CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r24 credit strategies IFT notes

Investment-Grade and High-Yield Corporate Bond Portfolios LO.a: Describe risk considerations in investment-grade and high-yield corporate bond portfolios; Investment-grade bond portfoli

Contents

1 Introduction 3

2 Investment-Grade and High-Yield Corporate Bond Portfolios 3

2.1 Credit Risk 3

2.2 Credit Migration Risk and Spread Risk 4

2.3 Interest Rate Risk 4

2.4 Liquidity and Trading 5

3 Credit Spreads 6

3.1 Credit Spread Measures 6

3.2 Excess Return 7

4 Credit Strategy Approaches 8

4.1 The Bottom-Up Approach 8

4.2 The Top-Down Approach 11

4.3 Comparing the Bottom-Up and Top-Down Approaches 14

4.4 ESG Considerations in Credit Portfolio Management 15

5 Liquidity Risk and Tail Risk in Credit Portfolios 15

5.1 Liquidity Risk 15

5.2 Tail Risk 16

6 International Credit Portfolios 17

6.1 Relative Value in International Credit Portfolios 17

6.2 Emerging Markets Credit 18

6.3 Global Liquidity Considerations 18

6.4 Currency Risk in Global Credit Portfolios 18

6.5 Legal Risk 18

7 Structured Financial Instruments 19

7.1 Mortgage-Backed Securities 19

7.2 Asset-Backed Securities 19

7.3 Collateralized Debt Obligations 20

7.4 Covered Bonds 20

Summary 20

Examples from the Curriculum 24

Example 1 24

Example 2 24

Example 3 25

Example 4 26

Example 5 27

Example 6 27

Example 7 28

Example 8 30

Example 9 31

Example 10 32

Example 11 32

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products

or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute

1 Introduction

In the previous reading, we covered yield-curve strategies where we focused on government bonds with

no credit risk However, in this reading we will cover bonds that have credit risk In Section 2 we look at the characteristics of investment grade bonds and high yield corporate bonds, specifically we will focus

on the differences in risk related to these two broad categories Then in Section 3 we'll talk about different measures of credit spread Section 4 deals with credit strategy approaches at a high level We will cover the top-down approach and the bottom up approach Section 5 deals with liquidity risk and tail risk in credit portfolios In section 6, we go over international credit portfolios and finally section 7 deals with structured financial instruments

2 Investment-Grade and High-Yield Corporate Bond Portfolios

LO.a: Describe risk considerations in investment-grade and high-yield corporate bond portfolios;

Investment-grade bond portfolios with high yield corporate bond portfolios can be compared on the basis of

 credit risk

 credit migration risk and spread risk

 interest rate risk

 liquidity and trading

2.1 Credit Risk

Credit risk is the risk of loss caused by a counterparty’s or debtor’s failure to make a promised payment There are two components of credit risk

 Default risk: Probability that the borrower defaults

 Loss severity (also called loss given default): Amount of loss if a default occurs

Credit loss rate = Default risk x Loss severity It combines the two components of credit risk and this is ultimately what matters for analysts

Exhibit 1 from the curriculum shows the annual credit loss rates for corporate bonds from 1983 – 2015

Notice the following

 Credit loss rate for high yield bonds is much higher relative to the credit loss rate for investment grade bonds

 Also, the variability of the credit loss rate is significantly higher with high yield bonds

Because of these two reasons a major consideration for high-yield portfolio managers is credit risk However, for investment –grade portfolio managers, credit risk is not a major concern They consider other factors like interest rate risk, spread risk and credit migration (We will cover these in the next two sections)

2.2 Credit Migration Risk and Spread Risk

Credit migration risk is the risk that the credit quality of a bond deteriorates One or more rating

agencies might downgrade a company’s bonds As the bonds become riskier, the spreads widen (spread

risk)

Since credit spread volatility rather than credit default loss is more relevant for investment-grade bonds,

we use a measure called ‘spread duration’ to measure the risk of a portfolio of investment-grade bonds

