Active Credit Portfolio Management: A Practical Guide to Credit Risk Management Strategies

Foreword 13

Introduction and Acknowledgements 17

Part I Markets 19

1 Market Structure 21

1.1 Market Development 22

1.1.1 Historical Development 22

1.1.2 Size and Growth of the Market 27

1.2 Market Participants 27

1.2.1 Banks 28

1.2.2 Insurance Companies 29

1.2.3 Funds and Asset Managers 30

1.2.4 Retail Clients 30

1.2.5 Hedge Funds 30

1.3 Issuing Debt from a Company’s Viewpoint 31

1.4 Ratings and Rating Agencies 33

1.4.1 Are Ratings an Efficient Source for Pricing Credits? 36

1.5 Credit Classes 39

1.5.1 High-Grade Universe 39

1.5.2 High-Yield and Crossover Credits 40

1.5.3 High-Quality Segment 41

1.5.4 Asset Backed Securities 42

2 Instruments 45

2.1 Straight Bonds 45

2.2 Bonds with Embedded Options 47

2.3 Exotics 48

2.3.1 Payment-in-Kind Notes 49

2.3.2 Hybrids or Subordinated Corporate Bonds 50

2.4 Hybrid Bank Capital 53

2.5 Single-Name Credit Derivatives 55

2.5.1 Credit Default Swaps 55

2.5.2 Digital Default Swaps 58

2.5.3 Equity Default Swaps 58

2.5.4 Recovery Default Swaps 60

2.5.5 Constant Maturity Credit Default Swaps 61

2.6 Portfolio Credit Derivatives 62

2.6.1 Basket/Index Swaps – iTraxx Europe Benchmark 62

2.6.2 Default Baskets 65

2.6.3 Standardized iTraxx Tranches 67

2.6.4 Spread Options 68

2.6.5 Future Contracts 70

2.7 Outlook on Product Development 70

3 Company and Debt Instrument Analysis 73

3.1 Sovereign Risk and Government Support 74

3.2 Business Risk 74

3.3 Financial Risk 82

3.3.1 Off-Balance-Sheet Adjustments 86

3.3.2 Adjustment of Ratios 91

3.4 The Rating Agencies’ Methodology 93

3.5 Evaluation of Specific Debt Instruments 96

3.6 Recovery Rate Estimates 99

4 The Economics of Credit Spreads 103

4.1 Macro Drivers 103

4.1.1 Credits in the Business Cycle 103

4.1.2 Yields and Spreads 106

4.1.3 Credits and Exchange Rates 108

4.1.4 Credits and Commodity Prices 109

4.1.5 Credits and Inflation 111

4.1.6 Credits and External Shocks 113

4.2 Micro Drivers 115

4.3 Credit Quality 117

4.3.1 Credit Quality Trend 117

4.3.2 Default Rates 117

4.3.3 Recovery Rates: The Collins & Aikman Case 120

4.3.4 Implied Ratings 122

4.4 Equity–Debt Linkage 123

4.4.1 The Basic Merton Approach: Structural Models 123

4.4.2 Merton in Practice 128

4.4.3 Leap-Put Skewness as an Equity–Debt Indicator 131

4.4.4 Empirical Evidence for the Equity–Debt Linkage 133

4.5 Market Technicals 136

4.5.1 Is there a New Issuance Premium? 137

4.5.2 Technical Bid 138

4.5.3 The Impact of Syndicated Loans on Corporate Bonds 139

Part II Models 141

5 Fixed Income Basics 143

5.1 Basic Valuation Concepts 143

5.1.1 The Discount Function 143

5.1.2 Spot Rates and the Term Structure of Interest Rates 149

5.1.3 Forward Rates 154

5.2 Obtaining the Term Structure of Interest Rates 158

5.3 The Yield to Maturity 159

5.4 Measurement of Interest Rate Risk 162

6 Spread Measures 171

6.1 Basic Considerations 171

6.2 Yield Spreads 173

6.3 Z-Spreads 177

6.4 Asset Swap Spreads 180

6.5 Spread Measures for Floaters 184

6.6 Spreads and the Real Economy 186

