Hi there. Good evening, good afternoon. Good morning everyone. Welcome to this Felix live session on corporate bonds.

My name is Thomas Krause. I'm head of financial products here at Financial Edge.

I started my career in fixed income, mostly trading interest rates and FFA and cash and derivatives, but also then had the opportunity to work within the cross asset mandate, which then gave me some good amounts of insights into credit and equity markets as well.

So, what's on the agenda today? Well, it is a course on corporate bonds.

So we're going to start with a definition of corporate bonds.

Gonna talk a little bit about credit spreads.

We will discuss some of the general building blocks of credit analysis, and then give an introduction to credit ratings.

We will have a very high level look at the corporate bond issuance process and how corporate bonds then are quoted in the secondary market.

And finally, if there's still some time, we will introduce some of the common spread measures that are being used by market practitioners.

Without further ado though, let's get started.

And as I said, we're gonna start with a definition of corporate bonds.

So what are they? Well, I think it's fair to say that when you move from government bonds into the world of corporate bonds, then you're moving into the world of credit. Because what corporate bonds are, they are debt obligations that aren't issued by a government, but instead by private corporations.

And that means that these investments come with a certain type of credit risk, whereas government bonds, especially those ones that are issued in domestic currency, are generally considered to be credit risk free.

However, that changes.

And of course, when you move from the government bond space into the corporate bond space, simply because the issues of those bonds don't have, for example, the taxation power that a government would have.

They also don't have the central bank basically being able to monetize their debt if that should ever be a requirement.

So when you invest in corporate bonds, then of course you do as an investor face credit risk, which loosely can be defined as simply the risk of not getting your money back on time at all or in full.

And then you'll remember obviously your finance 101, and that basically one of the first things I'm sure you will have learned is when you as an investor take additional risk, you should only ever do that if you receive additional return for taking this risk.

And more specifically, the return that you receive for taking the risk needs to be an adequate compensation for the risk you are taking.

And that's why corporate bonds typically pay a higher yield than an otherwise identical government bond.

And this difference loosely being described or de, you know, defined as the credit spread.

And that's what the visualization on the slide is really all about. Let's say we have a government bond here that's currently trading at a yield level of 6% in the market.

We can then see what is the yield of a government benchmark bond of same or similar maturity.

And that in this particular case was 5%.

So you now, as an investor have the choice to buy a 6% yielding corporate bond or a 5% yielding government bond.

And basically you can do the simple math here.

What is the extra payment that you receive for switching from credit risk free government bond investments to a credit risk containing corporate bond? That is the difference between the two. That's a credit spread of 1%.

And what's important to see or to realize is that obviously the corporate bond yield then consists of these two building blocks.

First, the credit risk free rate, the government bond yield if you wish, and then of course, a credit spread.

And both of these building blocks, those, both of these components can obviously change, right? For example, the credit risk free rate or the government bond yield might change because there's a change in invest expectation.

For example, there's been bad, some bad news on the inflation front yields have gone up.

But then of course also there might be a change in credit spread in the compensation that the market demands for this particular credit spread taken when you're investing in a bond that could, for example, happen if a corporate has, you know, announced disappointing earnings or disappointed earnings outlook.

And therefore the credit or the market, the credit investors are reconsidering the fair pricing of this credit spread.

But the bottom line is that as yields and bond prices are inversely related, that means that corporate bond investors are exposed to two main risks.

As I said, first the change in the credit risk-free rate, that's what we basically call the rates duration. And that's what investors in all sorts of fixed coupon bonds are exposed to, right? You buy a fixed coupon bond today, subsequently interest rates are going up.

The price of the bond you bought will most likely fall in response to that.

That's the interest rate risk that's taken by all investors in fixed coupon instruments.

The second risk, and that's specific to corporate bonds, something we don't necessarily have in the government bond space asset is the credit risk, the default risk, i.e. the chances that you know, the bond is not gonna be repaid at all in full on time or a little bit less dramatic that there simply is it change in credit spread as the market reconsiders the appropriate spread for taking the risk.

And I think this becomes a little bit more clear rather than being an abstract concept.

If one looks at a simple bond pricing model, that's basically something we have put together here.

So we're looking at a five year corporate bond, which pays a 4% coupon on an annual basis.

So here in the first column, we just see the years 1, 2, 3, 4, 5, and which payments happen.

We have then worked out the cash flows, not considering day counts, et cetera.

Any of that matter here.

So we're basically saying after year one, a 4% coupon will be paid the same after year two, year three, year four, and after year five, you receive as the investor in that bond, the last annual coupon of 4%.

But additionally, you also receive your capital backs.

The p amount of 100%t is repaid. That's why the cashflow looks like it does here with 104.

So then obviously if you think about what the bond price effectively is, it can be understood as the sum of the present values of all the bonds cash flows, because that's what irrational investors should pay for a bond.

And therefore what's missing here is obviously the calculation of those present values.

And if you have seen a general yield term maturity formula, you are aware that the general way of doing those sort of discountings in bond world is to just discount or you know, discount all the bonds, cash flows with the same yield, and that yield being the yield to maturity. So what we're doing here is we're discounting each of these cash flows by dividing it with one plus the yield to maturity or the yield of the corporate bond to the power of time.

