Title LM2 Fixed-Income Active Management Credit Strategies IFT Notes.pdf ✅

LM2 Fixed-Income Active Management: Credit Strategies 2024 Level III Notes © IFT. All rights reserved 1 LM2 Fixed-Income Active Management: Credit Strategies 1. Introduction .......................................................................................................................................................1 2. Key Credit and Spread Concepts for Active Management................................................................2 Credit Risk Considerations ..........................................................................................................................2 Credit Spread Measures................................................................................................................................9 3. Credit Strategies ............................................................................................................................................ 23 Bottom-Up Credit Strategies.................................................................................................................... 23 Top-Down Credit Strategies..................................................................................................................... 28 Factor-Based Credit Strategies................................................................................................................ 30 4. Liquidity and Tail Risk................................................................................................................................. 32 Liquidity Risk................................................................................................................................................. 32 Tail Risk............................................................................................................................................................ 34 5. Synthetic Credit Strategies ........................................................................................................................ 36 6. Credit Spread Curve Strategies ................................................................................................................ 42 Static Credit Spread Curve Strategies................................................................................................... 43 Dynamic Credit Spread Curve Strategies ............................................................................................ 45 7. Global Credit Strategies .............................................................................................................................. 47 8. Structured Credit........................................................................................................................................... 53 9. Fixed-Income Analytics............................................................................................................................... 54 Summary ............................................................................................................................................................... 56 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, 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. Version 1.0
LM2 Fixed-Income Active Management: Credit Strategies 2024 Level III Notes © IFT. All rights reserved 2 1. Introduction In the last reading, we discussed yield curve strategies involving government bonds with no credit risk. However, in this reading, we will cover bonds with credit risk and focus on credit spreads. We will discuss credit spread measures for fixed- and floating-rate bonds and assess spread changes on portfolio value. In Section 2, we look at key credit and spread concepts. In Section 3, we will talk about bottom-up and top-down credit strategies. Section 4 deals with liquidity risk and tail risk in credit portfolios. In section 5, we go over synthetic credit strategies. Section 6 focuses on credit spread curve strategies, and Section 7 looks at global credit strategies. Section 8 considers structured debt, and finally, Section 9 deals with fixed-income analytics. 2. Key Credit and Spread Concepts for Active Management The fourth term of the following expected return equation gives the excess return attempted by spread-based fixed-income portfolio managers: E(R) ≈ Coupon income +/− Rolldown return +/− E (Δ Price due to investor’s view of benchmark yields) +/− E (Δ Price due to investor’s view of yield spreads) +/− E (Δ Price due to investor’s view of currency value changes) Yield spreads compensate investors for assuming credit and liquidity risks. • Credit risk - the risk of not receiving due interest and principal cash flows. • Liquidity risk – refers to an investor’s inability to buy or sell a specify security. Credit Risk Considerations Credit risk for a borrower depends on the likelihood of default and the loss severity, while credit risk for a bond issuance also depends on the payment period, the debt seniority, and the repayment sources. Spreads vary across ratings categories and time periods. See the Exhibit below for yield spreads as a percentage of total YTM for A-, BBB-, and BB rated US corporate issuers from mid-2009 to mid-2020.
LM2 Fixed-Income Active Management: Credit Strategies 2024 Level III Notes © IFT. All rights reserved 3 During this period, 60% of total YTM was from the yield spread of BB rated issuers against 33% for A rated issuers. This percentage was at its peak in early 2020 due to the economic slowdown compared to 2010, when it was at its minimum for all rating categories. Default Probabilities and Recovery Rates Components of a Bond’s Credit Risk 1. Default risk or probability of default (POD) and 2. Loss severity or loss given default (LGD). CVA Framework The CVA framework helps evaluate these components of credit risk. Consider the following credit valuation adjustment (CVA) framework:
LM2 Fixed-Income Active Management: Credit Strategies 2024 Level III Notes © IFT. All rights reserved 4 • Default risk (or POD) is the likelihood that a borrower defaults or fails to meet its obligation to make full and timely payments of principal and interest of debt. POD is expressed as a percentage in annual terms. • Loss severity (or LGD) is the amount of loss if a default occurs. LGD is expressed as a percentage of par value. • One-period POD ≈ Spread/LGD for bonds trading close to par. • Distressed bonds tend to trade on a price instead of a spread approaching the recovery rate (1 − LGD) as default becomes likely. • Historical POD and the LGD rate are much lower for investment-grade bonds than for high-yield bonds. A credit loss rate = the realized percentage of par value lost to default for a group of bonds, or the bonds’ default rate x loss severity. The following Exhibit shows global annual corporate default rates from S&P Global Ratings. The solid line represents investment-grade bonds and the dashed line represents high- yield bonds. Notice that the probability of default rises significantly as the economy slows. This is evident during the 1990–91, 2001, and 2008 recessions. The percentage of par value lost in a default is based on a bond’s relative position in the capital structure and whether it is secured or unsecured. EXAMPLE (This is Example 1 of the curriculum) A bank analyst observes a first lien bank loan maturing in two years with a spread of 100 bps from an issuer considering a new second lien bank loan. Using average historical volume weighted corporate debt recovery rates (RR) as a guide, what is the estimated