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Asset Management

Managing Yield Spread and Credit Risk

Michael Schmid, September 2012

Managing Yield Spread and Credit Risk

Contents
Setting the scene Different types of spreads Measuring credit risks Managing credit risks

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Asset Management 2/38 September 2012

Managing Yield Spread and Credit Risk

Risk / return drivers in the fixed income world

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

yield

credit premium liquidity premium inflation premium

real yield maturity


Source: Credit Suisse

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Asset Management 3/38 September 2012

Managing Yield Spread and Credit Risk

A bond is like a portfolio of cash flows

Theres no free lunch! Every component of a cash flow has its own risk

carry

move

CF

PV

Source: Credit Suisse

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Asset Management 4/38 September 2012

Managing Yield Spread and Credit Risk

The basic relationship between price and yield

Source: Credit Suisse

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Asset Management 5/38 September 2012

Managing Yield Spread and Credit Risk

Contents
Setting the scene Different types of spreads Measuring credit risks Managing credit risks

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Asset Management 6/38 September 2012

Managing Yield Spread and Credit Risk

How are bond yields quoted? the bid/ask spread

Source: Bloomberg

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Asset Management 7/38 September 2012

Managing Yield Spread and Credit Risk

Spread risk and credit risk


Credit risk can be divided into two components:

Default risk typically is rather remote. It


implies the full loss or a significant amount of the invested principal amount as a result of a failure to honor an obligation

credit risk

Spread risk means changes in the price of a


bond due to a deterioration or improvement of the credit quality of an issuer

default risk

spread risk or downgrade risk

Source: Credit Suisse

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Asset Management 8/38 September 2012

Managing Yield Spread and Credit Risk

A lot of different spread information

Source: Bloomberg

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Asset Management 9/38 September 2012

Managing Yield Spread and Credit Risk

Government spread (also: benchmark spread)


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

y
sxy

Credit X Government Y

t
t0 t1
Advantages: Easy to calculate Readily observable Disadvantages: Rough measure Time gap
Source: Credit Suisse

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Asset Management 10/38 September 2012

Managing Yield Spread and Credit Risk

Calculation of government spread


Bond: Issuer: Credit Suisse (London) Coupon: 3.875% Maturity date: 01/25/2017 Current price (ask): 109.885 Yield: 1.51% Benchmark: German Government Bond Coupon: 3.75% Maturity date: 01/04/2017 Current price (ask): 114.345 Yield: 0.38%

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

Prices and calculations as of 09.11.2012 Source: Credit Suisse

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Asset Management 11/38 September 2012

Managing Yield Spread and Credit Risk

I-spread (issue spread)


The issue spread measures the difference between the yield of a bond and the yield with the matching maturity on the interpolated swap curve

y
sx

Credit X Interpolated swap curve S

t
t0
Advantages: same maturity often used for new issues Disadvantages: rough measure Different cash flows
Source: Credit Suisse

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Asset Management 12/38 September 2012

Managing Yield Spread and Credit Risk

Calculation of government spread


Bond: Issuer: Credit Suisse (London) Coupon: 3.875% Maturity date: 01/25/2017 Current price (ask): 109.885 Yield: 1.51% swap rates: 4 years 0.79% 5 years 1.00%

Linear interpolation of swap rates (actual/actual): 4 yrs 136d = 4.37y 0.79% + 0.37*(1.00%-0.79%)= 0.87%

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

Prices and calculations as of 09.11.2012 Source: Credit Suisse

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Asset Management 13/38 September 2012

Managing Yield Spread and Credit Risk

Z-spread (zero volatility spread)

The z-spread is a bonds constant spread over the benchmark zero coupon swap curve

y
zx

new zero coupon swap curve Z1 zero coupon swap curve Z0

t
t0
Advantages: true measure of credit risk Disadvantages: theoretical measure need to calculate a zero coupon swap curve
Source: Credit Suisse

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Asset Management 14/38 September 2012

Managing Yield Spread and Credit Risk

Calculation of Z-spread
Bond: Issuer: Credit Suisse (London) Coupon: 3.875% Maturity date: 01/25/2017 Current price (ask): 109.885 Yield: 1.51% zero coupon swap rates: 4 years 0.79% 5 years 1.00%

Spot rate for 4.37 years (linear interpolation): 0.79% + 0.37*(1.00%-0.79%)= 0.87%

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

Prices and calculations as of 09.11.2012 Source: Credit Suisse

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Asset Management 15/38 September 2012

Managing Yield Spread and Credit Risk

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 bonds imbedded options.

