Credit risk management

2007-09-06T13:58:00.000-07:00

To appreciate the various types of credit derivatives, we must review the
underlying risk which these new financial instruments transfer and
hedge. They include:
■ Default risk
■ Downgrade risk
■ Credit spread risk
Default risk is the risk that the issuer of a bond or the debtor on a
loan will not repay the outstanding debt in full. Default risk can be
complete in that no amount of the bond or loan will be repaid, or it can
be partial in that some portion of the original debt will be recovered.
Downgrade risk is the risk that a nationally recognized statistical
rating organization such as Standard & Poor’s, Moody’s Investors Services,
or Fitch Ratings reduces its outstanding credit rating for an issuer
based on an evaluation of that issuer’s current earning power versus its
capacity to pay its debt obligations as they become due.
Credit spread risk is the risk that the spread over a reference rate
will increase for an outstanding debt obligation. Credit spread risk and
downgrade risk differ in that the latter pertains to a specific, formal
credit review by an independent rating agency, while the former is the
financial markets’ reaction to perceived credit deterioration.
In this section we provide a short discussion on the importance of
credit risk. In particular, we provide a review of the credit risks inherent
in three important sectors of the debt market: high-yield bonds, highly
leveraged bank loans, and sovereign debt. Each of these markets is especially
attuned to the nature and amount of credit risk undertaken with
each investment. Indeed, most of the discussion and examples provided
in this book will focus on these three sectors of the debt market.
Credit Risk and the High-Yield Bond Market
A fixed-income debt instrument represents a basket of risks. There is the
risk from changes in interest rates (interest rate risk as measured by an
instrument’s duration and convexity), the risk that the issuer will refinance
the debt issue (call risk), and the risk of defaults, downgrades,
and widening credit spreads (credit risk). The total return from a fixedincome
investment such as a corporate bond is the compensation for
assuming all of these risks. Depending upon the rating on the underlying
debt instrument, the return from credit risk can be a significant part of a
bond’s total return.
However, the default rate on credit-risky bonds can be quite high.
Estimates of the average default rates for high-yield bonds range from
3.17% to 6.25%.4 In fact, default rates have been as high as 11% for
high-yield bonds in any one year.5 Three factors have been demonstrated
to influence default rates in the high-yield bond market. First,
because defaults are most likely to occur three years after bond issuance,
the length of time that high-yield bonds have been outstanding
will influence the default rate. This factor is known as the “aging affect.” Second, the state of the economy affects the high-yield default
rate. A recession reduces the economic prospects of corporations. As
profits decline, companies have less cash to pay their bondholders.
Finally, changes in credit quality affects default rates. Studies that will
be discussed in Chapter 2 have demonstrated that credit quality is the
most important determinant of default rates, followed by macroeconomic
conditions. The aging factor plays only a small role in determining
default rates.6
Credit derivatives, therefore, appeal to asset managers who invest in
high-yield or junk bonds, real estate, or other credit-dependent assets.
The possibility of default is a significant risk for asset managers, and
one that can be effectively hedged by shifting the credit exposure.
In addition to default risk for noninvestment grade bonds, there is the
risk of downgrades for investment-grade bonds and the risk of increased
credit spreads. For instance, in the year 2002, S&P had 272 rating changes
for investment-grade issues: 231 were rating downgrades and 41 were rating
upgrades. For Moody’s for the same year, there were 244 upgrades and
46 downgrades for the 290 rating changes by that rating agency.7
With respect to credit spread risk, in the United States, corporate
bonds are typically priced at a spread to comparable U.S. Treasury
bonds. Should this spread widen after purchase of the corporate bond,
the asset manager would suffer a diminution of value in his portfolio.
Credit spreads can widen based on macroeconomic events such as volatility
in the financial markets.
As an example, in October of 1997, a rapid decline in Asian stock
markets spilled over into the U.S. stock markets, causing a significant
decline in financial stocks.8 The turbulence in the financial markets,
both domestically and worldwide, resulted in a flight to safety of investment
capital. In other words, investors sought safer havens for their
investments in order to avoid further losses and volatility. This flight to
safety resulted in a significant increase in credit spreads of corporate
bonds relative to U.S. Treasuries.