Spread duration measures the effect of change in spread on a bond’s price It is the approximate percentage increase in a bond’s price if the spread decreases by 1%

For example, let’s say the following information is provided for a bond : P = 99.60; spread duration = 4.70; credit spread decreases by 20 bps The new price can be computed as new price = 99.60(1 + 0.2 x 0.047) = 100.54

For non-callable fixed rate bonds, spread duration ≈ modified duration This implies that interest rate changes and spread changes have a similar impact However, for other types of bonds, such as floaters

or bonds with embedded options the two duration measures can be quite different Therefore, the key point is that spread risk in an investment-grade portfolio should be measured by spread duration and not by modified duration

Since high-yield bonds have a much larger credit loss rate as compared to investment-grade bonds, therefore with high-yield bonds there is greater emphasis on credit risk and market value of position and

in the event of default, we are more concerned about the size of our position rather than its spread duration

2.3 Interest Rate Risk

Investment grade portfolios have a greater exposure to interest rate risk than high-yield portfolios This

is because credit spreads have a negative correlation with risk-free interest rates

To understand this concept, consider two bonds, i.e., an investment grade bond and a high yield bond The yields of both bonds will be equal to Risk free rate + Credit spread The risk free rate will be the same for both bonds; however, the credit spread will be much larger for the high yield bond In good economic times, the risk free rate goes up however, the credit spread narrows These two effects offset each other to an extent Similarly, in weak economic times the risk free rate goes down however the credit spread widens The overall yield for high yield bonds is therefore less impacted by changes in interest rate relative to investment-grade bonds

Empirical duration is a measure of interest rate sensitivity that is determined from market data Exhibit

2 from the curriculum shows the effective duration and empirical duration for corporate bonds with different credit ratings

The following observations can be made from this exhibit

 In general, the empirical duration is lower than effective duration For high yield bonds, the empirical duration is much lower

 This finding indicates that high yield bonds have a low sensitivity to changes in interest rate Therefore high yield portfolio managers are less likely to focus on interest rate risk; they rather focus on credit risk However it is important to note that in good economic times, when credit spreads are tight, high yield bonds behave more like investment grade bonds and they have greater interest rate sensitivity

2.4 Liquidity and Trading

Liquidity represents the ability to purchase or sell an asset quickly and easily at a price close to fair market value

Liquidity is positively correlated with:

 Bond’s issue size

 Size of market in which bond is traded

 Bond dealer inventory size

High yield bonds are generally less liquid as compared to investment grade bonds because they tend to have a smaller issue size, the size of the market in which they are traded is also smaller and dealers are reluctant to hold a large inventory of high yield bonds because they are risky

Since high-yield bonds are less liquid they have wider bid-ask spreads, this makes their turnover more expensive

Investment grade and high yield bonds are quoted differently Investment grade bonds are quoted as spreads over benchmark government bonds while high-yield bonds are generally quoted in price terms

This is due to the fact that for investment grade bonds we focus on spread changes, whereas for high yield bonds we focus on default losses and therefore focus on what is happening to the price of the bond

Refer to Example 1 from the curriculum

3 Credit Spreads

Credit spreads are based on various credit -related risks such as:

 likelihood of default

 probable loss given default

 credit migration risk

 market liquidity risk

The major credit spread measures are:

3.1 Credit Spread Measures

LO.b: Compare the use of credit spread measures in portfolio construction;

Benchmark spread = yield on credit security – yield on benchmark bond

 The benchmark bond should have similar duration and little or no credit risk

 If government bonds are used as a benchmark, then the spread measure is called G-spread

 If interest rate swaps are used as a benchmark, then the spread measure is called I-spread

G-spread is the spread over an actual or interpolated government bond

Interpolation: When no government bond exists that has the same duration as the credit security, a linear interpolation of the yields on two on-the-run government bonds is used as the benchmark rate The two bonds are weighted such that their weighted average duration matches the credit security’s duration