And if we do that, we get those present values here and then we sum them all up and that gives us the bond price as you can see here, which is at that point at par.

Is this coincidence? No, it's not because if you look at how we have or which yield, which discount rate we're using, that's happens here in the right hand side.

We are looking at an example where five year government bond yields were trading at 3.5%.

We said, okay, this bond should have a credit spread of 0.5%.

And then remember what we said, the corporate bond yield is nothing else but the five year government bond yield plus the five year credit spread.

So we're adding these two up and that gives us a yield to maturity of that corporate bond of 4%. And now you remember your bond mass 101, when you have the situation where the coupon equals the yield of the bond, then this bond will trade at a clean price of par or 100% So that's exactly what is the situation here.

So quick check for the model accuracy if you wish.

So that's the situation.

We have this bond trading at a 4% yield, pays a 4% coupon, and the price currently is a hundred percent.

Let's say this bond has been issued this morning at this particular price, we invested in it, and now the world starts or continues to move.

And let's say the first thing that could happen here is of course an increase of a five year government bond yield, let's say, as I said earlier, inflation number surprise to the upside.

So there's a re thinking of the feds rate cut past, et cetera. And as a result, let's assume five year government bond yields go up to 3.6%.

If that happens and credit spreads, don't move that, the assumption here, then the corporate bond yield will go up from 4% to 4.1%.

And as we said, yields and bond prices are generally inversely related.

As a result, the bond price will drop to 99.56.

So we bought this bond in the morning for a hundred.

Now a trading at that price, we are facing a mark to market loss.

And that loss is basically resulting of an increase in the risk free rate or credit risk free rate.

Let's bring this back to the starting point to back to three point a half percent.

And now we're just gonna play through a sort of different example of where not the risk free rate increases, but this time the crowd spread increases.

That may be, for example, because there's general concern or not, not concern obviously, but let's say there is a sort of like suboptimal news, from the issuer side.

So they had maybe some sort of disappointing earnings as I said, or they have just, you know, revised the outlook lower for the future, et cetera, that in turn makes credit investors reconsider what the fair spread of five year bond of this issuer would be.

And let's say the, you know, the credit spread as a result widens by 10 basis points to 0.6.

Again, the same impact on the yield because this time we're looking at a stable five year credit risk-free rate, we're looking at a 10 basis points wider credit spread, and that means the corporate bond yield as a result will have increased to 4.1%.

Again, the bond price has dropped to 99.56.

It doesn't really matter for the bond price, whether the increase in yield comes from an increase in the credit free rate or if it comes from a widening in credit spread.

The result on or the impact on the bond price is of course the same.

But this was just an example that should highlight really the two risks that we're taking.

We have, if we invest in fixed coupon corporate bonds to deal with the rates, duration, i.e. the general risk to a change in interest rate levels.

And then we also have to consider the credit duration because it's not just that bonds might default and we are struggling of getting all our investment back, but it actually a widening in credit spreads that could hurt us from a market to market perspective as credit investors.

Alright? But with that, let's go back to our slide deck and have a look at credit spreads and the risk return aspect. Because one of the fundamental or most fundamental concepts in finance, and I said it already, is that there needs to be a relationship between risk and return.

So basically when you take additional risk as an investor, you need to make sure that you get adequate returns as compensation.

Now, what this means in context of credit is that you really need to understand the underlying credit risk before you decide whether or not the compensation that a corporate bond pays you is adequate for the risk that you are taking.

Now, we cannot go deep into credit risk analysis here simply because that's a very complex process and will take us, it's a probably a, a several day course.

But what I wanted to do is at least share some of the main points that investors in credit really should consider.

And so what we've done here on this slide is we captured those main points from a high level standpoint.

And as you can see, all these points really fall into one out of two categories.

The first category is what we describe as the general issuer risk.

And, what this means is these are items that impact all debt instruments issued, or, you know, by a specific legal entity in the same way.

Okay? So the points that one then needs to consider when looking at the general risk of an issuer is first of all the business risk, right? So here we want to assess a company's business strategy and how it affects quality and stability of cash flows, earnings, et cetera, et cetera.

So we for example, need to think about which industry is this client or is this issue a part of? Is there maybe are there maybe high entrance barriers? So is there maybe a little bit of a monopoly situation or is this an industry where products are not protected by patent, right? And can be copied fairly easily and also quickly by competitors.

So it's about the competitive situation, how quickly margins erode, et cetera, et cetera.

Then it's also sort of other aspects like for example, the M&A appetite of this particular company.

So for example, if we have a company that has done a lot of M&A and continues to do so, that might take a slight, or that means we have to talk, take a slightly different view on the credit risk than on companies that have not done this historically, for example, because every integration comes with a certain risk, right? Will this be a successful acquisition? And then also part of the acquisitions might be debt financing. If there's ongoing acquisition activity in the future, then that could increase the amount of debt outstanding, which then of course feeds into the next point, which is the financial risk that you as an investor certainly need to have a look at.

