{"id":33572,"date":"2023-11-08T10:13:42","date_gmt":"2023-11-08T10:13:42","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=33572"},"modified":"2024-03-20T11:06:58","modified_gmt":"2024-03-20T11:06:58","slug":"credit-and-spread-concepts-for-active-management","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-iii\/credit-and-spread-concepts-for-active-management\/","title":{"rendered":"Credit and Spread Concepts For Active Management"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/BGinionbfpQ\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<h2>Fixed Income Vocabulary Review<\/h2>\n<p>Before delving into the content of Reading 22, let&apos;s quickly revisit some key terms. This section of the curriculum focuses on enhancing portfolio management using credit risk, which is inherent in the credit markets. The credit market encompasses the entirety of the fixed-income landscape, excluding highly rated and secure government credit. In simpler terms, if default or creditworthiness isn&apos;t a concern, these instruments won&apos;t be the main focus. This is because governments with high ratings, such as the United States or Germany, are generally considered virtually risk-free regarding credit rating and default. Even if such governments face challenges meeting interest payments, they could generate necessary funds through tax hikes.<\/p>\n<p>The credit market is broadly categorized into two types of issues: those with high credit quality, referred to as investment-grade (&ldquo;IG&rdquo;), and those with lower credit quality and higher yield (&ldquo;HY&rdquo;). While the exact definitions from credit rating agencies may vary, we don&apos;t require precise definitions for this discussion. Visualize these bonds as representing opposite ends of the credit-quality spectrum, with a gray area in between.<\/p>\n<p>In the credit markets, trading revolves around credit risk. It signifies the potential for loss arising from a counterparty&apos;s or debtor&apos;s inability to make the required payment(s).<\/p>\n<p>Credit risk can be broken down into two main components:<\/p>\n<ul>\n<li><strong>Default risk:<\/strong> This refers to the likelihood that a borrower fails to make its interest and\/or principal payments on time as per the agreed repayment schedule.<\/li>\n<li><strong>Loss severity (also known as loss-given default):<\/strong> This represents the extent of loss that would occur in the event of a default.<\/li>\n<\/ul>\n<p>The formula for the annual credit risk loss estimate is as follows:<\/p>\n<p>$$<br \/>\n(\\text{Default risk}) \\times (\\text{severity of loss given default occurs}) $$<\/p>\n<p>An issuer with a 1% chance of default and a 40% would have the following credit risk loss estimate:<\/p>\n<p>$$<br \/>\n1\\% \\times 40\\% = 0.4\\% $$<\/p>\n<h4>Default versus Credit Migration<\/h4>\n<p>Credit downgrades happen more often than upgrades among higher-rated bond issuers, impacting bond prices negatively due to the greater risk associated with downgrades, resulting in larger yield spreads compared to upgrades. Actual defaults are rare in this context.<\/p>\n<p>Investors classify credit risk using ratings, with investment-grade bonds having higher ratings, lower default risk, and lower yields. High-yield bonds have lower ratings, higher default risk, and higher yields. Credit spread curves are categorized by public ratings to track market changes in credit risk.<\/p>\n<h2>Credit Spreads<\/h2>\n<p>Credit spreads represent the yield differential between two specific classes of fixed-income securities. Credit spread risk focuses on how responsive the price of a fixed-income security is to shifts in credit spread. An often-used comparison examines the spread between high-yield (HY) and investment-grade (IG) yields.<\/p>\n<p>$$ \\text{HY rates} &#8211; \\text{IG rates}. $$<\/p>\n<p>We will delve deeper into this measurement in subsequent sections.<\/p>\n<p>Another form of credit risk, known as credit migration risk, revolves around the potential for the issuer&apos;s credit rating to unfavorably change during the security&apos;s lifespan. It&apos;s important to note that these two risk sources are sometimes used interchangeably in discussions. Context is key in discerning whether one type or both types of risk are being discussed.<\/p>\n<p>Spread duration quantifies a security&apos;s price change solely attributed to spread movements. Although one might assume that both IG and HY bonds would react similarly to spread changes, reality proves otherwise. IG bonds are considered a haven; during economic uncertainty, investors tend to gravitate towards IG, pushing up prices and reducing yields. This results in widened spreads. As a result, the risk-free rate often demonstrates a negative correlation with spreads.<\/p>\n<h2>Empirical vs. Effective Durations<\/h2>\n<p>Effective duration aims to forecast the expected impact on bond prices following a specific change in interest rates. It&apos;s a predictive measure. In contrast, empirical duration examines historical data to describe the impact on bond prices following a given interest rate change. Empirical duration employs regression analysis to illustrate the relationship between bond prices and interest rates.