1 managing yield spreads and credit risks michael schmid

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Asset Management

Michael Schmid, September 2012

Managing Yield

Spread and CreditRisk



Asset Management

2/38The disclaimer at the end is also applicable to this page. September 2012

Managing Yield Spread and Credit Risk

Contents

Setting the scene

Different types of spreads

Measuring credit risks

Managing credit risks



Asset Management

3/38The disclaimer at the end is also applicable to this page.

Risk / return drivers in the fixed income world

September 2012


Every risk that can be traded has a price (premium)

Source: Credit Suisse

maturity

yield

credit premium

real yield

inflation premium

liquidity premium



Asset Management


A bond is like a portfolio of cash flows

September 2012


There’s no free lunch! Every component of a cash flow has its own risk


CF

t

PV

carry move



Asset Management


The basic relationship between price and yield

September 2012





Asset Management6/38The disclaimer at the end is also applicable to this page. September 2012


Contents

Setting the scene






Asset Management7/38The disclaimer at the end is also applicable to this page.

How are bond yields quoted? – the bid/ask spread

September 2012


Source: Bloomberg




Spread risk and credit risk

September 2012


Credit risk can be divided into two

components:

Default risk typically is rather remote. Itimplies the full loss or a significant amount of

the invested principal amount as a result of a

failure to honor an obligation

Spread risk means changes in the price of a

bond due to a deterioration or improvement of

the credit quality of an issuer

credit risk

default risk spread risk or

downgrade risk





A lot of different spread information

September 2012


Source: Bloomberg




Government spread (also: benchmark spread)

September 2012


Benchmark spread is the difference between the yield of a bond and the equivalent government bond with the matching

maturity


t

y Credit X

Government Y

t0

sxy

t1

Advantages: Disadvantages:

Easy to calculate Readily observable

Rough measure Time gap





Calculation of government spread

Bond: Benchmark:

Issuer: Credit Suisse (London)

Coupon: 3.875%

Maturity date: 01/25/2017

Current price (ask): 109.885

Yield: 1.51%

German Government Bond

Coupon: 3.75%



Yield: 0.38%

Benchmark spread: 1.52% - 0.38% = 1.13% (113 bps)

Prices and calculations as of 09.11.2012






Calculation of government spread

Bond: € swap rates:


Coupon: 3.875%



Yield: 1.51%

4 years 0.79%

5 years 1.00%

Benchmark spread: 1.52% - 0.38% = 1.13% (113 bps)

Linear interpolation of swap rates (actual/actual):

4 yrs 136d = 4.37y 0.79% + 0.37*(1.00%-0.79%)= 0.87%






Z-spread (zero volatility spread)

September 2012


The z-spread is a bond’s “constant spread” over the benchmark zero coupon swap curve


tt0

zx

y

zero coupon swap curve Z0

new zero coupon swap curve Z1


“true” measure of credit risk theoretical measure

need to calculate a zero coupon swap curve





Calculation of Z-spread

Bond: € zero coupon swap rates:


Coupon: 3.875%



Yield: 1.51%

4 years 0.79%

5 years 1.00%

Z-spread: 1.51% - 0.87% = 0.64% (64 bps)

Spot rate for 4.37 years (linear interpolation):

0.79% + 0.37*(1.00%-0.79%)= 0.87%







OAS (option adjusted spread)

The OAS is equivalent to the z-spread in the case where a bond has no imbedded options (e.g. call, put or sinking features).

Calculating the OAS uses option pricing techniques to value a bond’s imbedded options.