And this is where you want to look at the company's existing funding structure.

So for example, how much leverage is there? How much debt versus equity does this company have? How stable are the cash flows in the free cash flows? And how, you know, because, or sorry, why our cash flow is important simply because debt needs to be repaid, right? We need to repay the debt, we need to make regular interest rate payments. And for all that politic cash flows are of course needed.

And we need to look at whether or not the company has an appropriate funding structure.

And then last but not least, we need to think about the macroenvironment.

Arguably, this may be a little bit more important for certain type of issues.

So if you're thinking about consumer discretionary, for example where maybe the demand for, for their products will sort of be strongly correlated with the economic environment, whereas this is probably less of an issue for utilities companies, for example.

But you see the point that economic activity or the macro environment altogether will have some sort of a, you know, feedback or some sort of a link to a company's overall probability, sorry.

And therefore also for the financial outlook. Okay? So those, as I said, are all specific or issuer, general issuer risk.

And what all these points have in common is that they basically influence the probability of default.

In other words, the risk that something is going wrong, the risk that the debt instrument will not be repaid as originally or as per original agreement.

However, it's important to realize that probability, while probability of default is of course very, very important.

It's not the only thing that matters when we're looking at credit risk.

'cause we need to think about what actually happens when something goes wrong.

I.e. the borrower defaults, right? And let's have a very simplistic view on this.

What will happen? Well, first of all, there's gonna be the appointment of some sort of liquidator, right? So the liquidator is announced, then moves into the company, looks at the assets, starts selling all the assets of the company, and then collects an amount of cash.

And then this cash will be used to repay the debt.

But of course not all debt is often repaid in full.

So that's where, you know, we obviously need to start being careful because, you know, we won't, we cannot assume that in case of default we're getting a hundred percent of our money back, right? And the amount that lenders won't recover in this liquidation process, that's what we call the loss given default, right? And so LGD is the abbreviation there.

So if we have a company that had a hundred million debt outstanding, and then let's say there's a default of that company and 60 million in cash is basically raised through selling all the assets, then you know, this will be reap or used to repay the debt.

But that also means we have 40 million collected or collective loss given default on the debt investor side.

Okay? Now why this is relevant simply is that, you know, while the probability of default is usually the same for all bonds that have been issued by a certain legal entity the LGD may not be.

Now, why is the probability of default usually the same? Because it would be a very, very strange scenario when a company defaults on one specific bond only, but then keeps paying the other bonds in fall on time, et cetera. So that hopefully feels slightly counterintuitive, either default on everything or on or not.

But when it comes to LGD, so the loss given default that there might be actually significant differences across different debt instruments.

And that's why we have to analyze those issue specific risk factors, right? Which brings us to the second category, and here what you see is that we need to analyze whether or not that instrument is secured or unsecured, and then we also need to generally analyze the security or seniority level apologies of this particular debt instrument.

So what do these terms generally mean? Well secured debt, I think that's something we've all probably come across at some point already.

And the example here that one might have some experience with are, for example, mortgages, which is a secured debt instrument.

Now, what debt instruments that are secured basically all have in common is that not only does the borrower promise to pay back the amount on time in full, et cetera, but this promise will be backed by a specific collateral that's pledged to the lender by the issuer. So if you're thinking about the mortgage example, you borrow the money to buy a house, you basically get some, or you transfer the, well, I don't say you transfer the title, but obviously you give some sort of right to the bank that in case you stop paying your mortgage payments, they can foreclose on your real estate, sell it, and then satisfy their financial demands through this process, which that basically means depending obviously on the value of the collateral, that collateralization potentially significantly reduces the risk for the lender, not because the probability of something going wrong has changed, that's not touched at all, right? Because you still might default on your mortgage with the same amount of probability regardless if it's, secured or unsecured.

But what differs obviously is a loss given default because in case there's a very valuable real estate backing the mortgage, the bank has a very, very good chance that in case there is a default on your side, they will be able to recover all the money they are owe through the sailing, of the collateral.

So that's why securitization or you know, collateralization can significantly reduce the credit risk overall, as I said, again, not on the probability of default, but on the loss given default side.

So that's the secured aspect.

Now, why does seniority matter? And then we're moving to the unsecured space right here.

Seniority comes into play.

And what does seniority generally refer to? Well, unsecured debt, first of all means that there's not a specific collateral that's been pledged to the lender.

Instead, the lenders have a general claim on the issuers assets and cash flows.

The important point here to make is that they are not all having the same priority when it comes to claims because there's different classes of debt, different classes of seniority.

And the two that one generally distinguishes is the unsecure, or sorry, the senior debt and then the subordinated or junior debt.

And basically you need to take this very literal, the senior debt holders are repaid first and only once the senior debt holders have been repaid in full, then the junior debt holders will start to receive payments. So if we go to our example from the earliest slide here, we have 100 million debt, we have 60 million in cash being raised.

And now let's say we have, uh, 50 million in senior debt and we have 50 million in junior debt.

Then there's a waterfall payment structure, which means first of all, these 60 million are used to repay the 50 million senior debt in fall, and then the remaining 10 million will basically be used to repay partially the junior debt.

