CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r24 credit strategies IFT notes

R24 Credit Strategies IFT Notes Contents Introduction Investment-Grade and High-Yield Corporate Bond Portfolios 2.1 Credit Risk 2.2 Credit Migration Risk and Spread Risk 2.3 Interest Rate Risk 2.4 Liquidity and Trading Credit Spreads 3.1 Credit Spread Measures 3.2 Excess Return Credit Strategy Approaches 4.1 The Bottom-Up Approach 4.2 The Top-Down Approach 11 4.3 Comparing the Bottom-Up and Top-Down Approaches 14 4.4 ESG Considerations in Credit Portfolio Management 15 Liquidity Risk and Tail Risk in Credit Portfolios 15 5.1 Liquidity Risk 15 5.2 Tail Risk 16 International Credit Portfolios 17 6.1 Relative Value in International Credit Portfolios 17 6.2 Emerging Markets Credit 18 6.3 Global Liquidity Considerations 18 6.4 Currency Risk in Global Credit Portfolios 18 6.5 Legal Risk 18 Structured Financial Instruments 19 7.1 Mortgage-Backed Securities 19 7.2 Asset-Backed Securities 19 7.3 Collateralized Debt Obligations 20 7.4 Covered Bonds 20 Summary 20 Examples from the Curriculum 24 Example 24 IFT Notes for the Level III Exam www.ift.world Page R24 Credit Strategies IFT Notes Example 24 Example 25 Example 26 Example 27 Example 27 Example 28 Example 30 Example 31 Example 10 32 Example 11 32 This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute IFT Notes for the Level III Exam www.ift.world Page R24 Credit Strategies IFT Notes Introduction In the previous reading, we covered yield-curve strategies where we focused on government bonds with no credit risk However, in this reading we will cover bonds that have credit risk In Section we look at the characteristics of investment grade bonds and high yield corporate bonds, specifically we will focus on the differences in risk related to these two broad categories Then in Section we'll talk about different measures of credit spread Section deals with credit strategy approaches at a high level We will cover the top-down approach and the bottom up approach Section deals with liquidity risk and tail risk in credit portfolios In section 6, we go over international credit portfolios and finally section deals with structured financial instruments Investment-Grade and High-Yield Corporate Bond Portfolios LO.a: Describe risk considerations in investment-grade and high-yield corporate bond portfolios; Investment-grade bond portfolios with high yield corporate bond portfolios can be compared on the basis of  credit risk  credit migration risk and spread risk  interest rate risk  liquidity and trading 2.1 Credit Risk Credit risk is the risk of loss caused by a counterparty’s or debtor’s failure to make a promised payment There are two components of credit risk  Default risk: Probability that the borrower defaults  Loss severity (also called loss given default): Amount of loss if a default occurs Credit loss rate = Default risk x Loss severity It combines the two components of credit risk and this is ultimately what matters for analysts Exhibit from the curriculum shows the annual credit loss rates for corporate bonds from 1983 – 2015 IFT Notes for the Level III Exam www.ift.world Page R24 Credit Strategies IFT Notes Notice the following  Credit loss rate for high yield bonds is much higher relative to the credit loss rate for investment grade bonds  Also, the variability of the credit loss rate is significantly higher with high yield bonds Because of these two reasons a major consideration for high-yield portfolio managers is credit risk However, for investment –grade portfolio managers, credit risk is not a major concern They consider other factors like interest rate risk, spread risk and credit migration (We will cover these in the next two sections) 2.2 Credit Migration Risk and Spread Risk Credit migration risk is the risk that the credit quality of a bond deteriorates One or more rating agencies might downgrade a company’s bonds As the bonds become riskier, the spreads widen (spread risk) Since credit spread volatility rather than credit default loss is more relevant for investment-grade bonds, we use a measure called ‘spread duration’ to measure the risk of a portfolio of investment-grade bonds Spread duration measures the effect of change in spread on a bond’s price It is the approximate percentage increase in a bond’s price if the spread decreases by 1% For example, let’s say the following information is provided for a bond : P = 99.60; spread duration = 4.70; credit spread decreases by 20 bps The new price can be computed as new price = 99.60(1 + 0.2 x 0.047) = 100.54 For non-callable fixed rate bonds, spread duration ≈ modified duration This implies that interest rate changes and spread changes have a similar impact However, for other types of bonds, such as floaters or bonds with embedded options the two duration measures can be quite different Therefore, the key point is that spread risk in an investment-grade portfolio should be measured by spread duration and not by modified duration Since high-yield bonds have a much larger credit loss rate as compared to investment-grade bonds, therefore with high-yield bonds there is greater emphasis on credit risk and market value of position and in the event of default, we are more concerned about the size of our position rather than its spread duration 2.3 Interest Rate Risk Investment grade portfolios have a greater exposure to interest rate risk than high-yield portfolios This is because credit spreads have a negative correlation with risk-free interest rates To understand this concept, consider two bonds, i.e., an investment grade bond and a high yield bond The yields of both bonds will be equal to Risk free rate + Credit spread The risk free rate will be the same for both bonds; however, the credit spread will be much larger for the high yield bond In good economic times, the risk free rate goes up however, the credit spread narrows These two effects offset each other to an extent Similarly, in weak economic times the risk free rate goes down however the credit spread widens The overall yield for high yield bonds is therefore less impacted by changes in interest rate relative to investment-grade bonds IFT Notes for the Level III Exam www.ift.world Page R24 Credit Strategies IFT Notes Empirical duration is a measure of interest rate sensitivity that is determined from market data Exhibit from the curriculum shows the effective duration and empirical duration for corporate bonds with different credit ratings The following observations can be made from this exhibit  In general, the empirical duration is lower