Is the risk of a loan going bad for the lender. With simple bonds it is the risk of
Government Bonds are meant to be risk free but recent events have affected the credit
ratings of Government Bonds of countries such as PIIGS.
Gilts v Junk Bonds: The journey towards the Financial Crisis of 2008
Fixed Income securities which bear credit risk can be classified on the basis of the
credit spread on their yields.
Credit spread is the excess yield of a corporate bond over a benchmark government
bond or LIBOR i.e it is the spread (difference in yields) between Treasury securities
and non-Treasury securities that are identical in all respects except for quality rating.
The additional yield in excess of those on treasuries on single A-rated industrial bonds
for example is compensation on their bonds because their credit is worse than the
government's i.e. their risk of default is deemed to be higher..
UK Treasury securities are regarded as default free (although recently the AAA Credit
rating has been diluted) and are called Gilts. Corporate Bonds have a credit spread
commensurate with its ratings. Highly rated corporate bonds are called Investment
Grade bonds and Lowly rated bonds are called High Yield bonds in the FT for
example but are commonly called ‘junk’ bonds. These are usually purchased for
speculative purposes as their interest rates can be a few percentage points higher than
safer government issues.
Historically Junks were a phenomenon of the US market in the 1970s and 1980s.
Michael Milken, a researcher @ Drexel Burnham Lambert found that Junks provided
higher yields than the Government’s after allowance for defaults because bigger
rating agencies were too harsh. This was consistent with what many academics had
found but he ‘acted on his belief’ and started dealing in these in the secondary market.
90% of bonds in issue were junks. His success was so great that Drexel Burnham
Lambert started making primary issues which became popular and allowed minnow
companies to get funding to take over bigger fish. The takeover of TWA by Carl
Icahn is a case in point.
Carl Icahn is an American billionaire investor with a reputation of a shrewd activist
investor. Icahn is known for buying large amounts of stock in a specific company, and
then pressuring the company to make significant changes to increase its value. An
annual convention was held by Drexel Burnham Lambert for the purpose of matching
high-risk companies searching for financing with investors who wanted the high
rewards that can come with higher risk. After the first convention in 1979, these
conventions became increasingly focused on setting up leveraged buyouts and hostile
takeovers using these junk bonds. These conventions came to be called the predators’
The predators' ball was an investment gala for corporate raiders and financiers. The
term became the title of a book about the rise of junk bond trading and the fall of
Drexel and Michael Milken. Since then, the term has been used to refer to meetings
between high-net-worth investors who make their money through shorting, buyouts
and other aggressive tactics.
Milken made millions of dollars by specializing in bonds issued by "fallen angels" -
companies that experienced financial difficulty which caused the price of their debt,
and subsequently their credit rating, to fall.
In 1989, Rudy Giuliani (then the U.S Attorney General of New York) charged Milken
under the RICO Act with 98 counts of racketeering and fraud. Milken was indicted by
a federal jury. After a plea bargain, he served 22 months in prison and paid over $600
million in fines and civil settlements. Today, many on Wall Street will attest that the
negative outlook on junk bonds still persists because of the questionable practices of
Milken and other high-flying financiers like him. Other see him as a Saint.
This story apart the relevance of credit risk is best considered in the context of
In the US housing market Savings and Loans associations (like mutual building
societies in the UK) provided (large) mortgages using a large number of (smaller)
investor deposits. This is the basic Originate-&-Hold model. In this way the S&Ls
convert short term deposits (liabilities) into long term maturities (assets), representing
the classic Asset Transformation role of banks. These (conforming) mortgage loans
were made only to borrowers with adequate credit worthiness.
In the mid 1980s interest rates rose sharply but lending rates were restricted. In
addition S&Ls could not borrow across States and inter-bank lending was difficult. As
a result the S&Ls collapsed.
The US Resolution Trust company was set up to take over these loans, repackage
them into bundles of securities backed by the collateral in the underlying properties
and sell them on to investors. These were early examples of Mortgage backed
securities (MBS). The Originate-&-Hold model became the Originate-&-Distribute
This had its costs. This required a $150b life line from the US Government.