But that means that the remaining junior or the the, the junior debtholders basically are bearing all the loss given or the complete loss given default here while the senior debt holders got actually repaid in full.

So this is why the seniority level in case of a default obviously becomes very, very important.

Okay? Now you probably now start to get a sense that a full blown credit analysis is, as I said earlier, very complex.

It's very difficult, requires a lot of expertise and of course, resources both financially and time-wise, right now, professional credit investors will of course make sure they apply those resources and they will have someone analyzing balance sheets, listening into investor calls, et cetera, et cetera, to perform those fully flat credit analysis.

But other type of investors that only every now and then might invest into corporate bonds, they might not have those resources.

Now, where can they go to get at least an initial view on the credit risk of a certain issuer? Well, the answer is they can go and look at credit ratings.

And what a credit rating basically is a measurement or a statement about the credit worthiness of either a borrower in general terms.

So that means we're talking about issuer ratings here, so where the rating is linked to the issue to the legal entity, but there can also be credit ratings that refer to a particular debt or financial obligation, right? And that's what we call in issue rating.

Now, most of the time there probably won't be a large difference between the two, but there are of course circumstances where, for example, an issue rating.

So the rating of a particular debt instrument can be, for example, better than the rating of an is of the issuer in general, which first of all sounds a little bit strange, but once you look at what drives or what could lead to such an improvement it hopefully becomes clear.

And the point to make here, obviously, or the point to refer to here, obviously, is the secured aspect.

So for example, let's say there is an issuer here that is thinking about, for example, a corporate that is thinking about acquiring a or building a new factory.

And for that they need to raise a certain amount of long-term funding and decide to do that by issuing a bond.

And the decision was made that this newly acquired real estate with all the factory buildings and all the machinery, et cetera, et cetera, will be pledged as collateral for those bond holders.

And assuming if this is a really, really good location, really high quality real estate here, then of course you could see as to why this might reduce the credit quality somewhat. So that may be the rating agency will assign a better rating to this specific bond than to the issue itself simply because there's this additional safety aspect of due to this high quality collateral.

And that's throw in some overcollateralization as well. Let's say there's higher value backing up of the collateral then actually on the bond side.

So that could lead to those differences.

Now, generally speaking, you know, these ratings are provided by credit rating agencies, and the common examples here are standard and Poors, Moody's and Fich. And just as a reminder, it's a rating agent or that those rating agencies are actually paid by the entities that are seeking a credit rating for itself you know, for one of their debt issues.

Now here, you can then see on the slide on the left hand side the rating scales of these three rating agencies that I just mentioned.

And we have attached a very brief verbal description here as well.

But I think what's important really, rather than, you know, discussing all those sort of nuances in the verbal statements is that we sort of realize that ratings, are also basically distinguished into two categories, right? And we can just draw the line here.

And these categories are called investment grade and high yield in return or speculative grade, sometimes junk et cetera.

And if we're looking at the s and p rating scale here in the middle just as an example, what we see is that every rating of triple B minus or better is referred to as investment grade.

And every rating of double B plus or worse falls in the category of high yield junk speculative grade, et cetera, et cetera.

And this is referred to as speculative grade simply because it has a higher credit risk.

And if just, you know, maybe worthwhile to just look at the change in language when we're moving from investment grade to the speculative grade. So let's have a look at the verbal statements, the, you know, worst one for investment grade and the best one for the high yield sector.

So here we have in the investment grade space an adequate capacity to meet financial commitments, but more subject to adverse economic conditions versus less vulnerable in the near term, but faces major ongoing uncertainties to adverse business, financial and economic conditions.

So you can see that the language does change from basically everything is all right right now, but there are some question marks to, you know, there are some severe challenges to overcome in a way.

So that changes the language ever so slightly.

Now, of course, you know, it's important also to realize that this distinction between investment grade and, and high yield is not just done because, you know, we, we want to categorize that into certain categories, but it has a very, very important practical relevance.

And this is because, for example, of professional investors, like fixed income fund managers, for example, are often restricted by the investment mandates to only invest in investment grade credit, for example.

So that means if an issuer gets unexpectedly downgraded from investment grade to high yield, the universe of potential investors typically becomes a lot smaller, which then could lead to a comparatively large change in credit spreads.

At least if, and I said that if the downgrade is unexpected, because if it was expected, then probably the spread widening would have already been priced in way before the actual downgrade then, then occur. But think about this, you are, let's say, put yourself in the shoes of an fixed income portfolio fund manager, our portfolio manager.

You have invested in a corporate bond.

You generally believe this company is on a good pause.

It has a, let's say triple B rating, but you think actually their outlook is improving.

And you know, you've seen the latest earnings and you find they are, you know, basically, proving, this expectation you have.

So you're invested in that bond and you don't expect, or you basically expect in the long run this company to, to get an upgrade, et cetera, et cetera.

Now, next day, or not next day, but now let's say there's some surprising news.

There was some accounting regularities that this firm has just uncovered, and as a result, they have to write down, let's just, you know, as an example, use $10 billion, which of course is a significant deterioration of their financial situation in case.