than effective duration For high yield bonds, the empirical duration is much lower  This finding indicates that high yield bonds have a low sensitivity to changes in interest rate Therefore high yield portfolio managers are less likely to focus on interest rate risk; they rather focus on credit risk However it is important to note that in good economic times, when credit spreads are tight, high yield bonds behave more like investment grade bonds and they have greater interest rate sensitivity 2.4 Liquidity and Trading Liquidity represents the ability to purchase or sell an asset quickly and easily at a price close to fair market value Liquidity is positively correlated with:  Bond’s issue size  Size of market in which bond is traded  Bond dealer inventory size High yield bonds are generally less liquid as compared to investment grade bonds because they tend to have a smaller issue size, the size of the market in which they are traded is also smaller and dealers are reluctant to hold a large inventory of high yield bonds because they are risky Since high-yield bonds are less liquid they have wider bid-ask spreads, this makes their turnover more expensive Investment grade and high yield bonds are quoted differently Investment grade bonds are quoted as spreads over benchmark government bonds while high-yield bonds are generally quoted in price terms IFT Notes for the Level III Exam www.ift.world Page R24 Credit Strategies IFT Notes This is due to the fact that for investment grade bonds we focus on spread changes, whereas for high yield bonds we focus on default losses and therefore focus on what is happening to the price of the bond Refer to Example from the curriculum Credit Spreads Credit spreads are based on various credit -related risks such as:  likelihood of default  probable loss given default  credit migration risk  market liquidity risk The major credit spread measures are:  Benchmark Spread  G-Spread  I-Spread  Z-Spread  Option-Adjusted Spread A related term is excess return, which is the additional return for purchasing a credit security Excess return is closely related to credit spreads (We will cover this concept later) 3.1 Credit Spread Measures LO.b: Compare the use of credit spread measures in portfolio construction; Benchmark spread = yield on credit security – yield on benchmark bond  The benchmark bond should have similar duration and little or no credit risk  If government bonds are used as a benchmark, then the spread measure is called G-spread  If interest rate swaps are used as a benchmark, then the spread measure is called I-spread G-spread is the spread over an actual or interpolated government bond Interpolation: When no government bond exists that has the same duration as the credit security, a linear interpolation of the yields on two on-the-run government bonds is used as the benchmark rate The two bonds are weighted such that their weighted average duration matches the credit security’s duration The advantages of using a G-spread are:  It is easy to calculate and understand  It is calculated in the same way by different investors  It indicates way to hedge the interest rate risk of credit securities  It provides a mechanism to estimate prices changes for option-free, fixed rate securities (covered in example 2) I-spread is the spread over the relevant swap rate i.e., swap rate denominated in the same currency as IFT Notes for the Level III Exam www.ift.world Page R24 Credit Strategies IFT Notes the credit security Following are some important considerations when evaluating G-spread and I-spread:  Swap curves are smoother than government bond yields This is due to the fact that government bond yield curves are impacted by supply demand for specific bonds Also, there are a lot more swap rates in the market as compared to on the run-government bonds  Benchmark rate is most helpful when it represents a credit risk-free rate Therefore, if you believe that government bonds have no credit risk, but swap rates have some embedded credit risk it will be more appropriate to use G-spreads instead of I-spreads and vice versa  If I-spread is calculated but government bonds are used to hedge this exposure, then realized spread will differ from calculated spread Refer to Example from the curriculum The benchmark spread measures we covered so far, the G-spread and I-spread are useful for pricing and hedging credit securities However if we want to compare relative value across credit securities, then we use the Z-spread and option-adjusted spread Z-spread is the yield spread that must be added to each point of the implied spot yield curve to make the present value of a bond’s cash flows equal its current market price OAS is the constant spread that, when added to all the one-period forward rates on the interest rate tree, makes the arbitrage-free value of the bond equal to its market price Z-spread is useful for comparing bonds without embedded options Whereas, OAS is useful for comparing bonds with different features Points to note when using OAS are:  The calculated OAS depends on assumptions regarding future interest rate volatility  The realized spread is likely to be different from OAS  OAS is an appropriate measure for portfolio level spread  Portfolio OAS is based on weighted average of OAS of individual bonds (covered in example 4) Refer to Example from the curriculum Refer to Example from the curriculum 3.2 Excess Return Excess return is the return of a bond after interest rate risk has been hedged In other words, it's the return an investor receives for assuming credit -related risks By definition, credit risk is different from interest-rate risk, so typically interest-rate risk and credit related risks are managed separately Credit spread is equal to excess return if there is no change in the security’s yield or in interest rates, and if the security does not default during the holding period Assuming no default losses, excess return can be computed as: XR ≈ (s × t) – (∆s × SD) Where, XR is the holding-period excess return, s is the spread at the beginning of the holding period, t is IFT Notes for the Level III Exam www.ift.world Page R24 Credit Strategies IFT Notes the holding period expressed in fractions of a year, Δs is the change in the credit spread during the holding period, and SD is the spread duration of the bond If there is a possibility of default loss, expected excess return can be computed as: EXR ≈ (s × t) – (Δs × SD) – (t × p × L) Where, p is the annualized expected probability of default and L is the expected loss severity Note that the term (p × L) is