Cash & Loans Advice Blog

If a credit event occurs…

Selling short-term and buying long-dated protection leaves a forward short position, which would benefit from a steepening in the credit curve and vice versa.

Senior versus subordinated CDS strategies: The senior-to-sub spread differential in CDS is driven fundamentally by expected recovery values. If senior spreads are half those of subordinated, then the expected senior loss following default is half that of sub. A 50 percent senior recovery (50 percent loss) would imply a 0 percent subordinated recovery (100 percent loss) A potential strategy is to sell subordinated protection and to buy senior protection (weighted). It offers the chance to unwind at a profit if the seniorto-sub ratio mean reverts to historical averages (positive carry trade). If a credit event occurs, the payoffs will reflect the actual relative recoveries in sub and senior debt.

Protection related to credit events

CDS are used to transfer the credit risk of a reference entity from one party to another. One party (the protection buyer) pays a periodic, fixed premium to another (the protection seller) for protection related to credit events on the reference obligation. If there is no credit event, such as default during the life of the swap, these premiums are the only cash flows . If a credit event occurs the protection seller is obliged to make a payment to the protection buyer. For physically settled contracts, following a credit event, the protection buyer delivers the defaulted reference obligation.

Cash settlement (par minus market value) is the alternative to physical settlement and is used less frequently in standard CDS but overwhelmingly in tranched CDOs. The 2003 ISDA definitions further clarify the three types of credit events:

• Bankruptcy
• Failure to pay
• Restructuring.

Just like cash bonds or loans, CDS transfer credit risk. To remove the interest rate component of a cash bond, a synthetic floating-rate note can be created via an asset swap which eliminates the duration and convexity exposure of the cash bond. An unfunded position in the bond would have to be financed in the repo market. A CDS is equivalent to a financed purchase of a bond with an interest rate hedge (selling protection through a CDS or buying a corporate bond, asset swapping the coupon to floating and financing the holding in the repo market).

When a credit curve is steep

On the other hand, if one has a negative short-term view on a credit but believes it to survive for the next 5 years, its credit quality will improve significantly. This view can be expressed via buying a long-dated 30-year par asset swap and buying 5-year protection on the single name thereby creating a long forward spread position (or buying short-dated default protection and selling longer dated default protection). This position would benefit from a flattening of the credit curve.

A steep credit curve implies a steep forward credit curve. A forward default swap is buying or selling protection for the given maturity at a given point in the future at the forward CDS spread. For example, Munich Re senior 2-year protection is at 21 bp and the 7-year protection trades at 34 bp. Selling 2-year protection and buying 7-year protection results in a 5-year CDS two years forward (2 _ 5 spread) at a level of 40 bp.

The phase of the credit cycle

According to our correlation matrix high yield is best comparable with equities. The value of $100 invested in January 1987 in high yield and the S&P 500 Index. It can be said that investors realized similar returns over the period Jan. 1987–Dec. 2003. It brings more clarity into the relationship between high yield and equity markets. Obviously both markets are affected by similar macroeconomic factors, so that they show parallel fluctuations in risk. But it is important to note that high yield experienced less risk over this period, meaning that high yield returns experience less volatility than that observed with equities.

It shows historical yields in the high-yield market versus 10-year Treasuries and BBBs. The spread differential varies significantly depending on the phase of the credit cycle.

The significance of credit brands

A brand is a design, name or identity that is given to a product or service in order to differentiate it from its competitors. Brands are likely to remain a potent force in the future, not least because, in an increasingly unclear and uncertain world, they help customers understand what they are buying or are being offered. If you buy a Rolls-Royce, for example, you expect certain brand values such as quality, reliability and prestige.

Brands are complex assets, and like people they possess, to some degree, distinguishing features. One increasingly popular method of managing brands is to view them as having “personalities”. The Rolls-Royce brand has a high-class, high-quality appeal throughout the world, and retailers such as Wal-Mart and K-Mart built their reputations on homely convenience and low price. It is this concept of brand personality that highlights their power.

Making the right online credit decisions

In 1996, General Electric (GE) pioneered the use of an extranet (a closed network for use by people external to the organisation) in its lighting division to develop effective business-to-business relationships. The lighting division established a global network, linking with suppliers worldwide, to enable the company to complete its purchasing transactions more quickly. A feature of the extranet, known as the trade processing network (TPN), allowed GE’s many international suppliers to download GE product specifications and communicate with the company via a secure, encrypted software link over the internet. The benefits of this approach for the lighting division were swift and significant: the cycle time in the purchasing process was reduced, enabling more efficient production and inventory management. GE suppliers continued to become an integrated part of a global community. Furthermore, TPN was employed in seven other GE business divisions as well as being licensed to other manufacturers to use with their suppliers.

In contrast, a survey of websites in 2000 found that 40% of e-mail questions went unanswered. Only 16% of sites followed up with a marketing offer to customers that had purchased from them in the last 30 days, and of these, only 2% were personalised. Other surveys suggest that as many as 60% of people using the internet believe that giving out personal information is “generally unsafe”. Many businesses now recognise the commercial importance of ensuring that their websites are safe and secure, and are seen to be so by their customers.