The advantages of using a G-spread are:

 It is easy to calculate and understand

 It is calculated in the same way by different investors

 It indicates way to hedge the interest rate risk of credit securities

 It provides a mechanism to estimate prices changes for option-free, fixed rate securities (covered in example 2)

I-spread is the spread over the relevant swap rate i.e., swap rate denominated in the same currency as

the credit security

Following are some important considerations when evaluating G-spread and I-spread:

 Swap curves are smoother than government bond yields This is due to the fact that government bond yield curves are impacted by supply demand for specific bonds Also, there are a lot more swap rates in the market as compared to on the run-government bonds

 Benchmark rate is most helpful when it represents a credit risk-free rate Therefore, if you believe that government bonds have no credit risk, but swap rates have some embedded credit risk it will be more appropriate to use G-spreads instead of I-spreads and vice versa

 If I-spread is calculated but government bonds are used to hedge this exposure, then realized spread will differ from calculated spread

Refer to Example 2 from the curriculum

The benchmark spread measures we covered so far, the G-spread and I-spread are useful for pricing and hedging credit securities However if we want to compare relative value across credit securities, then we use the Z-spread and option-adjusted spread

Z-spread is the yield spread that must be added to each point of the implied spot yield curve to make

the present value of a bond’s cash flows equal its current market price

OAS is the constant spread that, when added to all the one-period forward rates on the interest rate

tree, makes the arbitrage-free value of the bond equal to its market price

Z-spread is useful for comparing bonds without embedded options Whereas, OAS is useful for comparing bonds with different features

Points to note when using OAS are:

 The calculated OAS depends on assumptions regarding future interest rate volatility

 The realized spread is likely to be different from OAS

 OAS is an appropriate measure for portfolio level spread

 Portfolio OAS is based on weighted average of OAS of individual bonds (covered in example 4) Refer to Example 3 from the curriculum

Refer to Example 4 from the curriculum

3.2 Excess Return

Excess return is the return of a bond after interest rate risk has been hedged In other words, it's the return an investor receives for assuming credit -related risks By definition, credit risk is different from interest-rate risk, so typically interest-rate risk and credit related risks are managed separately

Credit spread is equal to excess return if there is no change in the security’s yield or in interest rates, and if the security does not default during the holding period

Assuming no default losses, excess return can be computed as:

XR ≈ (s × t) – (∆s × SD)

Where, XR is the holding-period excess return, s is the spread at the beginning of the holding period, t is

the holding period expressed in fractions of a year, Δs is the change in the credit spread during the holding period, and SD is the spread duration of the bond

If there is a possibility of default loss, expected excess return can be computed as:

EXR ≈ (s × t) – (Δs × SD) – (t × p × L)

Where, p is the annualized expected probability of default and L is the expected loss severity Note that the term (p × L) is the expected annual credit loss

Refer to example 5 from the curriculum

4 Credit Strategy Approaches

Credit strategy generally involves establishing a return objective given certain risk constraints Some examples of credit strategy statements are:

“Construct and manage a portfolio that maximizes return within a set of risk limits”

“Construct and manage a portfolio that outperforms a given benchmark by x% using only grade bonds”

investment-There are two broad credit strategy approaches:

1) Bottom-Up approach

2) Top-down approach

4.1 The Bottom-Up Approach

LO.c: Discuss bottom-up approaches to credit strategies;

The bottom-up approach is based on the assessment of the relative value of individual issuers or bonds

It is also called the ‘security selection strategy’ This approach is appropriate for analyzing companies that have comparable credit risk

Steps in a bottom-up approach:

Step 1: Establish a universe of eligible bonds and divide into industry sectors such as telecommunication

and capital goods Each sector can be broken down further, for example telecommunication can be broken down into wireless and wireline

A starting point for this step can be benchmark vendor’s sector classification However, one should determine whether the industry/ sector classifications of the benchmark are overly broad or inaccurate Refer to Example 6 from the curriculum