6.7 Conclusion 192

7 Basics of Credit Risk Models 195

7.1 The Components of Credit Risk 196

7.2 A Single-Step, Two-Stage Model 198

7.3 A Multi-Step Model for Zero Coupon Bonds 202

7.4 The Multi-Step Model 208

7.5 Continuous-Time Approach 210

7.6 Recovery Treatment 217

7.6.1 Fitch’s Recovery-Rating Methodology 228

7.7 The Term Structure of Credit Spreads 231

8 Single-Name Models 237

8.1 Reduced-Form Models 238

8.1.1 Binomial Tree Models for Default Risk 244

8.1.2 Reduced-Form Models and Illiquid Claims 249

8.2 Structural Models 250

8.3 Rating-Based Transition Matrix Models 260

8.3.1 Redefining the Default Event 265

9 Portfolio Models 271

9.1 The Loss Distribution and its Impact on Portfolio Derivatives 273

9.2 Independent Defaults 276

9.3 Default Dependency 282

9.4 Term-Structure Effects 288

9.5 Valuing First-to-Default Baskets 289

9.6 Valuing CDO Tranches with the HLPGC Model 292

9.7 Spread Dispersion 296

9.8 Price Discovery versus Model Competition 300

10 Valuation of Credit Derivatives 303

10.1 Credit Default Swaps 304

10.1.1 Discrete-Time Model 305

10.1.2 Obtaining the Survival Probability Curve 311

10.1.3 Forward CDS Valuation 314

10.1.4 CDS Sensitivities 316

10.1.5 Continuous-Time Model 318

10.1.6 Bloomberg’s CDSW Function 319

10.2 Options on Credit-Risky Instruments 322

10.2.1 Single-Name Credit Default Swaptions 323

10.2.2 Index Swaptions 326

10.3 CDS Indices 327

10.4 n^th-to-Default Baskets 330

10.5 Collateralized Debt Obligations 337

10.5.1 Standardized iTraxx Tranches 338

10.5.2 Compound and Base Correlation 341

10.5.3 Sensitivities of iTraxx Index Tranches 346

10.6 Exotic Derivatives 357

10.6.1 Equity Default Swaps 357

10.6.2 Constant Maturity Structures 358

10.6.3 Digital Default Swaps and Recovery Swaps 360

11 Portfolio Risk Measurement 365

11.1 Risk Measures 365

11.1.1 Market Risk versus Credit Risk 365

11.1.2 Value at Risk and Conditional Value at Risk 367

11.1.3 Risk Components 372

11.2 Credit Portfolio Models 373

Part III Management 377

12 Principles of Credit Portfolio Management 379

12.1 The Role of ACPM in the Asset Allocation Process 379

12.2 Management Styles: Passive or Active 386

12.2.1 Passive Management 386

12.2.2 Active Management 388

12.3 Quantitative and Fundamental Credit Research 389

12.4 Diversification in Credit Portfolios 391

12.5 Credit Risk Management in an ALM Environment 393

12.6 Credits in the Global Asset Allocation 394

12.6.1 Increasing Importance of Credit-Risky Instruments 394

12.6.2 Credits, Government Bonds, and Equities 395

12.7 Building Blocks of Credit Portfolio Management 397

12.7.1 Step 1: Investment Targets 398

12.7.2 Step 2: Risk Factors 400

12.7.3 Step 3: Economic Variables 401

12.7.4 Step 4: Forecasting and Scenario Assessment 401

12.7.5 Step 5: Sensitivities 402

12.7.6 Step 6: Portfolio Optimization Analysis 403

12.7.7 Step 7: Portfolio Adjustments 404

12.7.8 Step 8: Performance Analysis 405

12.8 Key Portfolio Figures 406

13 Portfolio Allocation 409

13.1 Indices 410

13.1.1 The Function of Indices 410

13.1.2 The iBoxx € Index Universe 411

