1 Managing Yield Spreads and Credit Risks Michael Schmid

Asset Management
Managing Yield Spread and Credit Risk
Michael Schmid, September 2012
Contents
Setting the scene Different types of spreads Measuring credit risks Managing credit risks
The disclaimer at the end is also applicable to this page.
Asset Management 2/38 September 2012
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
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
The basic relationship between price and yield
Contents
How are bond yields quoted? the bid/ask spread
Source: Bloomberg
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
A lot of different spread information
Source: Bloomberg
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
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
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
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)
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
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)
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
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
Disadvantages: measure of spread between credit spreads
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
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
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
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
Contents
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
Credit spread and relative value at the issuer level
Source: Bloomberg
Credit spread and relative value at the issue level
Source: Bloomberg
Level of seniority / subordination
1) Senior unsecured
2) Senior subordinated
3) Junior subordinated
Source: Bloomberg
Recovery rate depends much on subordination
Default rate rises and falls with the credit cycle
Source: Moodys
Default probability example from Moodys KMV
A structural form model that uses option pricing techniques to derive a default probability
Source: Moodys KMV
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
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
Credit ratings and default rates
Stability belongs to the high end of the rating scale
Default rate increases exponentially across rating buckets
Source: Moodys
Contents
Managing credit risks overview
Is the targeted return achievable with the current credit risks?
Source: UBS Delta
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%
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
Managing credit risks correlation and tracking error
Largest contributors to tracking error
Source: UBS Delta
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

1 Managing Yield Spreads and Credit Risks Michael Schmid

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Asset Management

Managing Yield Spread and Credit Risk

Michael Schmid, September 2012

Managing Yield Spread and Credit Risk

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

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)

credit premium liquidity premium inflation premium

real yield maturity

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

Asset Management 3/38 September 2012

Managing Yield Spread and Credit Risk

A bond is like a portfolio of cash flows

Source: Credit Suisse

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

Asset Management 4/38 September 2012

Managing Yield Spread and Credit Risk

The basic relationship between price and yield

Source: Credit Suisse

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

Asset Management 5/38 September 2012

Managing Yield Spread and Credit Risk

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

Asset Management 6/38 September 2012

Managing Yield Spread and Credit Risk

How are bond yields quoted? the bid/ask spread

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

Asset Management 7/38 September 2012

Managing Yield Spread and Credit Risk

Spread risk and credit risk

Default risk typically is rather remote. It

Spread risk means changes in the price of a

spread risk or downgrade risk

Source: Credit Suisse

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

Asset Management 8/38 September 2012

Managing Yield Spread and Credit Risk

A lot of different spread information

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

Asset Management 9/38 September 2012

Managing Yield Spread and Credit Risk

Government spread (also: benchmark spread)

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

Asset Management 10/38 September 2012

Managing Yield Spread and Credit Risk

Calculation of government spread

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

Prices and calculations as of 09.11.2012 Source: Credit Suisse

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

Asset Management 11/38 September 2012

Managing Yield Spread and Credit Risk

I-spread (issue spread)

Credit X Interpolated swap curve S

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

Asset Management 12/38 September 2012

Managing Yield Spread and Credit Risk

Calculation of government spread

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

Prices and calculations as of 09.11.2012 Source: Credit Suisse

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

Asset Management 13/38 September 2012