the expected annual credit loss Refer to example from the curriculum Credit Strategy Approaches Credit strategy generally involves establishing a return objective given certain risk constraints Some examples of credit strategy statements are: “Construct and manage a portfolio that maximizes return within a set of risk limits” “Construct and manage a portfolio that outperforms a given benchmark by x% using only investmentgrade bonds” There are two broad credit strategy approaches: 1) Bottom-Up approach 2) Top-down approach 4.1 The Bottom-Up Approach LO.c: Discuss bottom-up approaches to credit strategies; The bottom-up approach is based on the assessment of the relative value of individual issuers or bonds It is also called the ‘security selection strategy’ This approach is appropriate for analyzing companies that have comparable credit risk Steps in a bottom-up approach: Step 1: Establish a universe of eligible bonds and divide into industry sectors such as telecommunication and capital goods Each sector can be broken down further, for example telecommunication can be broken down into wireless and wireline A starting point for this step can be benchmark vendor’s sector classification However, one should determine whether the industry/ sector classifications of the benchmark are overly broad or inaccurate Refer to Example from the curriculum Step 2: Identify bonds with the “best” relative value within each sector Here we evaluate compensation for credit-related risk against the expected magnitude of the credit-related risks If credit-related risks are similar, then one should buy the bond with higher spread If credit-related risks are different, then we should determine if the additional spread is worth the additional risk For this analysis, the following factors should be considered:  Historical default rate information based on credit rating categories For example, we can compare the historical default rates of AA category bonds with AAA category bonds to IFT Notes for the Level III Exam www.ift.world Page R24 Credit Strategies  IFT Notes determine if it is worth investing in AA category given the additional risk Average spread level for each sector and credit rating For example, if an analyst identifies a BB rated cement company whose bonds trade at a wider credit spread than the average credit spread on bonds of other BB rated cement companies, the investor can investigate further and find out the reason for this higher spread The following equation for expected excess return can be used in the analysis EXR ≈ (s × t) – (∆s × SD) – (t × p × L) The credit spread, holding period, and spread duration can be determined by the investor; however, the change in credit spread is unknown in advance and the investor must enter an expected value for this variable Some other factors that are considered in the final selection of bonds are:  Liquidity: An investor may select a liquid bond over another cheaper bond that is less liquid, to improve the overall liquidity of his portfolio  Portfolio diversification: An investor may select a bond because of the potential diversification benefit it offers when added to his portfolio  Risk: An investor may select a bond that is a little more expensive, but has a lower risk Refer to Example from the curriculum Spread Curves Spread curve is a fitted curve of credit spread versus spread duration or maturity for a given issuer An issuer may have several bond issues with different maturities and duration We can draw a spread curve for each issuer and use it to conduct relative value analysis Exhibit from the curriculum, shows a sample spread curve for two issuers Verizon and AT&T At a given spread duration, we should pick a bond with higher spread if credit worthiness is the same IFT Notes for the Level III Exam www.ift.world Page R24 Credit Strategies IFT Notes We can also evaluate bonds that are significantly above or below the fitted spread curves Other Considerations in Bottom-Up Relative Value Analysis In addition to excess returns some other factors that should be considered in bottom-up relative value analysis are  Bond Structure: Senior bonds will have relatively low spreads as compared to subordinated bonds Similarly bonds with options will have different spreads as compared to option-free bonds  Issuance date: Recently issued bonds tend to have higher liquidity and lower spreads  Supply: When an issuer announces a new corporate bond issue, the spreads on the issuer’s existing bonds widen One reason for this is simply that the supply of bonds has gone up Another reason might be that the debt issuance signals an increase in the issuer’s credit risk  Issue Size: If the issue size is large, liquidity is relatively high and therefore spreads are low Refer to Example from the curriculum Bottom-Up Portfolio Construction When constructing a portfolio using bottom-up approach, how we figure out how much value to assign to different sectors and then to different securities within a sector? Broadly speaking models for coming up with position sizes can be based either on market value or on spread duration The following boxed example from the curriculum, illustrates the difference between these two approaches very well Bottom-Up Portfolio Construction Suppose that one sector in an investor’s benchmark consists of European retail companies If the European retail sector constitutes 8% of the investor’s benchmark based on market value, then she may target an 8% weighting in those European retailers that she has determined to be most attractively valued If the portfolio has a market value of £50,000,000, then an 8% weighting will imply purchasing £4,000,000 worth of European retailers Now suppose that the portfolio’s benchmark has a weighted-average spread duration of 4.0, and the European retailers in the benchmark have a weighted-average spread duration of 5.0 Then, measured by spread duration, the European retailers constitute 10% [(5.0 × 8%)/4.0] of the benchmark Using this spread duration metric, the investor would target a 10% weighting in European retailers The appropriate approach to use depends on the default risk We should use market value if default risk is an important consideration, otherwise spread duration is better If a given sector has many attractively valued bonds, then we may end up selecting more bonds from this sector and this could lead to a higher sector weight relative to benchmark Sometimes obtaining the desired bonds may be challenging, so investors can use alternatives such as: Substitution: If the best bond (the most undervalued bond) is