13.1.3 Analyzing the RDAX 413

13.2 Sector Allocation in a Markowitz Framework 418

13.3 Quality Allocation 421

13.4 Tools to Derive the Optimal Allocation 424

13.4.1 Alpha and Beta 425

13.4.2 The Shortcomings of a Beta Analysis 425

13.4.3 Aggregated Z-Scores 427

13.4.4 Equity Volatility as a Tool in the Allocation Process 428

14 Performance Measures 431

14.1 Tracking Error 432

14.2 Sharpe Ratio and Treynor Ratio 433

14.3 Information Ratio 435

14.4 Summary 436

15 Performance Analysis 437

15.1 Return Accumulation 437

15.2 Return Attribution Analysis 438

16 Hedging Credit Risk 443

16.1 Hedging on a Single-Name Level 443

16.1.1 Basic Considerations 443

16.1.2 Hedging Default Risk 445

16.1.3 Hedging Spread Risk 448

16.2 Hedging on a Portfolio Level 452

16.2.1 Basic Considerations 453

16.2.2 Hedging Systematic Spread Risk for a Single Cash Bond 453

16.2.3 Hedging Systematic Spread Risk for a Credit Portfolio 458

16.2.4 Finding the Right Hedging Instrument 462

17 Trading Strategies 469

17.1 Trading Cash Bonds 469

17.2 Trading Strategies with Single-Name CDS 472

17.2.1 Plain-Vanilla CDS Trades 474

17.2.2 Switch Ideas 474

17.2.3 Curve Trades 475

17.3 Portfolio Derivatives Trades 476

17.3.1 Single Name versus Sector or Market 476

17.3.2 Core–Satellite Strategies 477

17.3.3 Sector and Segment Trades 478

17.3.4 Trading the Skew 479

17.3.5 Basis Trades 481

17.3.6 First-to-Default Baskets 482

17.3.7 iTraxx Tranches versus Default Baskets 485

17.3.8 Playing the Steepness of the iTraxx Curve 488

17.4 Spread Options: Single and Complex Strategies 489

17.5 CPPI Strategies Including iTraxx Indices 490

17.6 Correlation Trading 492

17.7 Capital Structure Arbitrage Trades 494

17.8 Recovery Trades 495

17.9 EDS versus CDS and the Role of DDS 496

17.10 CDS–Cash–Repo Arbitrage 500

17.10.1 The Repo Market 500

17.10.2 How an Arbitrage Trade Works 501

18 Operational Issues: Accounting 503

18.1 An Introduction to IAS 39 504

18.1.1 The Scope of IAS 39 504

18.1.2 Categories of Financial Instruments 505

18.1.3 Measurement 507

18.1.4 Recognition and Derecognition 512

18.1.5 Embedded Derivatives 513

18.1.6 Hedge Accounting 515

18.2 IAS 39 Accounting for Credit Instruments 518

18.2.1 Bonds and Loans 518

18.2.2 Credit Default Swaps 521

18.2.3 Total Return Swaps 523

18.2.4 Credit Linked Notes 525

18.2.5 iTraxx Products 526

18.2.6 Other Instruments of Interest 527

19 Operational Issues: Basel II 529

19.1 An Introduction to Basel II 529

19.1.1 The Basic Structure 529

19.1.2 The Standardized Approach 533

19.1.3 The Foundation IRB Approach 534

19.1.4 The Advanced IRB Approach 538

19.1.5 Securitization Transactions 540

19.1.6 Credit Risk Mitigation 543

19.2 Basel II for Credit Instruments 547

19.2.1 Credit Default Swaps 547

19.2.2 Total Return Swaps 550

19.2.3 Credit Linked Notes 551

19.2.4 Default Baskets 553

19.2.5 iTraxx Products 555

Part IV Appendix 557

A.1 Analytics with Bloomberg and Reuters 559

A.1.1 Bloomberg 559

A.1.2 Reuters 560

A.2 Default and Recovery Data from Rating Agencies 563

References 569

Index 575