I had a few basic (stupid) fixed income investment related questions: a) If you invest (say $5 million) in a corp bond trading at $98 and hold it till maturity, do you get the $5M back regardless of where the bond is trading (say $90 or $104)? b) What is a CDS? When a CDS is quoted as 60 - what does it mean (is it quoted as L+60)? When it is quoted as 30pts upfront does that mean +3000bps? c) What are the risks associated with CDS investment? d) What is spread duration? example would be helpful e) What are swap spreads? example would be helpful. Thnx so much:)
alex123 Wrote: ------------------------------------------------------- > I had a few basic (stupid) fixed income investment > related questions: > > a) If you invest (say $5 million) in a corp bond > trading at $98 and hold it till maturity, do you > get the $5M back regardless of where the bond is > trading (say $90 or $104)? > b) What is a CDS? When a CDS is quoted as 60 - > what does it mean (is it quoted as L+60)? When it > is quoted as 30pts upfront does that mean > +3000bps? > c) What are the risks associated with CDS > investment? > d) What is spread duration? example would be > helpful > e) What are swap spreads? example would be > helpful. > > Thnx so much:) some of the answers like 4 and 5 can be found on investopedia.org or by googling.
A. Yes. Bonds Mature at par. B. Credit Default Swap. Points upfront is principal you have to pay to the dealer to insure on default plus a running interest payment (spread) to them. 30pts upfront is 30% of par you pay at inception. a. It is quoted at 60 bp, you pay 60 bp/yr to insure the bond. You generally don’t have points upfront and running until it is a pretty distressed name. b. L+60 is theoretically where cash should be trading in the above example, in a VERY PERFECT world (ie zero cash/cds basis). A bond spread is (in a perfect world) swap spread plus credit spread. C. Risks are counterparty risk (JPM fails to pay you or deliver bond), and all market risks – bond could rally and you are in the toilet. Probably more, others could chime in. D. Amount of $price change for change in spread over a benchmark. E. Spread at which fixed cash flows are exchanged for floating.
I am going to give you my thoughts on this but these aren’t textbook answers: a) If you invest (say $5 million) in a corp bond trading at $98 and hold it till maturity, do you get the $5M back regardless of where the bond is trading (say $90 or $104)? That doesn’t really make sense. If you buy $5 million worth of par, then you’ll get $5 mil at maturity. If its trading at 98 at the time, that means you are only paying 98% of 5 mil but will get the full 5 mil at maturity. There’s also a false assumption in your question. As the bond in near maturity, its price could not really be $90 or $104. Let’s say today is 1 day before maturity. You know that tomorrow you will get $100 for the bond. Why would you pay $104 today to get $100 tomorrow? Similarly, I’d never sell you the bond for $90 since I can hold it for a day to get $100. As bond approaches maturity, its trading price approaches par. b) What is a CDS? When a CDS is quoted as 60 - what does it mean (is it quoted as L+60)? When it is quoted as 30pts upfront does that mean +3000bps? c) What are the risks associated with CDS investment? CDS is default insurance on a bond. If you own a bond and it defaults, and I sold you a CDS, I will reimburse you for the amount you lost.
CDS means credit default swap. This is a derivative instrument that allows one party to short (sell) the bond and another party to go long (buy) the bond. But only synthetically, meaning that there isn’t any actual buying or selling of the bond in question. The short party is referred to as the protection buyer, and the long party is referred to as the protection seller. The protection seller receives a spread (in this case, 60 bps) from the protection buyer to “insure” the underlying credit. If the underlying bond defaults and takes a loss, payments are made by the protection seller to the protection buyer. People’s rationales for entering into a CDS contract vary widely. However, sometimes people decide to become protection sellers to gain exposure to a bond that they can’t find in the market. Protection buyers are sometimes hedgers who hold the underlying bond and wish to insure against losses on the bond.
If you “hold a corporate bond to maturity” you get back par if everything goes well. Of course, the whole game with corporate bonds is that you might get back substantially less than that and it might only come after lengthy bankruptcy court proceedings.
