High-yield bonds

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. 

Some practitioners argue that Merton models are more appropriate than reduced form models when pricing default swaps on high-yield bonds, due to the higher correlation of high-yield bonds with the underlying equity of the issuer firm. 

In 2001, Fitch Ratings launched a default index dedicated to the emerging European high-yield bond market. The index is a par based index and was created using the same methodology Fitch employs for its US high-yield default series (see Exhibit 28.2). In particular, in order to... 

EXHIBIT 28.9 Vintage Distribution of Defaulted High-Yield Bonds Excluding Fallen Angel United States 2001... 

Fitch used the market prices of defaulted bonds one month after default as a proxy for recovery value. The growth of a secondary market for European high-yield bonds made this analysis possible but ultimately the various bankruptcy jurisdictions in Europe will determine how bondholders will fare. The outcome of these filings will be very meaningful for the development of the market going forward because each country has its own bankruptcy laws and not all are favorable to bondholders. Some jurisdictions, such as France for example, strongly... 

To gain exposure to sectors where, for various reasons, they do not wish to make actual purchases, investors can use a variation on a TR swap called an index swap, in which one of the counterparties pays a total return tied to an external reference index and the other pays a LIBOR-linked coupon or the total return of another index. Indexes used include those for government bonds, high-yield bonds, and technology stocks. Investors who believe that the bank loan market will outperform the mortgt e-backed bond sector, for instance, might enter into an index swap in which they pay the total return of the mortgage index and receive the total return of the bank-loan index. 

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