This was an early form of securitisation.
What Does Securitization Mean?
It is the process through which an issuer creates a financial instrument by combining
other financial assets and then marketing different tiers of the repackaged instruments
to investors. The process can encompass any type of financial asset and promotes
liquidity in the marketplace.
Mortgage-backed securities are a perfect example of securitization. By combining
mortgages into one large pool, the issuer can divide the large pool into smaller pieces
based on each individual mortgage's inherent risk of default and then sell those
smaller pieces to investors.
The process creates liquidity by enabling smaller investors to purchase shares in a
larger asset pool. Using the mortgage-backed security example, individual retail
investors are able to purchase portions of a mortgage as a type of bond. Without the
securitization of mortgages, retail investors may not be able to afford to buy into a
large pool of mortgages.
In the early 1980s the US Governement also set up Government Sponsored
Enterprises (GSEs) to promote home ownership using securitisation. Two famous
examples are Freddie Mac (Federal Home Loan Mortgage Corp) and Fanny Mae (the
Federal National Mortgage Association). See diagram below.
Freddie Mac was a stockholder-owned, government-sponsored enterprise (GSE)
chartered by Congress in 1970 to keep money flowing to mortgage lenders to promote
homeownership and rental housing for middle income Americans. The FHLMC
purchases, guarantees and securitizes mortgages to form mortgage-backed securities.
The mortgage-backed securities that it issues tend to be very liquid and carry a credit
rating close to that of U.S. Treasuries. Freddie Mac had come under criticism because
its ties to the U.S. government allowed it to borrow money at interest rates lower than
those available to other financial institutions. With this funding advantage, it issued
large amounts of debt and in turn purchased and held a huge portfolio of mortgages as
its retained portfolio. Many people believed that the size of this retained portfolio
posed a great deal of systematic risk to the entire U.S.
Banks provided prime (conforming) mortgages to borrowers and then sold these on to
the GSEs, who repackaged them into bundles of Mortgage Backed Securities (MBS).
Although the US governemnt was not officially a guarentor it was perceived as one as
the GSEs were encouraged by the US government. In order to promote home
ownership across families with middle incomes in 2003 the US Government
encouraged banks to grant mortgages to a wider range of incomes. The rules on
conforming mortgages were relaxed and GSEs were selling MBS with a higher credit
risk. Since banks were not holding the risks a lot of sub-prime mortgages were being
Over 80% of sub-prime mortgages became securitised. In September 2008 Freddie
Mac and Fanny Mae collapsed and had to be bailed out by the US Government.
In the private, financial Sector Securitization took off to another level.
Banks set up Special Purpose Vehicles (SPVs). These were owned by the banks but to
overcome capital requirements they were set up as stand alone, off-balance sheet
The securitized products were in the form of tranches. There were three broad
tranches. The senior tranche was given AAA rating, the mezzanine BBB rating and
the unrated equity tranche. The banks often bought the unrated products themselves
increase the rating of the other tranches. The basic premise was that the banks would
monitor the credit worthiness of the original borrowers.
The nature of the Securitized products also became wider as other Asset Backed
Secutities (ABSs) such as car loans, credit card loans etc were include in the
Credit rating Agencies services were acquired to increase the salability of these
Credit Risk is measured by agencies such as Moody’s Investor Services, Standard &
Poor’s Corporation and Fitch Investor Services. They provide financial information
on firms as well as quality ratings on large corporate and municipal bond issues.
The top ratings are:
S & P’s Moody’s Grade
AAA Aaa Investment Grade
…. …. …
BBB- Baa3 Investment Grade
BB+ Ba1 High yield or
BB Ba2 JUNK status
C C High yield or
A ‘fallen angel’ is a bond which was Investment grade but became riskier. Others are
deliberately issued as high yield bonds for speculative purposes.
Determinants of Bond safety
The following are some of the metrics used as determinants of Bond safety by the
credit rating agencies.