And therefore, you know, let's say the rating agencies do take a look and say, okay, this is no longer triple B with the new information that we have, we're now rating this at, I dunno, single B plus, right? So you are holding that bond that you bought at triple B, but now unexpectedly the rating has been downgraded to single B plus.

And what that basically means is currently you're in breach of your mandate because you're not supposed to have this bond because it's high yield rated.

Now the, that means you now have to sell this bond.

And as you can imagine, you're probably not the only investor in that situation.

So there's a lot of supply of that bond trying to be sold into the market.

At the same time, the demand will be relatively slim because for obvious reasons, there won't be a lot of buying interest, at least not at fair prices.

As a result, the bond price will probably drop height considerably on this news, and therefore the yield will increase considerably.

And as a result, because the risk rates are not necessarily moving, um, the credit spread has one, so that's just again, to show the link between this and why this cutoff line is of practical relevance.

Of course, not in all scenarios, but it's worth pointing that out.

So then the only remaining question really is why was it decided to draw the line there? If you look at the chart here at the right hand side, where we're looking at the cumulative default rates over five years, you might get a little bit of an idea as to why this has basically been done.

And you see here, if we draw the cutoff line between investment grade and high yield into this chart, you see that's a point where we're starting to see when we're moving from investment grade over to high yield, a meaningful increase in those defaults rates.

Because, you know, triple B, so the investment grade column there is fairly close to zero, and then we're seeing a jump to 3% to almost 3% when we're moving to double B space.

And then of course, an exponential growth here as it can be seen on the chart.

Okay? So the next thing for us to look at then is the corporate bond mechanics.

And we wanted to sort of, you know, look a little bit, at the bonds lifecycle and then learn how corporate bonds are issued, how they're quoted, et cetera, et cetera.

Now unlike government bonds, corporate bonds are usually not issued via public auctions, but through the help of a syndicate of underwriters, which are usually then, for example, investment banks, right? And when these underwriting, or when these syndicate is used, they usually two main ways in which the bond can be issued.

One is what we call a board deal, and the other one is we're issuing the bond on a best effort basis.

Now, a board deal is fully underwritten, which basically means that the banks or the syndicate of banks here guarantee to place the bond, the full notional amount at a fixed guaranteed spread.

So basic, simple walkthroughs through such a process, the issue and the banks would basically analyze the financing needs and come up with, you know, the maturity, the total amount.

So let's say the client here is looking for a 10 year bond, 3 billion US dollar notional.

And then obviously, you know, the syndicate will look at the current spread levels.

The risk appetite out there in the market will probably do some analysis there with regards to investor appetite, et cetera.

But then let's say here the syndicate has agreed to a spread of 49 basis points over treasuries.

So then we're basically moving into the book building phase where we're marketing the issuance to investors, et cetera, et cetera.

And let's say that on a spread of 49 basis points we're collecting or we're seeing a, an aggregated demand, uh, of, or a demand for 2.2 billion US dollars, which falls short, offers 3 billion that the client wants to raise because it is a firm commitment. And the banks have guaranteed to sell 3 billion at a spread of 49 basis points.

They would now have to go and basically step in for the missing 0.8 billion dollars.

So that will actually be bought by the banks, and of course they're gonna offload this debt into the market over the next couple of days and weeks.

But you can see as to why this is a significant or not significant, but a higher credit or higher risk for the banks, higher capital requirements may be the result of those transactions.

Hence, from a fee point of view, board deals are generally more expensive than the next, way of issuing corporate bonds, which are the best effort deals, which are basically agency deals, right? And that means the bank just aims for the best possible spread and the complete placement.

But none of this is actually guaranteed.

How does that then differ? Well, still it starts with the same discussion, right? We're identifying the financing need, we're determining how, what the maturity of the bond should be and the size.

So again, 10 year, 3 billion dollars.

And we're looking at the market, has this company already issued some bonds? We're looking at which spreads are these bonds trading at.

If this isn't first time issue, we might want to look at comparable companies here, whether this spreads trade.

And so we use all available information together with the current market environment to come up with a meaningful initial spread guidance.

And let's say in this case, the syndicate has agreed to come with a guidance of 48 to 52 basis points over treasuries. That's then basically what's, again, being marketed and we're announcing the deal collect bids from investors, and then dependent on the bids that we receive we're gonna dis to determine the spread.

And so once we have that sufficient amount of bids, we will select or determine the spread, we will then price the bond and we will allocate the bond out to investors.

So let's run through this.

A very, very brief example here at the bottom.

Let's say we have received 1 billion in orders for this bond at a spread of 48 basis points.

So at the low end of the range.

And so that's clearly not sufficient to, you know, get 3 billion sold.

So we're moving to the next higher spread level here, let's say 49 basis points in this case.

And here what we see is we have received an additional demand of 1.2 billion at 49.

And let's say this has been already tidied up.

So none of the orders at 48 basis points is something we find in the 49 basis points. These are all additional orders.

And under this sort of assumption, then we can calculate the aggregated demand at a spread level of 49 by just aggregating 48 and 49 demand here. That gives us 2.2 billion.