Advantages: Option valuation

Disadvantages: may be confusing if benchmark curve used does not correspond to spot curve

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Asset Management 16/38 September 2012

Managing Yield Spread and Credit Risk

Basis spread

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

y
bx

CDS curve of issuer X Z-spread curve zx

t
t0
Advantages: comparison with derivative market basis can be traded
Source: Credit Suisse

Disadvantages: measure of spread between credit spreads

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Asset Management 17/38 September 2012

Managing Yield Spread and Credit Risk

Calculation of basis spread


Bond: Issuer: Credit Suisse (London) Coupon: 3.875% Maturity date: 01/25/2017 Current price (ask): 109.885 Yield: 1.51% zero coupon swap rates: 4 years 111 bps 5 years 132 bps

Linear interpolation of CDS spread at 4.37 years: 111 bps + 0.37*(132 bps 113 bps) = 118 bps

basis = 116 bps 64 bps = 54 bps

Prices and calculations as of 09.11.2012 Source: Credit Suisse

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Asset Management 18/38 September 2012

Managing Yield Spread and Credit Risk

ASW (asset swap spread)


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

fixed coupon

fixed coupon

Bank A
3m L+s

Bank B
3m L+s

Bond X
3m L+s

Investor

buy interest rate swap @ 1-px

buy bond @ px

buy asset swap @ 1


Advantages: spread can be realized Disadvantages: spread doesnt measure true credit risk
Source: Credit Suisse

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Asset Management 19/38 September 2012

Managing Yield Spread and Credit Risk

Comparison between Z-spread and ASW-spread

Sensitivity to interest rate changes

60 50 Z-Spread minus Asset Swap Spread in bp 40 30 20 10 0 -10 -20 -30 -40 50 100 Clean Price 150 200 250 70 80 90 100 110 120 130 140

Source: ABN Amro Credit Research

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Asset Management 20/38 September 2012

Managing Yield Spread and Credit Risk

Comparison between Z-spread and I-spread

Sensitivity to interest rate changes

10

Z-spread minus Issue Spread in bp

0 70 -5 80 90 100 110 120 130 140

-10

-15 Clean Price -20


50 100 150 200 250

Source: ABN Amro Credit Research

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Asset Management 21/38 September 2012

Managing Yield Spread and Credit Risk

Contents
Setting the scene Different types of spreads Measuring credit risks Managing credit risks

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Asset Management 22/38 September 2012

Managing Yield Spread and Credit Risk

Different ways to measure credit risk

Quantitative credit spread (CDS spread, Z-spread) default probability (Moodys KMV, Fitch equity implied rating)

Market judgment

Agency judgment Semi-quantitative credit rating (Moodys S&P, Fitch)

Qualitative credit research (buy, hold, sell)

Analyst judgment
Source: Credit Suisse

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Asset Management 23/38 September 2012

Managing Yield Spread and Credit Risk

Credit spread and relative value at the issuer level

Source: Bloomberg

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Asset Management 24/38 September 2012

Managing Yield Spread and Credit Risk

Credit spread and relative value at the issue level

Source: Bloomberg

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Asset Management 25/38 September 2012

Managing Yield Spread and Credit Risk

Level of seniority / subordination

1) Senior unsecured

2) Senior subordinated

3) Junior subordinated

Source: Bloomberg

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Asset Management 26/38 September 2012

Managing Yield Spread and Credit Risk

Recovery rate depends much on subordination

Default rate rises and falls with the credit cycle

Source: Moodys

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Asset Management 27/38 September 2012

Managing Yield Spread and Credit Risk

Default probability example from Moodys KMV

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

Source: Moodys KMV

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Asset Management 28/38 September 2012

Managing Yield Spread and Credit Risk

Credit ratings discriminating issuer quality

BoA Merrill Lynch EMU Corporate Indices, average ASW spreads

300 250 200 150 100 50 0 1y-3y 3y-5y maturity range 5y-7y 7y-10y AAA AA A BBB

Data as of 13.09.2010 Source: BoA Merrill Lynch, Credit Suisse

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Asset Management 29/38 September 2012