very illiquid and hard to buy, then we might use the next best or the third best bond Indexing: Indexing refers to constructing a portfolio to mirror the performance of a specific index Here IFT Notes for the Level III Exam www.ift.world Page 10 R24 Credit Strategies IFT Notes new bond issues (increased supply) in US during a particular time period, this increased supply will reduce bond prices and the US market will underperform An example of demand factor is the 2015 and early 2016 period for Europe During this period, interest rates on sovereign bonds were negative; this resulted in a higher demand for corporate bonds which were providing a better yield This increased demand lead to higher bond prices and the European market outperformed the US market 6.2 Emerging Markets Credit As analysts we should be aware of the differences between credit markets in emerging market countries and credit markets in developed countries Listed below are some major differences:    Concentration in commodities and banking: A very large percentage of bonds in the emerging markets are related to commodities and banking Even with the banking sector, the number of loans made to commodity companies is high, which means that even the banking sector is exposed to commodities Government ownership: Many emerging market bond issuers are either government owned or have a controlling or partial stake owned by the local government The advantage is that this reduces the probability of default However if a default occurs, the disadvantage is the uncertainty in the contractual rights and interests of non-domestic bondholders Historically it has been seen that the recovery rates for emerging market bonds are lower than the recovery rates for developed markets Credit quality: There is a high concentration in both the lower portion of the investment-grade spectrum and the upper portion of the high yield spectrum This is due to a ‘sovereign ceiling’ which refers to the fact that the highest rating for a corporate issuer will be equal to the sovereign rating of the emerging country 6.3 Global Liquidity Considerations As global investors we need to be aware of the liquidity implications on our global portfolio On the liquidity spectrum, at one end we have the US markets that are the most liquid and on the other end we have emerging markets that are the least liquid In addition, in US we have better reporting systems such as TRACE which provide transparency However, reporting systems elsewhere are virtually nonexistent Before investing, we should be aware of the liquidity issues we might face 6.4 Currency Risk in Global Credit Portfolios If we are investing internationally then currency risk will obviously be a concern Currency risk becomes even more important in a low interest rate environment, because when interest rates are low, changes in exchange rates can have a major impact on the portfolio We can deal with currency risk by hedging it using instruments such as forwards, futures and swaps Another mechanism is to invest in countries where the currency is pegged or tightly managed For example, Chinese yuan and Hong Kong dollar 6.5 Legal Risk Laws and regulations in different parts of the world are very different, and in particular bankruptcy laws IFT Notes for the Level III Exam www.ift.world Page 18 R24 Credit Strategies IFT Notes can be quite complicated If an international investor does not understand the bankruptcy laws in the various countries where he is investing, then the recovery rates can be relatively low Structured Financial Instruments LO.h: Describe the use of structured financial instruments as an alternative to corporate bonds in credit portfolios Structured financial instruments are backed by a pool of assets For example, Mortgage Backed Security (MBS) are backed by a pool of mortgages The main idea behind structured financial instruments is to repackage risks Advantages of using structured financial instruments in credit portfolios are listed below     There are multiple tranches with different risk and return profiles which can offer a potential for high returns Structured financial instruments are very different from corporate bonds with respect to their features, valuation and risk exposures and because of these differences, we can potentially find relative value opportunities There is a possibility of more-targeted exposure to a certain market or sector For example, if we invest in a MBS we gain exposure to the real estate sector Improved portfolio diversification: Given the differences between structured financial instruments and corporate bonds, there is clearly a diversification benefit by adding structured financial instruments to our portfolio 7.1 Mortgage-Backed Securities MBS offer the following advantages relative to corporate bonds     Liquidity: MBS backed by a government agency such as Ginnie Mae, Fannie Mae or Freddie Mac often have higher liquidity than high quality corporate bonds Exposure to real estate: Residential MBS provide exposure to the residential real estate markets, whereas commercial MBS provide exposure to commercial real estate market Exposure to expected changes in interest rate volatility: MBS securities have prepayment risk that is related to changes in interest rates If we are expecting interest rate volatility to be relatively low, then we should buy mortgage-backed securities and if we expect interest rate volatility to be relatively high, then we should sell mortgage-backed securities Mortgage-backed securities are also useful tool for investing based on views of the credit cycle and the real estate cycle For example, if we expect the credit cycle to weaken, but we expect real estate to remain stable, then it makes sense to invest in mortgage-backed securities In a weakening credit cycle, the spreads on corporate bonds will increase, which means that the price of corporate bonds will come down But since mortgage-backed securities are backed by real estate, their values are likely to remain stable So in such a situation mortgage-backed securities were outperform regular corporate bonds 7.2 Asset-Backed Securities There are several types of ABS based on the collateral that is being used to back up these securities For IFT Notes for the Level III Exam www.ift.world Page 19 R24 Credit Strategies IFT Notes example, auto loans, credit card receivables, student loans etc If we have a view on any particular segment, then we can invest in that type of ABS For example, if you believe that auto loans will perform, you can invest in asset backed securities backed by auto loans 