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.
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