1. Coverage Ratio: Ratio of company earnings to fixed costs.
2. Leverage Ratio: Ratio of Debt to Equity. Also called Debt-To-Equity Ratio.
3. Liquidity Ratios: Current ratio: Current asset/Current Liabilities
4. Quick Ratio: Current asset without current inventories/Current Liabilities
5. Profitability Ratios: 1. return on assets = earnings before interest and tax /total
6. Return on Equity = Net Earnings/Equity.
7. Cash Flow to Debt Ratio: Total Cash/Debt.
To boost the credit rating banks
i) Offered some third party guarantees against default
ii) Provided over collaterisation by increases the ratio of collateral
products in the securitised product
iii) provided an ‘excess spread’ by injecting cash into the SPV to meet
Securitisation of securitised products: CDOs
A special form of Securitised product, known as Collateralised Debt Obligations were
widespread in the run up to the credit crunch.
CDO issuers bundled MBS with other ABS. Whereas in a MBS the collateral is a pool
of mortgages in CDOs the underlying collateral were other securitised securities such
as MBS and ABS. This was thus the securitisation of securitised products. The
income stream from the underlying assets were used to first service the Senior tranche
and then the Meazzine tranche and then the lower tranche.
The SPV were a special form called Securty Investment Vehicles (SIVs) They issued
Asset Backed (short term) Commercial Paper, which had to be rolled over and
converted them into medium term loans. As the SIVs were not subject to regulation
there were no capital adequacy requirements.
CDOs were first created in 1987 by Drexel Burnham Lambert, a defunct dealer in
junk bonds. According to J.P. Morgan, $918 billion worth of CDOs were issued in
To create a CDO a bank first sets up a legally separate entity to buy and then resell a
portfolio of bonds and other loans (mainly mortgages). Such an entity is typically a
Structured Investment Vehicle (SIV). As SIV liabilities do not appear on the Bank’s
balance sheet it enables the bank to overcome capital requirement limits. The SIV
obtains short term loans by issuing short term commercial paper. This money is used
to buy bonds or mortgage debt. These loans of varying risk are pooled into a series of
tranches. Each tranche is given a different level of seniority in terms of its claim on
the underlying pool and each is sold off as a stand-alone security. As the pool of loans
receives interest payments these are used to pay interest to each tranche based on its
Senior Tranche: 70%-90% composed of Bonds with Aa-Aaaa rating.
Mezzanine 1: 5%-15% with investment grade bonds.
Mezzanine 2: 5%-15% with high quality junk bond rating.
Equity/First loss/residual tranche: <2%, unrated, coupon rate with 20% credit spread.
The top tranche constitutes about 80% of the entire pool. It is serviced first and
therefore has little risk. After this tranche is serviced the next tranche, the mezzanine
1 tranche is serviced from the remains in the pool. The shielding of the upper tranches
makes the lower ones bear the risk. In this way it is possible to construct Aaaa
tranches even though Aaaa bonds are rare. The lower tranches are given higher yields
if they are able to be serviced. Often the parent bank holds the equity tranche. This is
to provide incentives to the originator to make careful credit analysis of the securities
placed in the structure.
When the Fed flooded the markets with money from 2002-2005 most of it was
converted into subprime mortgages which fueled the US real estate bubble. This,
however, led to a problem: What were the investment banks going to do with all the
risky subprime loans they created?
This was the perfect time for Drexel Burnham Lambert's CDOs. At the height of the
CDO frenzy, over a trillion dollars of subprime debt was mixed in with high grade
debt and sold as high rated debt to pension funds, insurance companies, banks, and
When the credit crunch occurred the SIVs were unable to roll over ABCP and were
forced to be rescued by the parent bank which had to take the toxic assets onto their
Insuring Against Default:Credit Default Swaps (CDS)
In the US in the 1970s an insurance market to protect against default of a loan began
to emerge. The two principal players were MBIA Insurance Corporation and
American Municipal Bond Assurance Corporation (Ambac). This was to provide
insurance against default on Municipal Bonds. This was a lucrative low risk business
as Municipal Bonds are relatively safe.
MBIA used to back municipal bonds by promising to pay interest and principal on
any bonds that suffer an issuer default.