And the logic behind that is that someone that's willing to buy the bond at 48 basis points over treasuries, we'll of course be happy to buy the same amount at 49 basis points above treasuries.

Nonetheless, it's still not the 3 billion that is required.

So we're moving one basis point higher, 50, we have an extra additional demand here for 0.9.

That brings us to 3.1 billion in total.

So that's the level at which we can clear the whole 3 billion.

Let's assume that's in the spread level that's chosen.

And let's say that at the same time we had a government yield of 3.5%, the credit spread has been decided to be 0.5%. That gives us a yield of 4%.

If the coupon had a, sorry, if the bond had a coupon of 4%, then the issuance would be at par.

Now, that's not necessarily realistic, but you know, just for simplification as a nice, example, that also reminds us of the spreadsheet we've seen earlier.

Okay? So, that is then basically addressing the main points on the corporate bond issuance.

And then as soon as the bond has been issued, then of course trading off that bond begins in the secondary market where people that missed out on the bond issuance can buy the bond and people that might have bought too much or, you know, are no longer interested in this position, uh, we'll be able to sell the bonds, et cetera, et cetera, et cetera.

So the important point about the secondary market to realize is that we quote corporate bonds, especially those ones that are falling into the investment grade category, not in terms of yield or price, but we quote them in spread terms.

And that could be usually over government bonds.

And we're gonna talk a little bit more about this in a couple of minutes.

But generally speaking, we quote spread.

So if one was to call a market maker and ask for a quote for a particular corporate bond, you do get a bit and an ask, but quoted in spread terms rather than yields or prices.

Now why is that? So this actually makes perfect sense because earlier we said that the reason for a credit investor to get invested in credit is a credit spread, right? No one is going to buy a corporate bond just because it gives them the rates duration they're looking for.

If you are looking for rates duration, if you're looking to get exposure to a change in government bond yields, I would argue it's much more efficient to invest in government bonds because they tend to be a little bit more liquid than the corporate bond market, right? So the reason for credit investors to invest in corporate debt is in fact they want to take the credit risk because they feel adequate co adequately compensated for that.

But to make that judgment, you need to understand the credit risk.

There was a credit analysis we talked about, but you also need to under or need to know that credit spread.

And so it does make sense that we are trading and quoting corporate bonds in the secondary market on a spread basis because that's the one metrics that credit investors use to make a decision on whether or not they want to invest.

Now, then sometimes the question comes up, why do we do this? Why do we not care about the general level of interest rates? Well, I'm not saying we don't care as investors, but generally speaking, many credit investors will hedge the interest rate risk away anyway, for example, using interest rate derivatives.

And therefore they are really less or the general level of interest rates, therefore is of secondary concern.

Okay? With that in mind let's have a look at a practical example here.

So here's a Bloomberg screenshot that looks at a GE bond paying a coupon of 3%, and that matures on the 15th of August, 2025.

And so, you know, let's assume we asked for a quote and we were quoted, uh, a spread of 84.9 basis points as basically you can see here in this small box. What does it now basically mean? Well, it doesn't allow us right now to calculate the price of the bond, but basically what we learned from this quote is that we're gonna get a yield that's, you know, let's round it up to 85 basis points higher than the risk free rate or the credit risk free rate. Then of course, the question is which rate will used here as benchmark? And we're looking at something that's called the traditional, or that I call the traditional credit spread, because basically the spread is quoted above a real existing government bond current benchmark bond, if you wish, of the relevant government bond issuer, which of course is the US treasury hearing this case because we're looking at a dollar bond issued in the us.

And so that means we're not necessarily having a perfect match in terms of maturity.

And you can see this here that we're looking at a treasury bond that is maturing on the 31st of March, 2025.

And that's obviously quite different in a way from the 15th of August, 2025 of the GE bond. But we're looking at the closest match in terms of maturity that at the particular point of screen share was taken was in fact the 31st of March, 2020 5,378 treasury.

And that at the time traded at a yield of 3.979%.

So now we know the benchmark bond that's relevant for comparison here trades at a yield of 3.979.

We also have been told that we can buy this bond at 40 84.9 basis points over this yield.

And then basically we have to sum up these two numbers and we get to the 4.8 to 8% yield that's actually directly quoted in here. So the math is relatively simple but now we know, okay, that is the yield of the bond.

Now we can apply the yield and the coupon to the cashflow structure.

We can discount with that yield and we can work out the bond price.

But as I said, that's all technical stuff.

What the relevance of spread here is for the investors to think whether or not these 85 basis points is an adequate compensation for the credit risk taken, or if that actually isn't the case.

So that's a traditional credit spread.

Now, what I also want to, you know, draw your attention to is this box here that I just circled or, you know, drawn on the chart as well on the slide as well.

And that's where it says spreads.

And as you can see, there are quite a few of different spread measures here that are, looking different, right? So they have different values to the 85 basis points here.

Different names of course.

So the question is what do these spread measures actually mean? And I'm skipping that slide, the previous slide here because it been, we've been talking about that a couple of times.

So here, let's just focus on some of the different credit spread measures that investors use.