Managing Yield Spread and Credit Risk

Credit ratings sector level spread dispersion

BoA Merrill Lynch Euro Basic Industry Index (Investment Grade)

350 300 250 200 150 100 50 0 0 1 2 3

sector average

4 5 modified duration

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

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Asset Management 30/38 September 2012

Managing Yield Spread and Credit Risk

Credit ratings and default rates

Stability belongs to the high end of the rating scale

Default rate increases exponentially across rating buckets

Source: Moodys

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Asset Management 31/38 September 2012

Managing Yield Spread and Credit Risk

Contents
Setting the scene Different types of spreads Measuring credit risks Managing credit risks

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Asset Management 32/38 September 2012

Managing Yield Spread and Credit Risk

Managing credit risks overview

Is the targeted return achievable with the current credit risks?

Source: UBS Delta

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Asset Management 33/38 September 2012

Managing Yield Spread and Credit Risk

Managing credit risks portfolio segmentation

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


Rating AAA AA1 AA2 AA3 A1 A2 A3 BBB1 BBB2 BBB3 N.A. Cash Share Ticker Portfolio Share Ticker Benchmark Share Ticker Difference 29.234% 65.504% -36.270% 5.514% 5.083% 0.431% 1.984% 14.646% -12.661% 3.561% 1.059% 2.502% 7.519% 11.625% -4.106% 12.563% 0.000% 12.563% 9.552% 1.600% 7.952% 3.881% 0.000% 3.881% 4.744% 0.000% 4.744% 3.789% 0.000% 3.789% 0.000% 0.484% -0.484% 7.167% 0.000% 7.167%

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


Country FR SZ CI NE CA PD NO IR Share Ticker Portfolio Share Ticker Benchmark Share Ticker Difference 24.355% 12.380% 11.975% 6.957% 0.000% 6.957% 2.587% 0.000% 2.587% 5.766% 3.402% 2.364% 2.069% 0.000% 2.069% 1.309% 0.000% 1.309% 1.219% 0.000% 1.219% 1.683% 0.880% 0.803%

Source: Credit Suisse

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Asset Management 34/38 September 2012

Managing Yield Spread and Credit Risk

Managing credit risks small bets or large bets?

Largest bets against benchmark top 10 & bottom 10


Ticker .FMTTA .FMFTA BNG KFW UBS CFF ASIA Q GE RESFER Share Ticker Portfolio Share Ticker Benchmark Share Ticker Difference 2.506% 0.000% 2.506% 2.505% 0.000% 2.505% 2.268% 0.000% 2.268% 2.267% 0.000% 2.267% 2.261% 0.000% 2.261% 2.096% 0.000% 2.096% 2.075% 0.000% 2.075% 2.069% 0.000% 2.069% 1.984% 0.000% 1.984% 1.964% 0.000% 1.964% Issuer BF FIX MAT. 2013 BF FIX MAT. 2015 BK NEDERLANDSE GEMEENTEN KFW UBS AG STAMFORD CT CIE FINANCEMENT FONCIER ASIAN DEVELOPMENT BANK QUEBEC PROVINCE GENERAL ELEC CAP CORP RESEAU FERRE DE FRANCE

BGB BTNS SPGB FRTR OBL DBR JGB UKT BTPS T

0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000%

4.518% 5.675% 6.073% 6.705% 7.172% 7.905% 9.800% 10.030% 11.625% 19.943%

-4.518% -5.675% -6.073% -6.705% -7.172% -7.905% -9.800% -10.030% -11.625% -19.943%

BELGIUM KINGDOM FRENCH TREASURY NOTE BONOS Y OBLIG DEL ESTADO FRANCE (GOVT OF) BUNDESOBLIGATION BUNDESREPUB. DEUTSCHLAND JAPAN-75(5 YEAR ISSUE) TSY 8% 2013 BUONI POLIENNALI DEL TES US TREASURY N/B
Source: Credit Suisse

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Asset Management 35/38 September 2012

Managing Yield Spread and Credit Risk

Managing credit risks correlation and tracking error

Largest contributors to tracking error

Source: UBS Delta

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Managing Yield Spread and Credit Risk

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 18 Mail to: michael.schmid.2@credit-suisse.com

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Asset Management 37/38 September 2012