Step 2: Identify bonds with the “best” relative value within each sector Here we evaluate compensation

for credit-related risk against the expected magnitude of the credit-related risks

If credit-related risks are similar, then one should buy the bond with higher spread If credit-related risks are different, then we should determine if the additional spread is worth the additional risk

For this analysis, the following factors should be considered:

 Historical default rate information based on credit rating categories For example, we can compare the historical default rates of AA category bonds with AAA category bonds to

determine if it is worth investing in AA category given the additional risk

 Average spread level for each sector and credit rating For example, if an analyst identifies a BB rated cement company whose bonds trade at a wider credit spread than the average credit spread on bonds of other BB rated cement companies, the investor can investigate further and find out the reason for this higher spread

The following equation for expected excess return can be used in the analysis

EXR ≈ (s × t) – (∆s × SD) – (t × p × L)

The credit spread, holding period, and spread duration can be determined by the investor; however, the change in credit spread is unknown in advance and the investor must enter an expected value for this variable

Some other factors that are considered in the final selection of bonds are:

 Liquidity: An investor may select a liquid bond over another cheaper bond that is less liquid, to improve the overall liquidity of his portfolio

 Portfolio diversification: An investor may select a bond because of the potential diversification benefit it offers when added to his portfolio

 Risk: An investor may select a bond that is a little more expensive, but has a lower risk

Refer to Example 7 from the curriculum

Spread Curves

Spread curve is a fitted curve of credit spread versus spread duration or maturity for a given issuer An issuer may have several bond issues with different maturities and duration We can draw a spread curve for each issuer and use it to conduct relative value analysis

Exhibit 6 from the curriculum, shows a sample spread curve for two issuers Verizon and AT&T

At a given spread duration, we should pick a bond with higher spread if credit worthiness is the same

We can also evaluate bonds that are significantly above or below the fitted spread curves

Other Considerations in Bottom-Up Relative Value Analysis

In addition to excess returns some other factors that should be considered in bottom-up relative value analysis are

 Bond Structure: Senior bonds will have relatively low spreads as compared to subordinated bonds Similarly bonds with options will have different spreads as compared to option-free bonds

 Issuance date: Recently issued bonds tend to have higher liquidity and lower spreads

 Supply: When an issuer announces a new corporate bond issue, the spreads on the issuer’s existing bonds widen One reason for this is simply that the supply of bonds has gone up Another reason might be that the debt issuance signals an increase in the issuer’s credit risk

 Issue Size: If the issue size is large, liquidity is relatively high and therefore spreads are low Refer to Example 8 from the curriculum

Bottom-Up Portfolio Construction

When constructing a portfolio using bottom-up approach, how do we figure out how much value to assign to different sectors and then to different securities within a sector? Broadly speaking models for coming up with position sizes can be based either on market value or on spread duration

The following boxed example from the curriculum, illustrates the difference between these two approaches very well

Bottom-Up Portfolio Construction

Suppose that one sector in an investor’s benchmark consists of European retail companies If the European retail sector constitutes 8% of the investor’s benchmark based on market value, then she may target an 8% weighting in those European retailers that she has determined to be most attractively valued If the portfolio has a market value of £50,000,000, then an 8% weighting will imply purchasing

£4,000,000 worth of European retailers

Now suppose that the portfolio’s benchmark has a weighted-average spread duration of 4.0, and the European retailers in the benchmark have a weighted-average spread duration of 5.0 Then, measured

by spread duration, the European retailers constitute 10% [(5.0 × 8%)/4.0] of the benchmark Using this spread duration metric, the investor would target a 10% weighting in European retailers

The appropriate approach to use depends on the default risk We should use market value if default risk

is an important consideration, otherwise spread duration is better

If a given sector has many attractively valued bonds, then we may end up selecting more bonds from this sector and this could lead to a higher sector weight relative to benchmark

Sometimes obtaining the desired bonds may be challenging, so investors can use alternatives such as: Substitution: If the best bond (the most undervalued bond) is very illiquid and hard to buy, then we might use the next best or the third best bond