The presence of MBIA insurance on a municipal bond typically ensures an 'AAA'
rating or its equivalent from the major ratings agencies and also makes the bonds
much more marketable to investors.
Bond issuers may find they can even lower the total cost of issuing debt by
purchasing MBIA insurance, as the higher rating the bonds would garner could allow
the issuer to lower the coupon rate to investors.
MBIA and Ambac started broadening its focus from insuring only bonds to insuring
residential mortgage-backed securities (RMBS) and collateralized debt obligations
This insurance against default by CDOs was in the form of Credit default Swaps
Credit Default Swaps (CDSs)
A CDS is used to transfer the credit risk of a reference entity (corporate or
sovereign) from one party to another. In a standard CDS contract one party purchases
credit protection from another party, to cover the loss of the face value of an asset
following a credit event. The maximum amount of bonds covered is the credit default
swap’s notional principal. A credit event is a legally defined event that typically
includes bankruptcy, failure-to-pay and restructuring. When a credit event in the
reference entity is triggered, the protection seller either takes delivery of the defaulted
bond for the par value (physical settlement) i.e. the CDS seller is obligated to buy the
defaulted bonds for their face value from the CDS buyer or pays the protection buyer
the difference between the par value and Recovery amount of the bond (cash
settlement). Simply, the risk of default is transferred from the holder of the fixed
income security to the seller of the swap. This protection lasts until some specified
maturity date. To pay for this protection, the protection buyer makes a regular
stream of payments, known as the premium leg, to the protection seller as shown
The size of these premium payments is calculated from a quoted default swap spread
which is paid on the face value of the protection. The percentage of the notional
principal paid per year–even if the premiums are paid quarterly or semiannually—as a
premium is the CDS spread. So if a CDS buyer is paying 50 basis points quarterly,
then the CDS spread is 200 basis points, or 2% of the notional principal. These
payments are made until a credit event occurs or until maturity, whichever occurs
If a credit event does occur before the maturity date of the contract, there is a payment
by the protection seller, known as the protection leg in which the buyer of the CDS is
entitled to the notional principal minus the recovery rate of the bond. The recovery
rate of the bond is considered to be its value immediately after default.
CDS Payoff = Notional Principal x (1 – Recover Rate)
Most CDS contracts allow the buyer to select from a number of different bonds that
have defaulted to deliver to the CDS seller, although they must have the same
seniority. Even with the same seniority, however, bond prices may differ because of
accrued interest or because some bonds may have a higher value in a reorganization.
Bonds with a higher accrued interest have greater value than others in the same class.
In most cases, the CDS buyer has the option of delivering the cheapest-to-deliver
bond to the CDS seller. In the case of a cash settlement, the calculation agent will use
the cheapest-to-deliver price to determine the cash settlement.
Some CDSs are binary credit default swaps that pay a fixed dollar amount in the case
of default; thus, the recovery rate or the cheapest to deliver bond prices are not
This payment equals the difference between par and the price of the cheapest to
deliver (CTD) asset of the reference entity on the face value of the protection and
compensates the protection buyer for the loss. It can be made in cash or physically
settled format. This is shown below.
Because the premium leg payment is paid in arrears, any premium that would have
been due is prorated from the last period to the time of default and subtracted from the
Banks are usually the buyers of CDS protection and Insurance companies are the
sellers. A CDS can be traded in the secondary market. When the CDS is first created,
the value of the CDS in the secondary market is zero, assuming that the principals
negotiated their contract skillfully. The CDS acquires market value as the economy
changes, and as the fortunes of both the reference entity and the CDS seller change.
Large banks act as the market makers in this secondary market.
Suppose a protection buyer purchases 5-year protection on a company at a default
swap spread (CDS spread) of 300bp. The face value of the protection is $10 million.
The protection buyer therefore makes quarterly payments approximately equal to $10
million × 0.03 × 0.25 = $75,000.
Assume that after a short period the reference entity suffers a credit event and that the
CTD asset of the reference entity has a recovery rate of $45 per $100 of face value.
The payments are as follows:
• The protection seller compensates the protection buyer for the loss on the face value
of the asset received by the protection buyer. This is equal to $10 million × (100% –
45%) = $5.5 million.