Thanks for responding. Have a few more questions a) CDS Scenario: $5M notional, buy protection @50bps or cost of $25k per year; after 1 year CDS trading at 75bps; would the protection buyer bear a loss of $12.5k? i.e cost of insurance = $25k; profit from the trade= (75-50)bps*5M=$12.5k or net loss of $12.5k Is that right? b) What’s the relationship between CDS and recovery rates? c) So if there are Inv Grade names trading in excess of L+300; would you just make sure they have enough liquidity/capital until they mature (and better to pick shorter duration names) or would there be other risks you would look at? Thnx again
a) I just ran a CDS scenario on Bloomberg using 5yr COP as the reference entity and a flat 50 bp CDS curve (that isnt realistic, but for the sake of discussion its a simplifier). At reevaluation 1yr down the road, if spreads are flat at 75 bp (theoretically on 1/6/09), the JP Morgan model prices it at 99.038 (your bid wont be that good, probably) and a Market Value of $47,037. You have paid out approx 25k in carry and have an instrument worth almost 50k. The DV01 is 1.9k. (bear in mind, I dont trade CDS, so someone could tell me i am full of it). b) Recovery rates will impact the spread to compensate someone for taking on that credit risk. A lower recovery rate will imply that i need to be paid more to be long risk (long credit, short CDS). You can also back into implied recovery with CDS and a static default probability (and vice versa). Recovery is a fundamental measure of a bond’s valuation. c) That is a big, big question. At the end of the day you need to be comfortable with great deal of factors to buy any bond, let alone an IG name at L+300. Remember, liquidity/capital can change over the life of a bond. Take the banks for example (I’m assuming you are looking at a finance name with a spread like that). Look at relative value between similar names. How is the co’s leverage profile (look at Debt/Cap for finance names, not EBITDA leverage)? What is their tangible equity? is there secured debt ahead of you in line? What are cash flows like? Covering interest how many times? Financing needs? Capex/Acquisition plans? There are myriad of questions to think about, and no useful rules of thumb i can think of. Also, with respect to duration, it is my assumption that you may like the bond. If you like i t enough to commit capital, then you hopefully expect spreads to tighten (or at least outperform your index). P/L is reduced if you buy some par bond maturing in 09 or something. Sure, you get the carry (which admittedly at L+300 is pretty good), but if you truly believe in the credit and that the market will recognize its quality, trade something longer and hedge the rate risk out. Just my two cents. Since there is really no formula on this, I am sure others could add or tell me I am wrong.
That is, COP as the reference entity (it trades a little inside 50 bp) and a 5yr contract. Sorry, I used wrong terminology.
Yeah these are really broad questions. Grover’s done a great job, I’ll just add a few things. For a, I’ll fill in the theory behind the pricing model grover mentions, which should be enough for the interview. First off the trade will have made money; that’s the whole point of buying protection. You are thinking about the p&l of the trade wrong. You should think about it in terms of the unwind. You buy 5 yr protection at 50 bps. In one year, the CDS is trading at 75 bps. You could now enter into an offsetting trade, selling 4 year protection at 75 bps on the same notional (although if the 75 bps quote is for current 5 yr protection in normal markets the 4 year level would probably be a bit lower due to roll down. These days many credit curves are inverted, but that’s probably beyond the scope of this problem. You also have to account for crossing the bid / ask, which is a mile wide these days). You are now default neutral, because you have sold and bought protection on the same notional. So, you’ve now locked in a stream of 25 bps / year for the next four years. However, it isn’t totally risk free, because in the event of a default your income stream will stop. You need to adjust the 25 bps income stream by the probability of survival and then find the present value. So, you could say the market value of a CDS contract is the present value of the default-probability adjusted stream of cash flows generating by entering into the offsetting transaction at market levels. In practice you don’t actually enter into an offsetting trade, a dealer will unwind your position by just paying you the PV. Market practice does seem to be to use the CDSW function on Bloomberg grover is looking at. Anyway for your question, once you have the unwind value you then subtract your negative carry for the p&l. For B, think of the CDS spread as compensating you for your expected loss, which is basically the probability of default times one minus the recovery rate. So, with a recovery rate of greater than zero (which is almost always the case for senior debt) the probability of default is greater than the CDS spread. Put another way, all else equal there is an inverse relationship between recovery rates and CDS spreads. In the valuation method I described above, a simplifying assumption sometimes used is to imply the probability of default using the market CDS level and a 40% recovery rate. It’s a tricky game because none of these factors can be determined with 100% accuracy. You can use historical default probabilities of a wide range of corporate issues, and you can attempt to calculate a fundamental recovery value by doing a balance sheet liquidation analysis, but of course both are filled with assumptions. I guess that’s what keeps it interesting though. I’m not really going to answer C because it’s so broad. Just review the basics of credit analysis if this is for an interview or something. To Grover’s point, I don’t totally agree because it is a lot easier to get comfortable with near-term liquidity for a financial. Plus, you can find plenty of short debt trading at meaningful discounts, so if you can get comfortable with the credit there is plenty of pull to par.
Nodge, thanks for filling in. Very informative for me too. Thanks.
Thanks much. Very detailed and informative. Thank you.
how are credit hybrid products different from vanilla cds’s? i’ve heard there are lcdx (is that a loan index?) , tabx, abx and cmbx entities… what are these? are these a hybrid product?
Thanks much. Very detailed and helpful.
LCDX - Loan CDS Index TABX - Tranched ABS CDS Index ABX - ABS CDS Index CMBX - CMBS CDS Index check out www.markit.com. A hybrid generally refers to a hybrid security which have been issued mainly by financials. It counts as tier-1 capital (most of the time, I think), and has a fixed coupon for a number of years, then moves to floating after a set period.
what a spread duration be for an amortizing instruments such as MBS?