<\/p>\n<h2>Credit Cycle<\/h2>\n<p>Similar to the business cycle, the credit cycle illustrates variations in credit throughout different economic scenarios. It extends the insights from the business cycle to reveal developments in borrowing and lending activities.<\/p>\n<p>$$ \\begin{array}{l|c|c|c|c|c|c}<br \/>\n&#038; \\textbf{Economic} &#038;\t\\textbf{Corporate} &#038;\t\\textbf{Corporate} &#038;\t\\textbf{Corporate} &#038;\t\\textbf{Credit} &#038;\t\\textbf{Credit}   \\\\<br \/>\n &#038; \\textbf{Activity} &#038; \\textbf{Profits} &#038; \\textbf{Borrowing} &#038; \\textbf{Defaults} &#038; \\textbf{Spreads} &#038; \\textbf{Spread} \\\\<br \/>\n&#038; &#038; &#038; &#038; &#038; &#038; \\textbf{Slope} \\\\ \\hline<br \/>\n{\\textbf{Early} \\\\ \\textbf{Expansion}} &#038;\t\\text{Stable} &#038;\t\\text{Increasing} &#038;\t\\text{Decreasing} &#038;\t\\text{Peak} &#038;\t\\text{Stable} &#038;\t{\\text{Mixed} \\\\ \\text{for HY} \\\\ \\text{and IG} } \\\\ \\hline<br \/>\n{\\textbf{Late} \\\\ \\textbf{Expansion}} &#038;\t\\text{Increasing} &#038;\t\\text{Peak} &#038;\t\\text{Stable} &#038;\t\\text{Decreasing} &#038;\t\\text{Decreasing} &#038;\t\\text{Steeper} \\\\ \\hline<br \/>\n\\textbf{Peak} &#038;\t\\text{Decreasing} &#038;\t\\text{Stable} &#038;\t\\text{Increasing} &#038;\t\\text{Stable} &#038;\t\\text{Increasing} &#038;\t\\text{Steeper} \\\\ \\hline<br \/>\n\\textbf{Recession} &#038;\t\\text{Decreasing} &#038;\t\\text{Decreasing} &#038;\t\\text{Peak} &#038;\t\\text{Increasing} &#038;\t\\text{Peak} &#038;\t{\\text{Mixed} \\\\ \\text{for HY} \\\\ \\text{and IG}}<br \/>\n\\end{array} $$<\/p>\n<blockquote>\n<h2>Question<\/h2>\n<p>An investment-grade bond is being quoted for sale for 15 bps. Data for benchmark government bonds are shown below. The market price of the IG bond is <em>closest to<\/em>?<\/p>\n<p>$$ \\begin{array}{l|r}<br \/>\n\\textbf{Benchmark Israeli Bond} &#038; \\\\\t\\hline<br \/>\n\\text{Time to maturity} &#038;\t15 \\text{ years} \\\\ \\hline<br \/>\n\\text{YTM} &#038;\t5\\% \\\\ \\hline<br \/>\n\\text{Coupon (Semi-annual)} &#038;\t4\\% \\\\ \\hline<br \/>\n\\text{Par Value} &#038;\t\\$1,000<br \/>\n\\end{array} $$<\/p>\n<ol type=\"A\">\n<li>$895.35.<\/li>\n<li>$880.85.<\/li>\n<li>$881.84.<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p><strong>The correct answer is B.<\/strong><\/p>\n<p>The following steps guide to yield the correct answer: <\/p>\n<p><strong>Step 1:<\/strong> Calculate the semi-annual coupon payment:<\/p>\n<p>$$ \\text{Coupon Payment} = \\frac { (\\text{Coupon Rate} \\times \\text{Par Value}) }{ 2} $$<\/p>\n<p>$$ \\text{Coupon Payment} =\\frac { (4\\% \\times \\$1,000) }{ 2} = \\$20 $$<\/p>\n<p><strong>Step 2:<\/strong> Determine the number of semi-annual periods left until maturity:<\/p>\n<p>Since the benchmark Israeli bond has a 15-year maturity and payments are made semi-annually, \\(15 \\times 2 = 30\\) semi-annual periods are left until maturity.<\/p>\n<p><strong>Step 3:<\/strong> Calculate the present value of the bond&#8217;s future cash flows using the YTM:<\/p>\n<p>We&apos;ll use the present value formula for a bond:<\/p>\n<p>$$ \\text{Bond Price} = \\left[ \\frac {C }{ (1 + r)^1} \\right] + \\left[ \\frac {C }{ (1 + r)^2} \\right] + \\dots + \\left[\\frac {C}{ (1 + r)^n} \\right] + \\left[ \\frac {FV}{ (1 + r)^n} \\right] $$<\/p>\n<p>Where:<\/p>\n<p>\\(C\\) = Coupon Payment = $20.<\/p>\n<p>\\(r\\) = YTM = 5% or 0.05 (semi-annual rate).<\/p>\n<p>\\(n\\) = Number of semi-annual periods = 30.<\/p>\n<p>\\(FV\\) = Par Value = $1,000.<\/p>\n<p>Now, let&apos;s calculate the bond price:<\/p>\n<p>$$ \\begin{align*}<br \/>\n\\text{Bond Price} &#038; = \\left[ \\frac {\\$20 }{ (1 + 0.05)^1} \\right] + \\left[ \\frac {\\$20 }{ (1 + 0.05)^2} \\right] + \\dots + \\left[ \\frac {\\$20 }{ (1 + 0.05)^{30}} \\right] \\\\ &#038; + \\left[ \\frac {\\$1,000 }{ (1 + 0.05)^{30} } \\right] \\end{align*}  $$<\/p>\n<p>The calculated bond price is approximately $880.85 using a financial calculator or spreadsheet software.<\/p>\n<p><strong>A and C are incorrect.<\/strong> They either disregard the correct bond periodicity or exclude the 15 bps premium.<\/p>\n<\/blockquote>\n<p>Reading 22: Fixed Income Active Management: Credit Strategies<\/p>\n<p>Los 22 (a) Describe risk considerations for spread-based fixed-income portfolios<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Fixed Income Vocabulary Review Before delving into the content of Reading 22, let&apos;s quickly revisit some key terms. This section of the curriculum focuses on enhancing portfolio management using credit risk, which is inherent in the credit markets. The credit&#8230;<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[571],"tags":[],"class_list":["post-33572","post","type-post","status-publish","format-standard","hentry","category-cfa-level-iii","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Credit and Spread Concepts For Active Management - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Learn the calculation of credit risk loss estimates and how to apply scenario analysis to evaluate bond prices in various economic conditions.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-iii\/credit-and-spread-concepts-for-active-management\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Credit and Spread Concepts For Active Management - 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