The protection buyer pays the accrued premium from the previous premium payment
date to time of the credit event. For example, if the credit event occurs after a month
then the protection buyer pays approximately $10 million × 0.03 × 1/12 = $18,750 of
premium accrued. Note that this is the standard for corporate reference entity linked
default swaps. For sovereign-linked default swaps there may be no payment of
Unlike traditional insurance anyone can buy CDS protection whether they hold the
reference entity or not. Hence speculators took huge positions against issuers viewed
as being risky.
In Europe the sovereign debt of some the EU countries has been open to speculation
and the credit default spread curves show large spikes when news of imminent default
occurs. Intervention by EU countries (e.g. using quantitative easing by the ECB) to
support these states causes subsequent falls.
In 2007 the CDOs issued by Credit Suisse (Swiss Bank) defaulted wiping out all of its
$341m value. The senior tranches were protected by MBIA that had to pay out
$177m. In the same year MBIA and Ambac posted joint of $45b and its rating
plumetted from AAA to below BBB. In December 2008 AIG made posses of $30b
from sales of CDS.
In the mid 2007 the housing market started to stall as sub prime mortgages started to
default. The mezzanine tranches which were speculative grade investments were seen
as unduly risky and became unsaleable. Banks stopped lending to each other as the
level of exposure to subprime securitised products was unknown.
This was the credit crunch.
Pricing and valuation
There are two competing theories usually advanced for the pricing of credit default
swaps. The first, which for convenience we will refer to as the 'probability model',
takes the present value of a series of cashflows weighted by their probability of non-
default. This method suggests that credit default swaps should trade at a considerably
lower spread than corporate bonds.
The second model, proposed by Darrell Duffie, but also by Hull and White, uses a no-
We will look at the no Arbitrage model.
Credit Spreads and Probabilities
Probabilities also can also be related theoretically to Credit Spreads. One model for
doing this relies on the basic premise that that a risk free portfolio should earn no
more than the risk fee rate, otherwise arbitrage opportunities exist.
How is the CDS Spread determined?
As a CDS buyer is protected from the risk of a credit event from the reference entity,
the only risk is from the CDS seller defaulting in the case of a credit event. If this is
considered to be near zero (as was the case prior to the credit crisis of 2008), then the
combination of a long bond of the reference entity and a long CDS position creates a
nearly risk-free synthetic asset, whose no arbitrage return is the bond yield of the
reference entity minus the risk-free yield of a Treasury security with the same
CDS Spread = Bond Yield – Risk-free rate.
Violation of this relation (excluding trading and liquidity costs) implies arbitrage
opportunities: If the CDS spread is lower, then the investor can earn a higher risk-free
return rate by buying the bond and buying CDS protection. Of course, this synthesis is
not as risk-free as a Treasury, since there is a chance that both the bond issuer and the
CDS issuer will default. If the CDS spread is higher, then the investor can profit by
selling short the bond and selling CDS protection.
Simple Model to determine the CDS spread
Consider a portfolio consisting of a default free, zero coupon bond with T years to
maturity. The return on this portfolio is given by r = e rfT , where rf is the risk free rate.
The return on a risky zero coupon bond is given by r = e (rf s)T , where s is the credit
spread. If d is the probability of default and R is the Recovery rate then we have the
following pdf for the return on the Bond:
Probability of default Return on a risky zero coupon Bond
By comparing the risk free bond with a portfolio consisting of a risky bond and a CDS
on this bond, the no arbitrage condition can be shown to be
erfT = (1 – d)e(rf+s)T + dRe(rf+s)T = [1 – d +dR]e(rf+s)T
ln(1 - d dR)
Then s = -
Negative Basis Trading
Remember the basis is the difference between the futures price and the price of the
underlying. Here the “basis” is the difference between the CDS spread and bond
spread (CDS spread – Bond spread). This basis is negative when the CDS spread is
lower than the bond spread. Arbitrage opportunity exists when it is cheaper to buy the
risky bond together with the CDS, than it is buy the risk free bond.
