In prior posts, we have looked at credit default swaps. Let's take step back and look at credit derivatives as a whole. They are financial contracts such as options, forwards, futures, swaps and credit linked notes that are used used by fixed income managers to hedge positions (credit protection) or to enhance portfolio returns (credit exposure). Through credit derivatives, portfolio managers are able to isolate and transfer credit risk, get liquidity in the market and have transparent pricing by trading the underlying credit. Previously, they would have to hold the underlying assets in their portfolio which is capital intensive. To manage risk using this method, the manager would have to look at each company's financial statement and balance sheet to rate their soundness. He would also look at the industries of the portfolio companies and diversify loans to companies in different industries or sectors.
What is credit risk? There are three components: default, downgrade and credit spread. Default risk is the risk that the bond issuer or loan borrower will not pay the bond or loan in full. A loan is in default if a scheduled payment is not made. Downgrade risk is when a rating agency such as Standard & Poor's, Moody's or Fitch's lowers the credit rating of the debt. Credit spread risk is when the market spread between the underlying bond or loan increases for the remaining debt. Credit risk is usually measured by rating agencies or using the credit spread.
What are the underlying / reference assets that credit derivatives are used for? They are high yield bonds, leveraged loans, distressed debt and emerging markets bonds. These assets have low to medium correlation with US equities and low or negative correlation with US Treasuries. They have a high exposure to large declines in prices. High yield bonds a.k.a. junk bonds are rated below investment grade by the agencies (either below BBB by Standard & Poor's or Baa by Moody's). Leveraged loans are bank loans made to companies of credit ratings below investment grade or with a spread of 150 basis points over LIBOR (London Interbank Offer Rate). LIBOR is the interest rate at which banks borrow from other banks in London. In addition to the three credit risks listed above, the borrower can pre-pay the loan by re-financing or pre-paying the balance. This is call risk. There are to types of loans - revolvers and term loans. Revolvers are committed lines of credit that also back commercial paper loans of companies with high credit ratings. Term loans are given to companies with lower credit ratings, are funded commitments with fixed amortization schedules and are based on floating interest rates. In addition to credit risk, emerging markets debt is exposed to political risk. Distressed debt is composed of bonds of companies that are in default because of a missed payment, bonds going through Chapter 11 re-organization, the company having cash flow problems or have low credit ratings.
Options, futures and forwards are known as binary options. They are similar to equity options. If an event occurs as dictated by the terms of the contract, then the option seller pays money to the holder. A credit-linked note is a bond with an embedded credit option. These notes have a higher interest rate than regular bonds but the holder of the note provides the issuer with some credit hedge. The referenced asset is either a corporation or a basket of credit risks.
A total return credit swap allows an investor to rent a balance sheet. The investor trades the return of an asset for a guaranteed rate of return, usually LIBOR plus a spread. The seller of the swap retains ownership of the asset. For example, an investor could be positive on Apple bonds. A swap can be bought on the returns of Apple bonds. The buyer would receive that return and pay the seller LIBOR plus a spread. The seller has hedged his position in Apple bonds and is now receiving payments of LIBOR plus a spread.
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