And we've talked about the traditional one. We're gonna talk about it one more time on the next slide, but generally speaking, there are many different spread measures here where you have just drawn them up, the G spread, the I spread that spread, and so on and so forth.

And what is important to note is that obviously there's no right or wrong spread measure.

They all have the reason of being there and they're all being used.

But you know, investors, you know, some have just a preference for one over the other, others sort of used one, or over the other because of different, under different circumstances.

So they all differ ever so slightly.

So let's have a look at some of them and discover what the differences actually are, starting with the traditional credit spread that we've already discussed in the context of the GE bond.

Now we're gonna see it one more time because we need to build that story here slowly to understand what's the difference between traditional and G spread, for example, is, so here what we're looking at is now a European bond. Deutsche Telecom issued a bond that matures on the 17th of January, 2028, and the clean price was 104.08 at the time, and that led to a yield of 2.432%.

Now we want to calculate a spread over government, and we're using the traditional credit spread, which means we're looking at the spread in yield terms over the government bond benchmark that has the closest match in maturity.

So here at the time, there were two benchmark bonds outstanding.

We're looking at German bonds here because that's a benchmark generally in, in Europe these days.

And we see here there was a maturity of 15th of October, 2027, and there was also a maturity on the 15th of August, 2028.

So two bonds that are relatively close, but none of them matches identical or precisely.

So which are we going to use? We're using the one that's the closest match, and that actually was the 15th of October, 2027 because it's a bit of, bit more than three months difference, whereas the August one would be seven months difference. So this is a chosen one, and that means we now have a yield on that bond of 1.089.

And so now 2.432 minus 1.089, that gives us a traditional credit spread of 1.343, percent as shown on the slide. And that would be the similar calculation on the Bloomberg screen that we've seen before.

Now this is obviously very simple to calculate, which is generally great but then it's also, you know, tradable, right? Because what if you were an investor and you don't have a view on general direction of interest rates, for example, but you want to enter into position that will benefit from the expected tightening of credit spread.

So you basically expect that the spread here of dets telecom over, you know, government bonds will come down.

So, but you don't wanna expose yourself to any interest rate exposure.

What are possible ways of doing so? So one way of doing so would be just to buy the corporate bond and then short sell the government benchmark bond here that we're looking at.

And then basically you've locked in the spread of 1.343, and if subsequently the spread is gonna tighten you should benefit from that simply because the yield of the corporate bond falls relatively to the yield of the government bond. Of course, you know, you need to design this very carefully with matching durations, et cetera.

But generally speaking, that is something you can relatively easily and conveniently put together.

The downside of this spread measure, it becomes obvious when we're changing the shape of the curve.

So when we took this example, these two bonds that were in question, they were potential benchmarks had relatively similar yields. And you can see here, if you draw that line, it's almost perfectly flat yield curve.

But what would be the situation if, for example, this August, 2028 maturity wasn't trading at one point 10, but instead of 2% that dot would be here. And then you can see that obviously a hypothetical connected line between those two is not gonna be flat, but it's gonna be significantly upward sloping.

And then if you just sort of say, well, you know, we're, you're seeing the problem here, we're not comparing apples with apples, we're comparing a January, 2028 maturity with an October, 2027 maturity.

And if the yield curve is relatively steep as it is in this particular example, now that sort of mismatch in maturities could actually lead to some sort of overall under exaggeration of the credit spread, right? So here you can see as to why there's some inelegance or, or sort of, you know, maybe imperfection in the traditional credit spread.

And the g spread tries to overcome this by you know, overcoming this mismatch in maturity.

So this of course is only possible when we use interpretation.

So we're taking the yield of these two government bonds here.

One is slightly shorter, one is slightly longer than the, corporate bond, and then we calculate the theoretical yield of a bond with the same maturity than the corporate bond, right? So basically we're taking this linear line and we're, I interpolating the hypothetical government bond yield for this maturity on the 17th of January, 2028.

So the question is, what would be the yield of a German government bond on that day when the maturity would be 17th of January, 2028? We calculate that yield and now we have a apples to apples comparison with regards to maturity.

There's, however, two problems with this approach, and the first one is that, well, it's an inter interpolated yield, but we cannot really be sure that this is actually where the yield would be if there was such a bond because this bond doesn't exist.

Yes, we probably are gonna get relatively close to it, but there's no 100 percent certainty because this bond does not exist.

How can we say that's where the yield is? But the more I think impactful point is that this spread cannot really be traded, right? Because as we said on the previous slide, if you wanted to trade the traditional spread and you think the traditional spread is gonna narrow, then you go along the corporate bond, you go short the government bond. But how are you going to trade the G spread exactly when you cannot, you know, sell the government bond because there is no government bond, which is 17th of January, 2028 maturity.

Now, of course, you can probably work around selling a little bit of the October 27th and a little bit of the August 28th, but none of this will be a perfect match either.

So now we have apples to apples comparison with maturity, but we have other shortfalls to get around this interpolation uncertainty issue that we've just, and also the on tradability, if you wish, we could basically use a different spread and that's what we call the spread.

And that is basically the spread between the yield to maturity of the corporate bond and an inter interpolated swap rate.