In 2009 Weinstein, the former star trader and co-head of credit trading at Deutsche
Bank is down $1bn and John Thain’s Merril is said to be down $10bn+ all due to this
form of negative basis trading. The reason is illustrated below.
The expected rise in the basis did not materialise.
Warren Buffett famously described derivatives bought speculatively as "financial
weapons of mass destruction." In Berkshire Hathaway’s annual report to shareholders
in 2002, he said "Unless derivatives contracts are collateralized or guaranteed, their
ultimate value also depends on the creditworthiness of the counterparties to them. In
the meantime, though, before a contract is settled, the counterparties record profits
and losses -often huge in amount- in their current earnings statements without so
much as a penny changing hands. The range of derivatives contracts is limited only by
the imagination of man (or sometimes, so it seems, madmen)." The same report,
however, also states that he uses derivatives to hedge, and that some of Berkshire
Hathaway's subsidiaries have sold and currently sell derivatives with notional
amounts in the tens of billions of dollars.
The market for credit derivatives is now so large, in many instances the amount of
credit derivatives outstanding for an individual name are vastly greater than the bonds
outstanding. For instance, company X may have $1 billion of outstanding debt and
$10 billion of CDS contracts outstanding. If such a company were to default, and
recovery is 40 cents on the dollar, then the loss to investors holding the bonds would
be $600 million. However the loss to credit default swap sellers would be $6 billion.
In addition to spreading risk, credit derivatives, in this case, also amplify it
considerably. This will happen when the CDS have been made for purely speculative
purposes; if the CDS were being used to hedge, the notional values would be
approximately the same size as the outstanding debt.
The real losers, however, are not the pension funds, banks, insurance companies or
mutual funds that invested in CDOs; the real losers are you, the investors, producers,
and savers that use banks, pension funds, insurance companies, and mutual funds to
protect your savings against the erosion in the value of money that occurs in debt-
Q1. An investment fund, which has purchased corporate bonds from CBA Ltd with a
face value of $20m purchases a 5-year CDS, specified with physical delivery, at a
default swap spread of 60bp.
(i) What is the amount of the first, quarterly premium?
At the end of the first year the default swap spread is 160p.
(ii) What options does the seller of the CDS have? What are their relative
(iii) The reference entity suffers a credit event one month after the next
premium. The CTD asset of the reference entity has a recovery value of
$55 per $100 nominal.
What transactions follow the credit event?
2. A CDS with an issue premium of 60bp is written on a ABC plc, semi annual 5%
Bond with a two year maturity for a nominal holding of £10million. The recovery
rate of the bond is 30%. The probability of default is given by
0.1e-0.05t for t 0.5, 1.0, 1.5, 2.0
Use the probability model to find the fair price of the CDS.
4. Suppose the probability of default on a T period risky, zero coupon bond is d.
(ii) Express the expected return on the bond cum CDS in terms of d, R, r, s
(iii) What is the certainty equivalent return on this bond?
(iv) Use your answers to find the no arbitrage value of s in terms of d, R
(v) Calculate the credit spread of a 1 year zero coupon bond if the
probability of default is 0.2 and the recovery rate is 0.5.
(i) First, quarterly premium = $20m*0.06/4 = $0.3m
At the end of the first year the default swap spread is 160p.
The CDS seller can make a cash settlement based on the recovery value of the
reference entity or on the recovery value of a Cheapest To Deliver asset.
(iii) The protection seller pays $20m*(55/100) = $11m and receives one
month worth of accrued interest = i.e. $0.1m.
(i) E(return) = (1 – d)e(rf + s)T + dRe(rf + s)T
(ii) E(return) = erf*T
(iii) erf*T = (1 – d)e(rf+s)T + dRe(rf+s)T = [1 – d +dR]e(rf+s)T
e rf *T [1 - d - dR]e rf *T e sT
1 [1 - d dR]e sT
sT ln(1 d dR) = 0
ln(1 d dR)
(iv) When T =1, d = 0.2, R=0.5,
ln(1 - 0.2 .1)
s ln(0.9) 0.1054 10.54%