Indexing: Indexing refers to constructing a portfolio to mirror the performance of a specific index Here

we can use benchmark bonds, total return swaps on a benchmark index, and other derivatives, so that

we get the required market exposure

Cash: If the desired bonds are currently unavailable, but will become available in a few months’ time, then until such time we may hold our funds as cash However, this approach will create a drag on portfolio performance

4.2 The Top-Down Approach

LO.d: Discuss top-down approaches to credit strategies

The top-down approach to credit strategy focuses on macro factors such as: economic growth; overall corporate profitability; default rates; risk appetite; changes in expected market volatility; changes in credit spreads; interest rates; industry trends; and currency movements Based on these macroeconomic factors we identify industries, sectors or regions that are attractively priced and we overweight them

Sector divisions with top-down analysis tend to be relatively broad as compared to bottom-up analysis where the sectors are more narrowly defined

Credit Quality

It is important to determine desired credit quality based on expectations for credit cycle and credit spread changes There is a very strong link between macro factors such as GDP growth and the credit cycle The curriculum shows exhibits which clearly highlight the fact that when GDP growth is strong, default rates are low, which leads to narrow credit spreads Therefore if investors expect GDP to perform well, they will prefer to invest in high-yield bonds, because these bonds will outperform investment grade bonds

Measuring Credit Quality in a Top-Down Approach

Given the importance of coming up with the desired credit quality, we need a measure for credit quality Listed below are some approaches for measuring credit quality

 Average credit rating: Calculating the average credit rating can be tricky because credit risk is non-linear For example, if we have three bonds with the following ratings: AAA, AA+ and AA, we cannot say that the credit risk differential between AAA and AA+ bonds is the same as the credit differential between AA+ and AA bonds The curriculum outlines a method called non-arithmetic weightings where we use rating factors provided by vendors such as Moody’s and these help us come up with a more accurate average credit rating

 Average OAS: To calculate a portfolio’s average OAS, we take the weighted average of each individual bond’s OAS The problem here is that different bonds will have different interest rate sensitivities For example, if our portfolio contains a 30 year bond and a 2 year bond, the 30 year bond will be more sensitive to interest rates as compared to the 2-year bond

 Average spread duration: To address the above interest rate sensitivity issue we use a measure called average spread duration

 Duration times spread: This is the most accurate measure and combines average OAS and

average spread duration (i.e duration x spread) However, the issue with this measure is that it

is not very intuitive

Excess Returns in a Top-Down Approach

The expected excess return formula that we covered earlier can be used in a top-down context This is covered in Example 9

Refer to Example 9 from the curriculum

Industry Sector Allocation

Industry sector allocation means deciding whether to overweight or underweight an industry sector Industry sector allocation can be based on macro views, regression analysis and ratio analysis

Macro view example: In 2013, there was a slowdown in the Chinese and other emerging market economies Because of this slowdown there was a decline in the demand for oil and other industrial metals This led to lower bond valuations for companies that were selling oil or selling industrial metals

If an analyst had predicted this slowdown he could have underweighted the oil sector and the industrial metals sector

Regression analysis example: An analyst might regress the average spread of high yield bonds in a particular industry sector versus average spread of investment grade bonds in the same sector If the spreads are currently wider than historical levels, it means that we are getting more returns by investing

in high yield bonds An analyst should check if these higher returns are justified given the additional risk

we are taking

We can also use regression analysis to compare different sectors as shown in exhibit 10 from the curriculum This exhibit compares the OAS of BB rated media bonds with BB rated ex-media bonds during the 2011-2016 period

We can observe that at the start of the period the OAS on media bonds was higher relative to other bonds This meant that we would get more returns by investing in BB rated media bonds as compared to other bonds If we believed that the risk of the bonds was the same, then investing in media bonds using this regression analysis would have been a good strategy The opposite is true towards the end of the

period where the OAS of media bonds is lower than other bonds

Ratio analysis example: An analyst could compare sector spreads and sector leverage by using a ratio such as Debt/EBITDA A higher leverage ratio should imply higher credit risk and wider spreads If this is not the case for a particular industry, the analyst could consider overweighting that industry sector

