Credit spreads factors

An average credit spread factor in the euro and sterling market. 

For the following example, we utilize the Barclays Capital Portfolio Analytics System XQA, which incorporates the aforementioned multifactor model. Again, this model incorporates factors that include points on the yield curve as well as factors related to credit spreads. We took the yield curve data in the sterling model from gilts and for the euro model from Bunds. The credit spread factors consist of buckets by sector and rating, among other factors. 

The general rule of corporate bonds is that they are priced at a spread to the government yield curve. In absolute terms, the yield spread is the difference between the yield to maturity of a corporate bond and the benchmark, generally a yield to maturity of a govermnent bond with the same maturity. Corporate bonds include a yield spread on a risk-free rate in order to compensate two main factors, liquidity premium and credit spread. The yield of a corporate bond can be assumed as the sum of parts of the elements as shown in Figure 8.1, in which the yield spread relative to a default-free bond is given by the sum of default premium (credit spread) and liquidity premium. 

Credit spread options are options whose payout is linked to the credit spread of the reference credit. This product can be used to manage the credit risk on corporate bond and corporate bond option positions. It isolates credit spread risk, which is an important factor in the underling... 

The payoffs may be multiplied by a leverage or duration factor to relate the spread changes to price changes of the underlying instrument. However, in our examples, we have ignored this factor. Exhibit 21.10 illustrates how an investor may use a credit spread put option as part of... 

The Das-Tufano (DT) model is an extension of the JLT model. The model aims to produce the risk-neutral transition matrix in a similar way to the JLT model however, this model uses stochastic recovery rates. The final risk neutral transition matrix should be computed from the observable term structures. The stochastic recovery rates introduce more variability in the spread volatility. Spreads are a function of factors that may not only be dependent on the rating level of the credit as in practice, credit spreads may change even though credit ratings have not changed. Therefore, to some extent, the DT model introduces this additional variability into the risk-neutral transition matrix. 

The pricing of a European spread option requires the distribution of the credit spread at the maturity (T) of the option. The choice of model affects the probability assigned to each outcome. The mean reversion factor reflects the historic economic features overtime of credit spreads, to revert to the average spreads after larger than expected movements away from the average spread. 

More complex models for the credit spread process may take into account factors such as the term structure of credit and possible correlation between the spread process and the interest process. 

At the time of this writing, corporate bonds denominated in currencies others than euro and sterling are only exposed to the local interest factors and if it exists, the swap factor. This swap factor is roughly equivalent to a financial AA spread factor, as the bulk of organizations that engage in swaps are AA-rated financial institutions. The swap model is coarser than the two local credit models discussed in the next section, but it performs adequately because spread changes are highly correlated within markets. 

Credit spreads are computed with respect to the local swap curve to accommodate for the swap spread factor. 

Our sterling multifactor model consists of 32 factors reflecting changes in yield curve and credit spreads. We obtained historical monthly... 

The credit spread reflects a number of macroeconomic and micro-economic factors, and at any one time is a good snapshot indicator of the perceived health and future prospect of the economy. For example, the reduction in spread from 2001 to 2004 reflects a general increase in favorable perception on the health of the U.S. economy, following the technology and dot-com boom and bust of the previous years and the market disruption following September 11, 2001. 

Credit options allow market participants to express their views on credit alone, without reference to other factors, such as interest rates, with no cost beyond the premium. For example, investors who believe that the credit spread associated with an individual entity or a sector (such as all AA-rated sterling corporates) will widen over the next six months can buy six-month call options on the relevant spread. If the spread widens beyond the strike during the six months, the options will be in the money, and the investors will gain. If not, the investors loss will be limited to the premium paid. 

This section discusses the factors that must be assessed in analyzing the relative values of government bonds. Since these securities involve no credit risk (unless they are emerging-market debt), credit spreads are not among the considerations. The zero-coupon yield curve provides the framework for all the analyses explored. 

Of these factors, one of the most significant is the term to maturity. The term structure of credit spreads exhibits a number of features. For instance, lower-quality credits trade at a wider spread than higher-quality credits, and longer-dated obligations normally have higher spreads than shorter-dated ones. For example, for a particular sector they may look like this ... 

Speculative trading is based on the views of the trader, the desk, or the department head. The view may be that of the firm s economics or research department—based on macro- and microeconomic factors affecting not just the specific market but the economy as a whole—or it may be that of the individual trader, resulting from fundamental and technical analysis. Because credit spreads are key to the performance 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 ... 

Where credit exposure is spread across geographic and industry sectors, the risk associated with localised events or problems in any individual sector will be much reduced. Where concentrations do exist, it is important to understand the underlying factors that will affect the performance of those loans. 

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 ... 

The model uses average spread levels observed within each rating category. Since these levels are market-dependent, so is specific risk. Another consequence is that this approach can only be implemented in highly liquid markets, where there are enough bonds to robustly estimate average spread levels—in practice, markets for which we can construct sector-by-rating credit factors. 

In this chapter we review credit ratings and their function, and then go on to consider the main factors involved in corporate bond credit analysis. The second part of this chapter looks at measuring bond returns and spreads, which are necessary if one is assessing the relative value of holding one bond position vis-a-vis another position, or a risk-free investment. 

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