Posts Tagged ‘making money’

Traditional credit analysis is a bottom-up approach November 21st, 2009

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Traditional credit analysis is a bottom-up approach which focuses on the selection of companies. The credit quality/risk has to be determined and the two following questions have to be answered:

  • Is the issuer able to make the coupon payments?
  • Will the company value at maturity be large enough to pay back the principal?

During highs and lows of market cycles psychological and technical factors tend to push asset prices to extremely elevated or depressed levels. At those times it is appropriate to focus on credit fundamentals and detect companies where such moves were not justified. Credit analysis should be able to identify opportunities to add substantial yield by assuming only little higher credit risk at the same time. The following paragraphs describe a possible way of analyzing the credit risk and investing in corporate bonds.

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Shortcomings of the credit curve November 13th, 2009

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A way to avoid the shortcomings of the above-described credit curve trade are duration-neutral box trades. Essentially, the trade consists of two legs. The investor buys the long-term bond of issuer A and sells the longterm bond of issuer B. Additionally, he sells short-term bonds of the first issuer and buys short-term bonds of the second issuer. Consequently, the trade benefits from a flattening of issuer A’s credit curve and a steepening of issuer B’s credit curve. This trade, of course, can be constructed to be duration neutral. Yet, there are myriad possibilities to do this. Assuming that no borrowing and leveraging are allowed the duration of the combined trade will always lie between the durations of the second shortest and second longest bond. While the position is insensitive to changes in the yield curve, its performance in general depends not only on changes of the credit curve but also changes of the level of spreads.

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Benefit from a steepening credit curve November 11th, 2009

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There is an alternative way to benefit from a steepening credit curve. If an investor expects issuer A’s credit curve to steepen more than implied by forward spreads and issuer B’s credit curve to flatten at the same time, he could switch from company A’s long bonds into company B’s long bonds. Whenever company B has a bond outstanding with a longer maturity than the bond that is sold, the trade can be set up on a durationneutral basis. Crabbe and Fabozzi (2002) point out that the return from this strategy over a 1-year horizon is approximately equal to

Return = spread differential – duration * change in spread differential, assuming roughly equal durations for both bonds. But it should be noted that this trade is not a pure bet on an issuer’s credit curve. Even if the credit curves behave as expected and the trade turns out to be profitable, taking another position may have been more beneficial in absolute terms and with respect to the individual credit curves of the two involved issuers. This is true, for example, if the spreads of company A and B widen significantly across their credit curves. In this case the capital loss due to the spread widening can exceed the profit of the bond swap. Being positioned at the short end of the credit curve then would have been a better strategy from an absolute return perspective.

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