7.3 Collateralized Debt Obligations A CDO is a security backed by a diversified pool of one or more debt obligations Typically the debt obligations are corporate bond or corporate loans Therefore adding a CDO to a portfolio that already contains corporate bonds provides low diversification benefits However the benefits of including CDOs in a credit portfolio are:  Relative value: The value of a CDO may be different from the value of the underlying collateral bonds This mispricing can be exploited profitably  Exposure to default correlations: The correlation of expected defaults between the underlying collateral bonds affects the relative value of the senior and subordinated tranches of the CDO If the correlation increases then the subordinated tranche becomes more valuable So based on our view of the default correlations, we can take a position in the subordinated tranche  Leveraged exposure to credit: Subordinated tranches provide a mechanism to earn additional returns if the underlying collateral bonds perform well However, if the bonds not perform well, subordinated tranches can lead to losses This risk-return trade off matches a leveraged position in credit 7.4 Covered Bonds A covered bond is a debt obligation issued by a financial institution, usually a bank, and backed by a segregated pool of assets called a “cover pool” In the event of a default, investors have a recourse to both the assets in the cover pool as well as to the financial institution Due to this additional protection, covered bonds have lower credit risk and therefore offer lower yields Refer to Example 11 from the curriculum Summary LO.a: Describe risk considerations in investment-grade and high-yield corporate bond portfolios;       High-yield bonds have relatively high credit loss rates which implies high credit risk Investment-grade bonds have relatively low credit loss rates, therefore the focus is on other risks such as credit migration risk and spread risk Spread duration measures the effect of a change in spread on a bond’s price It is the approximate percentage increase in bond’s price if spread decreases by 1% For non-callable fixed rate bonds, spread duration ≈ modified duration; for floaters the two duration measures can be quite different Investment grade portfolios have greater exposure to interest rate risk than high-yield portfolios This is due to the fact that credit spreads have a negative correlation with risk-free interest rates A measure used to confirm this fact is empirical duration which is a measure of interest rate sensitivity that is determined from market data Investment grade bonds are more liquid than high yield bonds IFT Notes for the Level III Exam www.ift.world Page 20 R24 Credit Strategies IFT Notes LO.b: Compare the use of credit spread measures in portfolio construction; Spread Measure Benchmark spread G-spread Description Yield on credit security – yield on benchmark bond Yield on credit security – yield on government bond I-spread Yield on credit security – swap rate Z-spread Constant spread that must be added to each point of the implied spot yield curve to make the present value of a bond’s cash flows equal its current market price Constant spread that, when added to all the one-period forward rates on the interest rate tree, makes the arbitrage-free value of the bond equal to its market price OAS Comment  Actual or interpolated govt bond;  Indicates way to hedge interest rate risk; Swap curves are smoother than government bond yields; Works for bonds without embedded options;     Depends on assumptions regarding future interest rate volatility; Realized spread is likely to be different from OAS ; Appropriate measure for portfolio level spread; Portfolio OAS is based on weighted average of OAS of individual bonds;  Credit spreads are based on:  likelihood of default  probable loss given default  credit migration risk  market liquidity risk   Excess return is the return of a bond after interest rate risk has been hedged Credit spread is equal to excess return if there is no change in the security’s yield or in interest rates, and if the security does not default during the holding period XR ≈ (s × t) – (∆s × SD) assuming no default losses EXR ≈ (s × t) – (∆s × SD) – (t × p × L)   LO.c: Discuss bottom-up approaches to credit strategies;  The bottom-up approach (security selection strategy) is based on the assessment of the relative value of individual issuers or bonds; appropriate for analyzing companies that have comparable credit risk Step 1: Establish universe of eligible bonds and divide into industry sectors Step 2: Identify bonds with the “best” relative value within each sector IFT Notes for the Level III Exam www.ift.world Page 21 R24 Credit Strategies IFT Notes   Considerations: spread versus risk, bond structure, issuance date, supply and issue size Spread curve: fitted curve of credit spread versus spread duration or maturity for a given issuer  At a given spread duration, pick bond with higher spread if credit worthiness is the same  Evaluate bonds that are significantly above or below the fitted spread curves  With portfolios, position sizes can be based on market value or spread duration; use market value if default risk is an important consideration, otherwise spread duration is better If a given sector has many attractively valued bonds then we can give it a higher sector weight relative to benchmark Other factors to consider include: liquidity, portfolio diversification, risk   LO.d: Discuss top-down approaches to credit strategies;  The top-down approach to credit strategy focuses on macro factors such as: economic growth; overall corporate profitability; default rates; risk appetite; changes in expected market volatility; changes in credit spreads; interest rates; industry trends; and currency movements  Here we overweight attractively priced sectors (sector divisions tend to be relatively broad)  Industry sector allocation can be based on macro views, regression analysis and ratio analysis   Determine desired credit quality based on expectations for credit cycle and credit spread changes Approaches for measuring credit quality in a top-down approach:  Average credit rating  Average OAS  Average spread duration  Duration times spread  Interest rate management: We can manage our interest rate exposure using bonds or by using derivatives Country and currency exposure: Typically forwards, futures and swaps are used to manage currency risk Spread curves: We can construct portfolios based on our expectations of the spread curves (for example, will the spread curve