Credit spreads level

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

The risk-free rate affects both elements, option-free bond and embedded option. Conversely, the credit spread is applied to the risk-free rate in order to find the price of the option-free bond. If the credit spread is also included into the option pricing model, the option value rises. For instance, consider the scenario in which the risk-free rate is 1.04% and the option value is 0.46. If the risk-free rate is 7.04%, then the option value increases to 0.66. Figure 9.16 shows the effect of a different interest rate level. 

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. 

In the Euro corporate market s short life, the level of credit spreads and spread volatility have increased almost beyond recognition. As we show in Exhibit 6.9, with the exception of the recovery from the market shock of 11 September 2001, credit spreads moved out more or less in a straight... 

An investor has the view that credit spread on the corporate issue ABC pic maturing in 2008 will narrow from today s level of 80 bps in six months. Therefore the investor enters into a 6-month credit spread forward with the counterparty (for example a bank) with strike level at the 80 bps level. The payout of the contract is structured so that as ... 

The buyer has the right to buy the spread and benefits from the spread decreasing in value. The payoff has the form max (strike - spread, 0). This option pays out if the spread tightens below the strike level, a tightening spread would result in an increasing bond price. Therefore the credit spread call option provides a payout should the underlying bond position increase in value. 

In this case let us assume that the premium for a credit spread put option is 30 bp. The credit spread put option will be sold by the investor to the counterparty (for example a bank) with a strike level of 370 bp. The option will provide the following payout ... 

During the life of this type of CLN, the investor would receive LIBOR + spread on the notional outstanding. The spread level would be related to the credit risk in the CLN and the costs of issuing the CLN. 

A credit spread assumption for each rating level. 

The disadvantages of the model include the fact that it depends on the selected historical transition matrix. The applicability of this matrix to future periods needs to be considered carefully, whether, for example, it adequately describes future credit migration patterns. In addition it assumes all securities with the same credit rating have the same spread, which is restrictive. For this reason the spread levels chosen in the model are a key assumption in the pricing model. Finally, the constant recovery rate is another practical constraint as in practice, the level of recovery will vary. 

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. 

Here we demonstrate that the credit spread is related to risk of default (as represented by the hazard rate) and the level of recovery of the bond. We assume that a zero-coupon risky bond maturing in a small time element At where ... 

The pricing of credit derivatives that pay out according to the level of the credit spread would require that the credit spread process is adequately modeled. In order to achieve this, a stochastic process for the distribution of outcomes for the credit spread is an important consideration. 

A key issue with credit spread options is ensuring that the pricing models used will calibrate to the market prices of credit risky reference assets. The recovery of forward prices of the reference asset would be a constraint to the evolution of the credit spread. More complex spread models may allow for the correlation between the level of the credit... 

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. 

Take a credit view (widening or narrowing of credit spreads during the selected period). For this purpose views could be taken by sector, rating (e.g., A, triple-B) or even on issue level. 

The bonds credit spread over Treasuries widens beyond a specified level... 

A bond s swap spread is a measure of the credit risk of a bond relative to the interest-rate swap market. Because the swap is traded by banks, or interbank market, the credit risk of the bond over the interest-rate swap is given by its spread over the IRS. In essence, then the IRS represents the credit risk of the interbank market. If an issuer has a credit rating superior to that of the interbank market, the spread will be below the IRS level rather than above it. 

However, a critical issue on this spread measure is how the asset swap has been stmctured. ASW measure works very well when bond prices trade at or near to par. Most corporate bonds trade with price away from the par (as in this case), thus making the ASW an inaccurate spread measure. If the bond trades at premium, the ASW spread will overestimate the level of credit risk conversely, if the bond trades at discount the ASW spread will underestimate the level of credit risk. Therefore, in the case of HERIM and TKAAV, the ASW spread overestimates the credit risk associated with the bonds because both trade significantly at premium. 

The Bloomberg ASW screen shows the Z-spread. It is 46.1 for HERIM and 45.9 for TKAAV. The Z-spread provides hence a better measure of spread, although giving a similar result in terms of investor s decision. However, being a constant measure, it does not consider the timing of default In fact, each cash flow has a different level of credit risk. To overcome this hmitatirHi, the Z-spread spread could be adjusted by introducing a probability of default for each cash flow. This other spread is referred to adjusted Z-spread or C-spread. 

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... 

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... 

Excess spread is available to build up the reserve fund to its required level and cover any principal deficiencies. For example, in the Holmes Financing transactions there is a mechanism whereby, if the yield on the mortgages falls below a certain specified level, excess spread will be trapped in a second reserve fund to provide additional credit enhancement as compensation for the reduction in excess spread. 

The class C noteholders benefit from a dynamic spread account. If 3-month average excess spread falls below a predetermined level, the spread account builds from monthly excess spread until the target level is reached. In order to fully understand the protection afforded by the spread account we need to assess the degree to which the spread account traps excess spread. Exhibit 13.10 shows excess spread trigger levels and trapping levels for a typical credit card issue. 

In this example, the dynamic spread account builds up only to approximately 1.6% of the transaction size, which is well below the target level of 5%. These two examples highlight the importance of the originator s ability to service the receivables pool effectively and, as such, avoid a rapid deterioration in the performance of the collateral. An originator that follows strict credit underwriting procedures and has experienced staff servicing accounts that enter a state of delinquency... 

Excess spread is important because it is the first line of protection for noteholders in that it absorbs charge-offs. While this is true, two portfolios with similar levels of excess spread can behave very differently in a worsening economic environment. Exhibit 13.21 shows excess spread for two different credit card portfolios. 

Strictly speaking, the FIAT 1 transaction does not generate excess spread. This explains the high level of credit enhancement from the unrated class M notes (usually, unrated tranches are either privately sold or kept as an equity tranche by the originator). On the closing date, an amount of notes was issued which was equal to the net present value of all future cash payments due from the collateral (as opposed to the principal balance of the collateral). The discount rate used was the fixed rate payable to the swap counterparty (swap rate plus coupon on the class A notes and all fees associated with the transaction). Structured this way, the receivables always yield the discount rate, leaving no excess spread in the transaction. However, losses on the FIAT 1 portfolio can be covered to a certain degree from interest collections because the structure provides for delinquent principal and defaults to be covered before interest is paid on the class M notes. 

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. 

In this way, any changes of shape and perceptions of the premium for CDS protection are reflected in the spreads observed in the market. In periods of extreme price volatility, as seen in the middle of 2002, the curves may invert to reflect the fact that the cost of protection for shorter-dated protection trades at wider levels than the longer-dated protection. This is consistent with the pricing theory for credit default swaps. 

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... 

However, it is also possible that an investor may find that there is a negative basis. For example, the credit default swap spread is less than the asset swap level for a cash instrument issued by the same reference entity. This situation may arise in the markets ... 

Long credit risk (i.e., long the bond risk) Short credit risk (i.e., short the bond risk) CDS spread is higher than the asset swap level CDS spread is lower than the asset swap level Long asset and long protection Short asset and short protection Long-credit risk Short-credit risk... 

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