And we're looking at interest rate swaps here because they are OTC instruments, and that means relatively frequently we're trading broken or custom maturity.

So not only five years, six year swaps are traded, but we trade swaps with five and a half, five years, six months, three weeks and two days, not, you know, every minute or every day, but they are relatively frequent demands for those broker maturities in the swap market.

So there are fairly well established interpolation techniques, which basically means that the interpolation technique that we're using leads to somewhat reliable results.

And not just that, but also if we wanted to, we could actually trade an interest rate swap that matures on the 17th of January, 2028.

So this swap now has, well, the eye spread, if you wish, has the advantage of being relatively reliable from a a calculation point of view, even though we're using interpolation.

And then also we can potentially trade this by buying the corporate bond and then paying the fixed rate on an interest rate swap that matures on the 17th of January, 2028 And one additional point should be made as well.

And that is that in some markets, swaps might be the more appropriate or more often used benchmark anyway.

And this is for example, the case in Euros where we very commonly use swaps or the interest rate swap curve as a benchmark because we have multiple sovereign issuers in Euro land and they have varying credit risks.

So very significant differences in yield, for example, which basically means there's somewhat fragmented government bond market, but there's a unified market in interest rates.

So, so the swap curve, if you wish, is maybe then for this reason the more appropriate benchmark.

The one thing that you might have realized though is that the ice spread in comparison to the G spread and the traditional credit spread is considerably lower, right? So the G spread here was one 34 ish if we're rounding a little bit, and the ice spread is now 44 basis points.

So there's a 90 basis point difference. Where does it come from? Well, generally what we, you know, and, and you probably are thinking about the right thing already, we're not, or swaps are strictly speaking at least in, in in Euro because we're using EURIBOR here as the reference on the floating lag, which is an unsecured term rate between banks, right? So that means in a swap rate and then rate of an interest rate swap, there's somewhat short term banking credit risk baked in, which then means that as a result that swap rates are in euro, often in comparison to the German government, for example, higher than the actual, yeah, that they, they are higher than the government bond yields.

And so that means that then as a result, the spread will be lower because the SWAT rate, the one that we're subtracting from the corporate bond yield is actually higher than the government bond yield.

And this difference at that time we took this example was actually quite meaningful.

I think the SWAT rate was 70 or eight is basis points higher than than the bond yield at the time.

And that explains then the difference between those spreads.

Okay, so that is then telling us or, or help explaining hopefully the G spread and the I spread.

And as you've seen, there's then a whole range of other spreads which now become somewhat more complex to talk about and we don't really wanna do it and we don't have the time to do it. But I just wanted to point out one significant difference between the traditional the G spread and the I spread and not what comes next here, the Z spread or Z spread.

And that is that all spreads we've looked at so far are basically calculated by just taking the difference between two interest rates, which means we're looking at one point of the, or in some cases two, when we're looking at the traditional spread.

But it's basically a simple difference of two yields, if you will, your interest rates that does not consider at all the shape of the yield curve, right? So it doesn't really matter for the calculation of the G spread or the I spread or that spread for that matter.

How steep or flat yield curve is only when, of course there's interpolation in the two maturities that we're considering.

There's obviously where the, where the steepness matters, but you know what happens, for example, if, if this is a four year bond, let's say where six year bond it was at the time the example was taken, what happens in the one or two year parts of the curve isn't really relevant for the calculation of the GDI and the traditional spread.

And this is whether that spread basically comes in, which is taking a very, very different approach in the sense saying, okay, we're not just comparing here the two rates, but we're actually calculate considering the shape of the complete yield curve.

In other words, we're gonna roll out the cash flows of the corporate bond, we're then gonna discount each cash flow with a maturity specific discount rate.

And we're starting, for example, using discount rates generated from the swap curve or from our government bond curves.

But basically the idea is to discount a one year cash flow was a one year rate, two year cash flow was a two year rate, and so on and so forth.

So we're doing the appropriate way of discounting.

And then because, you know, the bond price that we then obtain by using either SWAT rates or government bond deals will not be the market price of the corporate bond. We're gonna start adding a constant spread on all the involved government bond or SWAT rates, and we're gonna change the spread until the theoretical price that we get with discounting all our bonds, cash flows with the curve of a bond deals or swap rates adjusted by this constant spread until this price that we have calculated matches the market price.

And then this spread that we have added to all the discount rates being used, that's called the Z spread.

And there, you see, this is the approach that considers the shape of the complete U curves fundamentally different.

And therefore, you know, in a way, from a theoretical point of view, many argue it's much more accurate to look at this to spreads at spreads in this way.

But it has then, again, a shortfall. And that is you cannot directly trade the, that spread. And that's what investors obviously are looking for, in many cases, at least to get into positions where they benefit from an expected widening or narrowing of credit spreads.

With that, I've reached the end of what I wanted to talk to you about today.

So thank you so much for being our guest here today.

I hope you found it beneficial.

Have a great rest of your Friday and a wonderful weekend ahead.

Take good care of yourself and I hope to see you soon in one of the following sessions.

Take care. Bye bye.