flatten or steepen)   LO.e: Discuss liquidity risk in credit markets and how liquidity risk can be managed in a credit portfolio;  Measures of secondary market liquidity  Trading volume  Spread sensitivity to fund outflows; example: spread widening / percentage outflow  Bid-ask spreads  Structural industry changes and liquidity risk  Increased dealer reluctance to maintain large bond inventories after 2008-09 crisis  Increased distribution of investment grade and high yield bonds  Management of liquidity risk IFT Notes for the Level III Exam www.ift.world Page 22 R24 Credit Strategies      IFT Notes Percentage of cash in portfolio Managing position sizes Holding liquid non-benchmark bonds Making use of CDS index derivatives Making use of ETFs LO.f: Describe how to assess and manage tail risk in credit portfolios;    Tail risk is the risk that there are more actual events in the tail of a probability distribution than probability models would predict Assessing tail risk:  Historical scenario analysis  Hypothetical scenario analysis  Correlation in scenario analysis Managing tail risk in credit portfolios:  Portfolio diversification o Advantage: cost effective o Disadvantage: difficult to identify attractively valued investment opportunities that can protect against every tail risk  Tail risk hedges LO.g: Discuss considerations in constructing and managing portfolios across international credit markets;   Credit portfolio managers can improve returns through geographic diversification Relative value opportunities arise when there are country or regional differences in:  Credit cycles  Credit quality  Sector composition  Market factors  Differences between credit markets in emerging and developed countries:  Concentration in commodities and banking  Government ownership  Credit quality  Additional factors to consider:  Global liquidity considerations  Currency risk in global credit portfolios  Legal risk LO.h: Describe the use of structured financial instruments as an alternative to corporate bonds in credit portfolios  Advantages of using structured financial instruments in credit portfolios:  Multiple tranches with different risk and return profiles (potential for high returns) IFT Notes for the Level III Exam www.ift.world Page 23 R24 Credit Strategies    IFT Notes Potential for relative value opportunities Possibility of more-targeted exposure to a certain market or sector Improved portfolio diversification  Mortgage backed securities (MBS) offer: liquidity, exposure to real estate, exposure to expected changes in interest rate volatility; useful tool for investing based on views of the credit cycle and the real estate cycle  CDO: security backed by a diversified pool of one or more debt obligations; not offer much diversification but there are other potential benefits: relative value; exposure to default correlations and leveraged exposure to credit  Covered bonds: debt obligation issued by a financial institution, usually a bank, and backed by a segregated pool of assets called a “cover pool”; investors have recourse to financial institution and assets in the covered pool This additional protection results in lower credit risk and therefore lower yields Examples from the Curriculum Example Investment-Grade and High-Yield Bond Portfolios Compared with an investment-grade bond portfolio manager, a high-yield bond portfolio manager will most likely put greater emphasis on: A credit risk B spread risk C interest rate risk Solution: A is correct Credit risk is usually the most important consideration for high yield portfolio managers because of the higher credit risk and credit loss rate in high-yield portfolios compared with investmentgrade portfolios For investment grade portfolio managers, interest rate, spread, and credit migration (downgrade) risks are typically the most relevant considerations Back to Notes Example Using G-Spread to Calculate Interest Rate Hedges and Price Changes On 31 March 2016, a portfolio manager gathers information for the following bonds: Citigroup 3.75% due 16 June 2024 US Treasury 1.5% due 31 March 2023 (on-the-run 7-year Treasury note) US Treasury 1.625% due 15 February 2026 (on-the-run 10-year Treasury note) Price, yield, and effective duration measures for the three bonds are as follows: IFT Notes for the Level III Exam www.ift.world Page 24 R24 Credit Strategies IFT Notes Later, the portfolio manager observes that the 7-year Treasury note’s yield falls from 1.53% to 1.43% while the 10-year Treasury note yield remains unchanged Based on the interest rate changes, what is the portfolio manager’s estimate of the price change in the Citigroup bond? Solution:      A weighting of 87.5% = [(9.1 – 7.0)/(9.1 – 6.7)] of the 7-year Treasury note and 12.5% = [(7.0 – 6.7)/(9.1 – 6.7)] of the 10-year Treasury note matches the duration of 7.0 = [0.875(6.7) + 0.125(9.1)] of the Citigroup bond The linearly interpolated yield from the two government bonds is 1.56% = [0.875(1.53%) + 0.125(1.77%)] Te linearly interpolated yield can also be calculated using duration, 1.56% = [(7.0 – 6.7)/(9.1 – 6.7) × (1.77% – 1.53%) + 1.53%] The G-spread on the Citigroup bond is 1.68% = 3.24% – 1.56%, or 168 bps, which is the difference between its yield and the interpolated yield To hedge the Citigroup bond, the portfolio manager sells or sells short the 7-year Treasury note and the 10-year Treasury note, using weightings of 87.5% and 12.5%, respectively The portfolio manager estimates the new yield on the interpolated Treasury to be 1.47% = [0.875(1.43%) + 0.125(1.77%)] or = [(7.0 – 6.7)/ (9.1 – 6.7) × (1.77% – 1.43%) + 1.43%] The interpolated Treasury yield has fallen by 0.09%, or bps, from 1.56% to 1.47% Therefore, she assumes that the yield of the Citigroup bond has fallen by 0.09% as well The portfolio manager estimates that the price on the Citigroup bond has risen from 103.64 to 104.29 = 103.64 × [1 + (7 × 0.09%)], representing an absolute increase of 0.65 or a percentage increase of 0.63% Back to Notes Example Using Credit Spread Measures The Charter Communications 5.75% bond issue due 15 January 2024 has the following call schedule: On 11 April 2016, the bond issue is trading at a price of 104 Spread measures are as follows: IFT Notes for the Level III Exam www.ift.world Page 25 R24 Credit Strategies IFT Notes Based on the information given, explain why the OAS differs from the other spreads, what the difference in spread implies, and why OAS is the best measure of relative value for the Charter Communications bond Solution: Because the bond is trading significantly above the price