Credit Risk
Measuring and Managing the Credit Risk of a Bond Portfolio
Credit risk is different from counterparty credit risk. Credit Risk relates to the default of assets in your portfolio.
- Non-payment of interest on a note or loan
- Non-payment of the principal of a note or loan
When assigning a Credit Risk limit to a bond portfolio many risks are taken into account. Each risk is measured separately and as a portfolio of the same risk in other bonds.
- Liquidity risk: is the asset liquid enough to trade; as bonds age, they become less liquid, the bid-ask spread gets wider. It will cost more to reverse your positions.
- Measured as bid-ask spread / 2
- The % of the outstanding bonds that are freely trading in the open market.
- Concentration risk: risk your client has too much risk in one market sector
- Collateral risk: especially under agreements which allow for re-hypothecation (to be lent), are carefully measured and care is taken not to post collateral of great value (the on-the-run note, the most liquid note in a class, etc. )
- Call/Put risk: A callable bond will be called if interest rates go down or the credit risk of the corporation has improved significantly. The right to call the bond from the bondholders has a value or premium. While we can use some of the same variables to price the bonds embedded call.
- Typically a call is exercised if it’s “in-the-money”, the price of the bond is above the strike price.
- In a corporate call, the corporation may not save enough money to call the bond making this variable very difficult to value
- The Call feature’s value is often financed by the Put Feature
- The Put feature allows a bondholder to “put” the bond back to the issuer and request their principal money back.
- The Put feature is typically used to finance the cost of the call. So you will often see both features used together.
- The Call feature requires the owner to replace the bond in their portfolio.