Credit Derivatives

2007-09-03T14:58:00.000-07:00

Credit derivatives are financial instruments designed to efficiently transfer
some form of risk between two or more parties. Credit derivatives can be
classified based on the form of risk that is being transferred: interest rate
risk (interest rate derivatives), credit risk (credit derivatives), currency
risk (foreign exchange derivatives), commodity price risk (commodity
derivatives), and equity prices (equity derivatives). Our focus in this
book is on credit derivatives, the newest entrant to the world of derivatives.
Credit derivatives are financial instruments that are designed to
transfer the credit exposure of an underlying asset or assets between
two parties. With credit derivatives, an asset manager can either acquire
or reduce credit risk exposure. Many asset managers have portfolios
that are highly sensitive to changes in the credit spread between a
default-free asset and credit-risky assets and credit derivatives are an
efficient way to manage this exposure. Conversely, other asset managers
may use credit derivatives to target specific credit exposures as a way to
enhance portfolio returns. In each case, the ability to transfer credit risk
and return provides a new tool for asset managers to improve performance.
Moreover, as will be explained, corporate treasurers can use
credit derivatives to transfer the risk associated with an increase in
credit spreads.
Credit derivatives include credit default swaps, asset swaps, total
return swaps, credit-linked notes, credit spread options, and credit
spread forwards. In addition, there are index-type products that are
sponsored by banks that link the payoff to the investor to a specified
credit exposure such as emerging or high yield markets. By far the most
popular credit derivatives is the credit default swap. Credit default
swaps include single-name credit default swaps and basket default
swaps. Credit default swaps have a number of applications and are used
extensively for flow trading of single reference name credit risks or, in portfolio swap form, for trading a basket of reference credits. Credit
default swaps and credit-linked notes are used in structured credit products,
in various combinations, and their flexibility has been behind the
growth and wide application of the synthetic collateralized debt obligation
and other credit hybrid products.
Credit derivatives are grouped into funded and unfunded instruments.
In a funded credit derivative, typified by a credit-linked note,
the investor in the note is the credit protection seller and is making an
upfront payment to the protection buyer when buying the note. In an
unfunded credit derivative, typified by a credit default swap, the protection
seller does not make an upfront payment to the protection buyer. In
a funded credit derivative, the protection seller is in effect making the
credit insurance payment upfront and must find the cash at the start of
the transaction; whereas in an unfunded credit derivative the protection,
payment is made on termination of the trade (if there is a credit event).
Unlike the other types of derivatives, where there are both exchangetraded
and over-the-counter (OTC) or dealer products, as of this writing
credit derivatives are only OTC products. That is, they are individually
negotiated financial contracts. As with other derivatives, they can take the
form of options, swaps, and forwards. Futures products are exchangetraded
and, as of this writing as well, there are no credit derivative futures
contracts.
Moreover, there are derivative-type payoffs that are embedded in
debt instruments. Callable bonds, convertible bonds, dual currency
bonds, and commodity-linked bonds are examples of bonds with
embedded options. A callable bond has an embedded interest rate derivative,
a convertible bond has an embedded equity derivative, a dual currency
bond has an embedded foreign exchange derivative, and a
commodity-linked bond has an embedded commodity derivative. Derivatives
have made it possible to create many more debt instruments with
complex derivative-type payoffs that may be sought by asset managers.
These debt instruments are in the form of medium-term notes and
referred to as structured products.
Credit derivatives are also used to create debt instruments with
structures whose payoffs are linked to or derived from the credit characteristics
of a reference asset (reference obligation), an issuer (reference
entity), or a basket of reference assets or entities. Credit-linked notes
(CLNs) and synthetic collateralized debt obligations (CDOs) are the
two most prominent examples. In fact, the fastest growing sector of the
market is the synthetic CDO market. Credit derivatives are the key to
the creation of synthetic CDOs.

Credit information

Credit risk management

Credit Derivatives