at which it can be called, the probability of the bond being called on the next call date is reasonably high A call option on a bond is effectively “sold” by the investor to the issuer The issuer is likely to exercise the option only when the exercise is favourable for the issuer The bond’s OAS of 297 bps is lower than its G-spread, I-spread, or Z-spread because of the call option on the bond The difference between the OAS and the other spread measures implies that the value of the call option is about 70 bps The option-adjusted spread is the best measure of the value of the Charter Communications bond compared with the other spread measures because it reflects the value of the embedded option Back to Notes Example OAS of a Portfolio A portfolio consists of investments in two bond issues, Bond A and Bond B The following table shows relevant information on the bonds in this portfolio Calculate the portfolio’s OAS Solution: Market value of investment in Bond A = $1 billion × (0.95 + 0.015) = $965 million Market value of investment in Bond B = $2 billion × (0.97 + 0.02) = $1.980 billion Portfolio market value = $965 million + $1.98 billion = $2.945 billion Portfolio weight for Bond A = $965 million/$2.945 billion = 32.8% Portfolio weight for Bond B = $1.980 billion/$2.945 billion = 67.2% IFT Notes for the Level III Exam www.ift.world Page 26 R24 Credit Strategies IFT Notes OAS of portfolio = (0.328 × 125 bps) + (0.672 × 150 bps) ≈ 142 bps Back to Notes Example Calculating Excess Return A corporate bond has a spread duration of five years and a credit spread of 2.75% (275 bps) What is the approximate excess return if the bond is held for six months and the credit spread narrows 50 bps to 2.25%? Assume the spread duration remains at five years and that the bond does not experience default losses What is the instantaneous (holding period of zero) excess return if the spread rises to 3.25%? Assume the bond has a 1% annualized expected probability of default and expected loss severity of 60% in the event of default What is the expected excess return if the bond is held for six months and the credit spread is expected to fall to 2.25%? Solution to 1: Using Equation 1, the excess return on the bond is approximately 3.875% = (2.75% × 0.5) – [(2.25% – 2.75%) × 5] Solution to 2: Using Equation 1, the instantaneous excess return on the bond is approximately −2.5% = (2.75% × 0) – [(3.25% – 2.75%) × 5] Solution to 3: Using Equation 2, the expected excess return on the bond is approximately 3.575% = (2.75% × 0.5) – [(2.25% – 2.75%) × 5] – (0.5 × 1% × 60%) Back to Notes Example Dividing the Credit Universe An investor is conducting a relative value analysis on bond issuers in the retail sector He is trying to decide whether the global clothing retail sector is a sufficiently granular (narrowly defined) sector for his analysis Through his research, he has determined the following:  Large clothing retailers are diversified across Europe, Asia, and the Americas  Small clothing retailers tend to sell into only one of these three regions  Clothing retailing is a cyclical business, and the three regions differ substantially in their economic growth cycles Describe considerations that the investor may use in determining how to divide the retail sector Solution: The investor typically wants each sector to contain a set of companies for which he expects companylevel risks, rather than industry or macro risks, to be the dominant factors Based on the investor’s IFT Notes for the Level III Exam www.ift.world Page 27 R24 Credit Strategies IFT Notes analysis, smaller clothing retailers differ meaningfully from larger retailers Smaller retailers sell in only one region, whereas larger retailers sell in many regions globally The investor may want to divide the global retail clothing sector into larger and smaller companies Larger clothing retailers may be reasonably viewed as a single sector, because they are diversified across the world He may want to consider European, Asian, and American small retailers as three separate sectors, however, because their macroeconomic trends differ Back to Notes Example Using Expected Excess Return in Relative Value Analysis An investor has gathered the following information on four bonds she is considering for purchase: She uses the following historical information on annual default rates to estimate the probability of default She assumes a 40% recovery rate on any defaults (that is, a 60% expected loss severity) The investor has a six-month holding period Based on expected excess return, determine which bond the investor is most likely to buy if she expects that spreads will remain unchanged If the investor expects that spreads will narrow by 50 bps during the holding period, determine which bond the investor is most likely to buy If the choice of bond has changed from Question 1, explain why Explain why an investor considers factors other than expected excess return in relative value IFT Notes for the Level III Exam www.ift.world Page 28 R24 Credit Strategies IFT Notes decisions Solution to 1: The expected annual default probability for each of the four bonds based on their respective rating category is as follows: Equation is used to calculate the expected excess return for each bond For Bond W, the expected excess return is 0.87% = (2% × 0.5) – (0 × 2) – (0.5 × 0.43% × 60%) The following table summarizes the relevant information for all four bonds: Based on the expected excess returns, the investor will most likely purchase Bond W Despite having the lowest yield among the four bonds, Bond W has the highest expected excess return Solution to 2: The expected excess return calculation now incorporates a change in the bonds’ spreads For Bond W, the expected excess return is 1.87% = (2% × 0.5) – (–0.5% × 2) – (0.5 × 0.43% × 60%) The following table summarizes the relevant information for all four bonds: Based on the expected excess returns, the investor will most likely purchase Bond Z Te choice of bond differs from the previous question because, as a result of Bond W’s shorter spread duration, the spread narrowing had a smaller effect on it compared with the other bonds Solution to 3: IFT Notes for the Level III Exam www.ift.world Page 29 R24 Credit Strategies IFT Notes A credit investor may select the securities on which her excess return expectations are the highest, but other considerations, such as liquidity, portfolio diversification, and risk, also play a role Bonds are chosen and managed in the context of an overall portfolio Because bonds vary in their riskiness, liquidity, and