Interest Rate Measurement and Management in a Top-Down Strategy

It is important to measure interest rate sensitivity for investment grade bonds and to some extent even for high yield bonds

Measuring interest rate exposure: There are several measures that can be used to measure interest rate exposure We use effective duration to measure sensitivity to parallel shifts in the yield curve If we want to measure non-parallel shifts in the yield curve we should use key rate durations To measure the interest rate volatility we can use effective convexity (All these measures have been discussed in the previous readings.)

Managing interest rate exposure without derivatives: Lets’ say we expect interest rates to come down, and we want to increase the duration of our portfolio to take advantage of this situation To increase duration we could add high duration bonds to our portfolio i.e increase duration without derivatives Managing interest rate exposure with derivatives: There are several challenges to increasing duration by adding bonds and not using derivatives

 Most fixed income managers like to separate the management of interest rate risk and credit risk But if we add a long duration bond, for example a 20-year corporate bond, it will take care

of interest rate risk but also impact the credit risk of the portfolio which is not desired

 Another issue is that it may be difficult to find corporate bonds with the right maturity

 Finally we might have managers who want to completely hedge away interest rate risk This cannot be achieved by simply adding longer duration bonds

To overcome these challenges we can manage interest rate risk using derivatives such as futures contracts and interest-rate swaps The advantage of this approach is that interest-rate management can then be controlled independently of credit risk management Also, derivatives are more liquid as compared to corporate bonds The disadvantage of using derivatives is that it might be very costly for small investors, so this approach may not be practical

Volatility management: A portfolio’s exposure to interest rate volatility can be managed through credit securities such as callable bonds or mortgage pass through securities Volatility can also be managed with derivatives such as options

Country and Currency Exposure

An investor may want to overweight or underweight positions in other countries based on his country and currency views Currency and/or country views are often implemented using a top-down approach, through the use of credit securities or derivatives

For example, if you believe that the interest rate differential between two countries will change, then you can buy credit securities in the currency where yields will fall and sell credit securities where yields will rise

Typically country and currency exposures are managed through derivatives such as forwards and

futures By using derivatives an investor can manage currency risk separately from other portfolio

exposures Also, derivatives tend to be quite liquid

Spread Curves in Top-Down Approach

An investor can have many different views related to spread curves and he can construct different

portfolios based on these views For example,

 An investor might believe that two spread curves will converge or diverge

 An investor might believe that a particular credit spread will flatten or steepen This is

demonstrated in exhibit 11 from the curriculum which shows the spread curve between 10-year and 3-year BB bonds The spread curve appears very steep, which means that the curve could flatten in the future So the investor should overweight 10 year bonds and underweight 3 –year bonds

4.3 Comparing the Bottom-Up and Top-Down Approaches

Bottom-Up Approach Top-Down Approach

Difficult to earn substantial returns from bottom-up

security selection without exposing the portfolio to

macro factors

Challenge:

Difficult to gain information advantage

In practice, investors often combine these two approaches For example, an investor might use down analysis to identify attractive industry sectors Then he can use bottom up analysis to identify good securities within these sectors

top-Another strategy might be to use bottom up analysis first to identify securities that are underpriced and which are likely to perform well Then we can use top-down analysis to minimise exposure to the credit

cycle by making sure that risk statistics such as credit quality, duration, and credit spread, equal to those

of the investor’s benchmark

Refer to Example 10 from the curriculum

4.4 ESG Considerations in Credit Portfolio Management

Some fixed-income mandates include a requirement that the portfolio consider environmental, social, and governance (ESG) factors in the investment process

