Credit risk management

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.