correlation with other portfolio assets, an investor may prefer a bond with lower risk or greater liquidity, or a bond that provides better portfolio diversification, even if she anticipates a lower average return In Question 2, Bond Z was selected based on its superior expected excess return compared with the other three bonds Bond Z, however, has a lower credit rating than the other bonds, implying higher credit risk and possibly lower liquidity than the other bonds As a result, the investor may prefer Bond Y, which has a higher credit rating than Bond Z, even if she anticipates a slightly lower average return for Bond Y She may even prefer Bond X, which has the highest credit rating, even though according to her analysis it has lower expected excess return than Bond Y or Bond Z Back to Notes Example Using Spread Curves in Relative Value Analysis At the end of 2016, an analyst is about to conduct a relative value analysis of the following bonds issued by a single company All of these bonds are available in the market at the time he is conducting his analysis: Evaluate whether the analyst should include Bond C in the relative value analysis The company is issuing a new 10-year bond with the following features: Explain how the analyst may compare the relative value of the company’s new issue with that of the outstanding bonds Solution to 1: Bond C has a much higher spread than the company’s other bonds The analyst should try to identify the cause(s) of this difference before including Bond C in the relative value analysis Bond C’s higher coupon and lower credit rating suggest that it is riskier than the other bonds Bond C may be subordinated in the company’s capital structure Bond C also has a much smaller issue size, indicating that the bond may be IFT Notes for the Level III Exam www.ift.world Page 30 R24 Credit Strategies IFT Notes less liquid than the company’s other bonds Relatively illiquid bonds often carry greater spreads to compensate investors for this disadvantage Finally, Bond C’s higher price means that the loss in the event of default is likely to be larger To summarize, it is most likely unsuitable to include Bond C in the relative value analysis Solution to 2: The company has no outstanding bonds maturing around 2026 The spread for a bond maturing in 2026 can be roughly interpolated, however, using issues already in the market The spread should be somewhere between the spreads of Bonds B and D Using the bonds’ durations to interpolate, we find the interpolated spread to be approximately 66 = 50 + {[(8.2 – 4.6)/(15.8 – 4.6)] × (100 – 50)} The new issue, with a spread of 80 bps, appears to be attractively valued in the context of the company’s outstanding issues Back to Notes Example Top-Down Excess Returns An investor has gathered information and formed expectations for four bond indexes Each index contains bonds within a single, unique rating category The investor has a one-year holding period He intends to purchase bonds of a single rating category and is choosing among the categories represented by the four indexes Based on expected excess return, determine which rating category the investor is most likely to choose (Assume that the spread duration does not change during the one-year holding period.) Solution: The following table summarizes the approximate expected excess returns (EXR) for each of the four rating categories: Based on the investor’s expectations for default losses and credit spread changes, the Ba rated and B rated bonds are expected to outperform the more highly rated A and Baa bonds Based only on expected excess return, the investor is most likely to choose B rated bonds The investor must weigh IFT Notes for the Level III Exam www.ift.world Page 31 R24 Credit Strategies IFT Notes these return expectations against the more volatile, less liquid nature of lower-quality bonds and construct a portfolio accordingly Back to Notes Example 10 Choosing a Credit Strategy A credit investor has conducted extensive research on the European chemicals and consumer staples industries He is constructing a portfolio of bonds issued by companies in these industries The investor seeks to outperform a benchmark consisting of bonds issued by European chemicals and consumer staples companies Evaluate whether a top-down or bottom-up approach is most appropriate for this investor Solution: A bottom-up approach is more appropriate than a top-down approach for this investor The key aspect of the bottom-up approach to credit strategy is assessing the relative value of individual bonds or issuers The investor has conducted extensive research on companies within the industries By contrast, a top-down approach first determines which sectors have attractive relative value and then selects bonds within those sectors More broadly, a top-down approach involves taking views on macro factors Back to Notes Example 11 Structured Financial Instruments Describe how an investor may benefit from adding structured financial instruments to a credit portfolio Solution: In credit portfolios, structured financial instruments may provide several benefits when added to a credit portfolio One potential benefit is the possibility of higher portfolio returns of structured financial instruments compared with corporate credit securities; potential relative value opportunities may exist for structured financial instruments because of different features, valuation, and risk exposures compared with corporate credit securities Another benefit of structured financial instruments is the possibility of more-targeted exposure to a certain market or sector For example, if an investor wants exposure to the real estate sector, structured financial instruments provide investment opportunities that may be more difficult to implement through corporate credit Finally, structured financial instruments improve the diversification to a credit portfolio Back to Notes IFT Notes for the Level III Exam www.ift.world Page 32 ... exposure to the credit IFT Notes for the Level III Exam www .ift. world Page 14 R24 Credit Strategies IFT Notes cycle by making sure that risk statistics such as credit quality, duration, and credit spread,... currency where yields will fall and sell credit securities where yields will rise IFT Notes for the Level III Exam www .ift. world Page 13 R24 Credit Strategies IFT Notes Typically country and currency... trademarks owned by CFA Institute IFT Notes for the Level III Exam www .ift. world Page R24 Credit Strategies IFT Notes Introduction In the previous reading, we covered yield-curve strategies where