There are different ways to incorporate ESG considerations

 Relative value considerations: Companies with poor ESG practices will have higher credit risk and therefore wider spreads For example, if a company causes high pollution it faces the risk of lawsuits and fines

 Guideline constraints: For example, the IPS of some portfolios may prohibit investments in alcohol, tobacco and firearm companies

 Portfolio level risk measures:

o We can monitor the exposures to ESG-related risk factors and make adjustments when required

o We can also target an average ESG portfolio score

 Positive impact investing opportunities: Here we look favourably at issuers who are making a positive economic or social impact

5 Liquidity Risk and Tail Risk in Credit Portfolios

5.1 Liquidity Risk

LO.e: Discuss liquidity risk in credit markets and how liquidity risk can be managed in a credit portfolio; Liquidity refers to the ability to purchase or sell an asset quickly and easily at a price close to the fair market value The risk of not being able to do so is called liquidity risk If liquidity is low, then liquidity risk is high

The liquidity of corporate bonds tends to be lower than the liquidity of government bonds; this implies that corporate bonds have relatively higher liquidity risk

Measures of Secondary Market Liquidity in Credit

The three major measures of liquidity risk are:

 Trading volume: Higher trading volume implies higher liquidity Over the last few years, the trading volume in several large markets has trended downwards, which implies that the liquidity

of credit markets as gone down

 Spread sensitivity to fund outflows: When large withdrawals are made, the spread usually widens Measuring the spread sensitivity to fund outflows therefore helps measure liquidity For example, we can use a ratio such as spread widening / percentage outflow The curriculum points out that for a given percentage outflow the spread widening is higher for high yield bonds relative to investment grade bonds This implies that high yield bonds have lower liquidity

 Bid-ask spreads: A higher bid-ask spread implies low liquidity However, we should be careful

while using this measure as this information is stable only when the markets are stable During volatile market conditions, the bid-ask spreads tend to be volatile

Structural Industry Changes and Liquidity Risk

 After the 2008 crisis, new regulations were introduced due to which the ability of dealers to maintain large bond positions went down In the US, which is the largest bond market, the Volcker Rule was introduced which restricts dealers from taking risk, holding inventories and engaging in some trading activities that would have supported credit market liquidity Also the crisis affected the dealers’ willingness to take risk as they have now become more risk averse

 In the past a very large percentage of investment grade and high yield bonds were concentrated

in a few funds, but now they are distributed across a much larger set of funds

The impact of the first structural change is lower liquidity Whereas, the impact of the second structural change is higher liquidity However, the first change dominates and overall we have seen a reduction in liquidity

Management of liquidity risk

 Percentage of cash in portfolio: Due to increased liquidity concerns, several fund managers have increased the percentage of cash in their portfolios

 Managing position sizes: Fund managers can hold larger positions in bonds that are more liquid

 Holding liquid non-benchmark bonds: Fund managers can deviate from their benchmarks and hold non-benchmark bonds that are more liquid

 Making use of CDS index derivatives: This is an alternative way to gain exposure to credit risk The curriculum points out that the liquidity of CDS index derivatives is far higher than that of corporate bonds

 Making use of ETFs: Credit ETFs have become very popular after the 2008 crisis However the concern here is that since ETFs are very easy to trade, during periods of high volatility they may experience unusual market movements and their prices may deviate from their net asset values 5.2 Tail Risk

LO.f: Describe how to assess and manage tail risk in credit portfolios;

Tail risk is the risk that there are more actual events in the tail of a probability distribution than probability models would predict Most probability models are based on normal distribution A normal distribution suggests that there will be a certain percentage of outcomes in the left tail However, in reality, we may see far more negative outcomes and the severity of the outcomes may also be higher than what the model suggests

Due to this tail risk events are difficult to model and almost impossible to predict in advance We therefore need some tools to assess tail risk

Assessing Tail Risk in Credit Portfolios

 Historical scenario analysis: Here we look at actual events from the past which were unusual and had a severe negative impact on bond prices and evaluate what would happen to our portfolio if these events were to occur again