations about the future directirMi of short-term interest rates. They are important because they signify the market s expectafirMis about the future path of interest rates however, they are also used in derivative pricing and to create synthetic bond prices from the extent of credit spreads of corporate bonds. 

The yield of a benchmark government bond depends on expected inflation rate, currency rate, economic growth, monetary and fiscal policy. Conversely, the spread of a corporate bond is influenced by the credit risk of the issuer, taxation and market liquidity. Moreover, the yield spread depends on other factors such as ... 

Z-spread The Z-spread or zero volatility spread calculates the yield spread of a corporate bond by taking a zero-coupon bond curve as benchmark. Conversely to other yield spreads, the Z-spread is constant. In fact, it is found as an iterative procedure, which is the yield spread required to get the equivalence between market price and the present value of all its cash flows. The Z-spread is given by Equation (8.2) ... 

Like Black and Cox s work, the authors find spreads similar to the market spreads. Moreover, they find a correlation between credit spread and interest rate. In fact, they illustrate that firms with similar default risk can have a different credit spread according to the industry. The evidence is that a different correlation between industry and economic environment affects the yield spread on corporate bonds. Then, the duration of a corporate bond changes following its credit risk. For high-yield bonds, the interest-rate sensitivity increases as the time to maturity decreases. 

In chapter 2 of the companion volume to this book in the boxed-set library, Corporate Bonds and Structured Financial Products, we introduced the concept of the yield curve, and reviewed some preliminary issues concerning both the shape of the curve and to what extent the curve could be used to infer the shape and level of the yield curve in the future. We do not know what interest rates will be in the future, but given a set of zero-coupon (spot) rates today we can estimate the future level of forward rates using a yield curve model. In many cases however we do not have a zero-coupon curve to begin with, so it then becomes necessary to derive the spot yield curve from the yields of coupon bonds, which one can observe readily in the market. If a market only trades short-dated debt instruments, then it will be possible to construct a short-dated spot curve. 

The different types of bonds in the European market reflect the different types of issuers and their respective requirements. Some bonds are safer investments than others. The advantage of bonds to an investor is that they represent a fixed source of current income, with an assurance of repayment of the loan on maturity. Bonds issued by developed country governments are deemed to be guaranteed investments in that the final repayment is virtually certain. For a corporate bond, in the event of default of the issuing entity, bondholders rank above shareholders for compensation payments. There is lower risk associated with bonds compared to shares as an investment, and therefore almost invariably a lower return in the long term. 

Bonds with embedded call and put options comprise a relatively small percentage of the European bond market. Exhibit 1.6 shows the percentage of the market value of the Euro Corporate Index and Pan-Euro Corporate Index attributable to bullets (i.e., option-free bonds), callable and putable bonds from the late 1990s through 31 May 2003. Accordingly, our discussion of bonds with embedded options in the remainder of the book will be confined to structured products. 

The CCABS market continues to be a safe haven for European ABS investors. Especially in 2002, when corporate bonds of various sectors showed increased price volatility and the CDO market experienced a significant number of downgrades, credit card ABS transactions continued to show strong and stable performance. In fact, since the market s inception in 1995, no European CCABS have experienced any downgrades. We believe that CCABS are likely to continue to exhibit strong and stable performance and remain one of the core asset classes for European ABS investors. 

The calibrated tree can now be used to calculate corporate bond spreads as well as bond options. The outlined procedure is close to that advanced by Black, Derman, and Toy in that the process fits observed market rates and short rate volatility. There is, however, a danger that interest rates could go negative in this procedure. 

Exhibit 21.4 illustrates a generic TR swap. The protection buyer has contracted to pay the total return on a specified reference asset, while simultaneously receiving a LIBOR-based return from the protection seller. The reference or underlying asset can be a bank loan such as a corporate loan or a sovereign or corporate bond. The total return payments include the interest payments on the underlying loan as well as any appreciation in the market value of the asset. The protection seller will pay the LIBOR-based return it will also pay any difference if there is a depreciation in the price of the asset. The economic effect is as if this entity owned the underlying asset, as such TR swaps are synthetic loans or securities. 

This same factor can also be used to compute spread risk in markets where there is not enough data to build a detailed credit block. It can also be used in markets where more detailed credit factors are available, but when there is not enough information to expose a bond to the appropriate credit factor. As we will see in what follows, this will be the case when a euro- or sterling-denominated corporate bond is not rated. Based on the observation that bonds with larger spreads are on average more risky, Barra s model assumes the following exposure to the swap factor ... 

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