Option valuation may be confusing if benchmark curve used does notcorrespond to spot curve




Basis spread

September 2012


The basis spread measures the difference between the interpolated CDS rate and the zero volatility spread (z-spread)



comparison with derivative market

basis can be traded

measure of spread between credit spreads

t

y CDS curve of issuer X

Z-spread curve zx

t0

bx





Calculation of basis spread

Bond: € zero coupon swap rates:


Coupon: 3.875%



Yield: 1.51%

4 years 111 bps

5 years 132 bps

basis = 116 bps – 64 bps = 54 bps

Linear interpolation of CDS spread at 4.37 years:

111 bps + 0.37*(132 bps – 113 bps) = 118 bps






ASW (asset swap spread)

September 2012


The asset swap spread (also: par asset swap spread or LIBOR spread) compares the theoretical price of a bond with

the market price in bps in an asset swap


Bank A Bank B Bond X Investor

buy interest rate swap @ 1-px buy bond @ px

buy asset swap @ 1

fixed coupon fixed coupon

3m L+s 3m L+s 3m L+s


spread can be realized spread doesn’t measure “true” credit risk




Comparison between Z-spread and ASW-spread

September 2012


Sensitivity to interest rate changes

Source: ABN Amro Credit Research

-40

-30

-20

-10

0

10

20

30

40

50

60

70 80 90 100 110 120 130 140

Clean Price

Z - S p r e a d m i n u s A s s e t

S w a p S p r e a d i n b p

50 100 150 200 250




Comparison between Z-spread and I-spread

September 2012


Sensitivity to interest rate changes

Source: ABN Amro Credit Research

-20

-15

-10

-5

0

5

10

70 80 90 100 110 120 130 140

Clean Price

Z - s p r e a d m i n u s I s

s u e S p r e a d i n b p

50 100 150 200 250





Contents

Setting the scene







Credit spread and relative value at the issuer level

September 2012


Source: Bloomberg




Level of seniority / subordination

September 2012


1) Senior unsecured 2) Senior subordinated 3) Junior subordinated

Source: Bloomberg




Recovery rate depends much on subordination

September 2012


Default rate rises and falls with the credit cycle

Source: Moody‘s




Default probability – example from Moody’s KMV

September 2012


A structural form model that uses option pricing techniques to derive a default probability

Source: Moody’s KMV




Credit ratings – sector level spread dispersion

September 2012


BoA Merrill Lynch Euro Basic Industry Index (Investment Grade)

Data as of 14.09.2010Source: BoA Merrill Lynch, Credit Suisse

0

50

100

150

200

250

300

350

0 1 2 3 4 5 6 7 8 9

modified durationsector average



Asset Management


Managing credit risks – overview

September 2012


Is the targeted return achievable with the current credit risks?

Source: UBS Delta



Asset Management


Managing credit risks – portfolio segmentation

September 2012


Bets at the rating level – How much credit (rating) risk?

Bets at the country level – Is this relevant for credit risk?


Rating Share Ticker Portfolio Share Ticker Benchmark Share Ticker Difference

AAA 29.234% 65.504% -36.270%

AA1 5.514% 5.083% 0.431%

AA2 1.984% 14.646% -12.661%

AA3 3.561% 1.059% 2.502%

A1 7.519% 11.625% -4.106%

A2 12.563% 0.000% 12.563%

A3 9.552% 1.600% 7.952%

BBB1 3.881% 0.000% 3.881%

BBB2 4.744% 0.000% 4.744%

BBB3 3.789% 0.000% 3.789%

N.A. 0.000% 0.484% -0.484%Cash 7.167% 0.000% 7.167%

Country Share Ticker Portfolio Share Ticker Benchmark Share Ticker Difference

FR 24.355% 12.380% 11.975%

SZ 6.957% 0.000% 6.957%

CI 2.587% 0.000% 2.587%

NE 5.766% 3.402% 2.364%CA 2.069% 0.000% 2.069%

PD 1.309% 0.000% 1.309%

NO 1.219% 0.000% 1.219%

IR 1.683% 0.880% 0.803%



Asset Management


Managing credit risks – correlation and tracking error

September 2012


Largest contributors to tracking error

Source: UBS Delta



Asset Management

37/38The disclaimer at the end is also applicable to this page. September 2012


Contacts

Do you have questions?

We look forward to hearing from you.

Michael Schmid

Head Corporate Credit and European High Yield

Zurich: +41 44 333 22 18Mail to: [email protected]

1 managing yield spreads and credit risks michael schmid

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