Credit quality

We assume we have constructed a market curve of Libor discount factors where Df(t) is the price today of 1 to be paid at time t. From the perspective of the asset swap seller, it sells the bond for par plus accrued interest. The net up-front payment has a value 100 F where P is the market price of the bond. If we assume both parties to the swap are interbank credit quality, we can price the cash flows off the Libor curve. 

Interest rates and credit spread A greater level of interest rates decreases the value of the option-free bond or bond floor. Because the credit spread is applied only into the bond floor valuation, a greater credit quality decreases the credit spread and interest rate, and increases the value of the option-free bond. Conversely, higher is the interest rates and credit spread, lower is the value of an option-free bond. 

Bonds with embedded options are instruments that give the option holder the right to redeem the bond before its maturity date. For callable bonds, this right is held by the issuer. The main reason for an issuer to issue these debt instruments is to get protection from the decline of interest rates or improvement of issuer s credit quahty. In other words, if interest rates fall or credit quality enhances, the issuer has convenience to retire the bond from the market in order to issue again another bond with lower interest rates. 

In contrast, for putable bonds, the right to exercise the option is held by the bondholder. In fact, putable bonds allow the bondholder to sell the bond back before maturity. Conversely to callable bonds, this happens when interest rates go up (risk-free rate increases, or the issuer s credit quality decreases). In fact, the bondholders may have the advantage to sell the bond and buy another one with higher coupon payments. 

That said, there are two reasons why the performance of German swap spreads are related to Euro peripheral spreads. The first one is that, flows apart, the bond-swap spread reflects the yield difference between a government rate and the composition of a string of EURI-BOR rates (i.e., a swap fixed rate). As the average credit quality of the banks in the EURIBOR panel is A-AA, any increase in the investors preference for credit quality will make both swap and peripheral spreads widen versus the core Euro government rate, thus increasing the correlation between both differentials. Yet this increase in the correlation will be mainly due to the outperformance of the benchmark asset... 

Credit quality levels will wax and wane, and credit spread levels will fluctuate accordingly. But many of the structural shifts in the mar-... 

Issues are initially priced and sold at a fixed spread over the reference rate. The price of an FRN can fluctuate considerably during the life of the issue, mainly depending on trends in the issuer s credit quality. The frequent resets in the reference rate means that changes in market interest levels have a minimal impact on an FRN s price. For investors, movements in an FRN s price are reflected in changes in the discount rate. The discount rate is effectively the yield needed to discount the future cash flows on the security to its current price. It thus functions in the same way as the yield to maturity for a fixed-rate instrument. And like a fixed-rate bond, the market convention is to use a constant spread... 

This new Irish product provides an interesting enhancement to the range of high quality products available in this sector. The legal framework combines all the traditional elements of covered bonds from existing European markets with innovative augmentations that serve to strengthen credit quality further. 

Individual gilts are given names such as the 5% Treasury 2012 or the 9% Conversion 2011. There is no significance attached to the name given to a gilt, they are all identical in makeup and credit quality, and they all trade in the same way. Most issues in existence are now Treasury issues, although in the past it was sometimes possible to identify the purpose behind the loan by its name. For example a Conversion issue usually indicates a bond converted from a previous gilt. The 3V2% War Loan on the other hand was issued to help refinance loans raised to help pay for the 1914-18 war. The 3% Gas 1995/98 was issued to finance the nationalisation of the gas industry and was redeemed in 1998. 

The basic principle is illustrated with the following example. This considers a specific repo, that is, one in which the collateral supplied is specified as a particular stock, as opposed to a general collateral (GC) trade in which a basket of collateral can be supplied, of any particular issue, as long as it is of the required type and credit quality. 

They only invest with dealers of good credit quality, since an HIC repo may be perceived as an unsecured transaction. 

The credit quality of the counterparty supplying the collateral for example, a central bank counterparty, interbank counterparty and corporate will all suggest different margin levels. 

The type of mortgage can also influence the credit quality of the loan. In summary, mortgage products that exaggerate payment shocks are likely to experience increased levels of defaults, whereas those that provide a degree of stability or payment shock protection are likely to see fewer defaults. 

There is usually a correlation between the MPR and the credit quality of the cardholder. Convenience users are not overextended, while cardholders who make the monthly minimum payment have less flexibility in their budget should an interruption in their income occur. Exhibit 13.15 shows that while fluctuating on a month-on-month basis, monthly payment rates overall were relatively stable between January 2000 and September 2002. 

Tranched securities are generally rated by a rating agency, with the rating reflecting both the credit quality of the underlying assets as well as any measures put in place to reduce credit risk, known as credit enhancement. 

Managed transaction In case some of the credit quality of some of the exposures in the portfolio change, the manager is able to trade in and... 

If daily fixings of 3-month EURIBOR over the next year stay in the range 2.00% to 3.50%, the investor will receive an enhanced yield of 6.75% p.a. on a structured note, this coupon being paid as a single annual payment on the maturity of the note. This compares well with the 4.50% one year rate currently available on vanilla notes of similar credit quality. 

The most prominent impediment to swap market liquidity is swap counterparty credit exposure, which is balance-sheet intensive, in that it is a bilateral contract. The risk is the potential loss to a counterparty of the present value of a swap position if a swap party defaults. Therefore, parties to a swap transaction must be confident in the credit quality of... 

The credit curves (or default swap curves) reflect the term structure of spreads by maturity (or tenor) in the credit default swap markets. The shape of the credit curves are influenced by the demand and supply for credit protection in the credit default swaps market and reflect the credit quality of the reference entities (both specific and systematic risk). The changing levels of credit curves provide traders and arbitragers with the opportunity to measure relative value and establish credit positions. 

CDS prices are often compared to bond asset swap levels in order to gain an initial comparison of the credit quality implied by the market. In fact, differences do exist between the CDS spread and the asset swap spread, even though both spreads may be viewed as compensating the... 

Generally speaking, the five Treasury yield curves prove to be very correlated with each other. This evidence is consistent with the fact that there is uniqueness of monetary policy (same short-term rate for all countries) and that selected countries are fairly homogeneous in terms of credit quality and liquidity. 

In 2002 credit quality deteriorated, reflected in the increased share of lower-rated bonds in the indices (see Exhibits 25.5 and 25.6). In particular, we note that the proportion of triple-B rated bonds in the iBoxx Euro... 

First, the event of new supply may be symptomatic of deterioration in credit quality of the issuing company and/or sector (as in the case of the telecom and auto sectors). Second, some investors have a sector and name limits, hampering demand, resulting in wider spreads. Third, new... 

However, there is a more fundamental question that needs to be addressed here How does one measure credit quality Traditionally, investors have looked at the rating spectrum to represent credit quality,... 

With the introduction of the credit element, a new dimension is added to the concept of the yield curve. It becomes imperative to look at the credit spread curve, that is, the spreads offered by instruments in various credit quality buckets over the maturity continuum on the horizontal axis with the associated spread associated with those ratings on the vertical axis, as shown in Exhibit 26.14. 

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