Welcome to this Felix live session, introduction to corporate bonds and, uh, credit default swaps.

My name is Thomas Krause, and I'm head of financial products here at Financial Edge, and it's my absolute pleasure to take you through this session here today.

So what exactly are we looking to cover? Well, we're going to take a look at the world of credit today, right? And that means we will start with a quick overview of the relevant cash instruments.

Mostly, obviously we're going to talk about corporate bonds.

Then we're going to sort of take one example and look at, um, sort of the importance of credit risk credit spreads, and make some general points on, uh, credit risk analysis.

And then we will take a look at some of the common spread measures that are being used in the corporate bond markets.

Not all of them, but we're at least going to, uh, look at some of the more frequently used ones.

Uh, and then we move into the world of CDS, which means we will explore some of the, uh, CDS terminology.

We're also going to have a look at some conventions, and we're doing this on a single name, um, CDS basis.

And if we have time towards the end of the session, we will have a very brief look at, um, CDS index contracts as well. So, very packed agenda today.

Um, before we start though, couple of, uh, reminders as usual.

First thing, of course, yes, you can access the course materials and you can do this in, uh, multiple ways.

The most convenient one, although it might not work for all of you, is to just go to the chat right now and click on the link that I've just shared in the Zoom chat.

Uh, that gets you straight to the relevant Felix five website where you can find, uh, the, uh, download or the materials available for download in PDF format.

Let us know which topics you would like to see covered in this format next year.

And, um, if possible, we will, um, consider your interest there.

But that should be enough. We have, as I said, a pretty packed agenda.

So let's get right to it.

And as I said, we're going to start with a general look into the world of credit, and we're going to start with the cash instruments. Then we'll move to derivatives in this sort of like for the first quar last quarter of this, uh, session.

And when you think about credit, uh, markets from a cash point of view, and more specifically, you think about the part of the market where credit can be traded in more or less liquid fashions than that gets you to the corporate, um, bond space.

Not suggesting this is the only tradable credit instrument, but that's certainly what most people have in mind when they think about, uh, trading, um, a credit, at least, you know, from a mm, you know, more or less liquid, um, point of view.

And I'm just not talking about, um, you know, all the securitization things right now. We're just looking at the plain vanilla, uh, corporate debt.

And, uh, I'm probably not telling you anything new here when I tell you that these corporate bonds, as we call them, are then just nothing else but debt obligations, very much like the ones we know from the government. Bond space traded, Uh, instruments, fixed coupons, prices east, and the yield attached to this.

The difference is here, obviously those are instruments that are then issued by private corporations, not by governments.

And as a result of that, investors face a different risk profile simply because in contrast to government bonds, at least those ones that have been issued in domestic currency, um, there is no such thing as credit risk, free corporate debt, if you wish.

Um, at least not if, uh, there's nothing added to it.

Uh, simply because corporations won't have the power to tax, they won't have the, uh, power to print money via central banks, et cetera.

So there is of course, uh, the theoretical and also the practical, uh, or, or, you know, which we also see in practice materializing risk that, um, you know, corporations will default.

And that means they're not going to repay investors that have lent them money or bought their bonds either in time at all or in fall or anything.

Uh, then obviously in between.

So that means investors when buying corporate bonds will not just take interest rate risk as they would, um, do when they buy government bonds, as we said, but they will also take credit exposure.

And then of course, the question arises, why would an investor ever do this? And of course, we know the answer is because they get additional, uh, return.

And this return is most generically, often referred to as the credit spread. And as I already said in the introduction, when we're looking at the agenda, there are multiple types of credit spread.

So actually quite a few different ones that investors look at. They all have their sort of own pros and cons, um, but generally, you know what the elephant income, they look at the, um, compensation that an investor receives for taking a specific credit risk, um, on top of a specific interest rate, um, benchmark.

So very often the benchmark that is chosen, um, then in order to determine the credit spread, is the yield of an underlying government, um, bond.

So if we, for example, look at a five year, um, USD ated, uh, corporate bond that comes with a yield of 6%, let's say, um, then, um, we can sort of figure out what is the credit spread that this bond pays.

So we could, for example, look at the relevant five year, uh, treasury bond here, let's say, that has a yield to maturity of 5% at that point.

And then the difference between the yield of the corporate bond and the yield of the, um, five year treasury benchmark is simply the credit spread or one credit spread, right? And this is then going to be here, um, 1%.

And so that's often, um, something that investors like to know, what is the credit spread IE the pickup that I will receive for investing into this credit or into this bond that has credit risk attached in comparison, obviously to the credit risk-free, um, benchmark rate.

And that's why, because this is sort of like the question that interests investors the most.

It's not so much about the absolute level of yield to maturity here, because investors in corporate bonds do not necessarily invest in those bonds because they want to lock in that absolute level of, um, you know, yields.

They are, um, moving into the credit space simply because they wanna achieve a yield pickup by taking this additional risk component.

And so what interests them, most of all, is of course, this extra compensation, IE the additional reward for taking this additional risk.

The absolute level of yield here is mostly determined by the level of the credit risk-free rate, IE the government bond yield.

So investors that decide to go into corporate bonds rather than, uh, treasuries, for example, they would probably be mostly interested in the spread directly, which results in the fact that when we're quoting corporate bonds, uh, on the secondary market, uh, and even in the issuance process, um, you know, corporate bonds are usually quoted on a spread basis, right? So you would call a market maker, ask for this particular price in this five year corporate bond issued by whichever company we wanna choose.

Uh, and then the answer would be, in this particular case, that would be treasuries plus a hundred basis points, IE you get the current treasury yield plus a hundred, um, basis points on top.

And if the current treasury benchmark was 5%, then you can work out that the yield to maturity of this bond would be six.

And with that, you can then basically discount all the cash flows this bond has, um, you know, prev all those cash flows back to today, and, uh, sum them up and you have the bond price.

And I've done that just as an example because there's some interesting, uh, things to show here.

So let's switch to, um, a spreadsheet, uh, overview here, which hopefully works seamlessly.

Yes, there it is. So here's the bond that we have seen sort of in abstract forms on the previous slide. We have a five year maturity. We have an annual coupon.

I just, you know, make the most simple, uh, cashflow structure possible here of 6%.

Um, the yield to maturity as we have learned, was 6%.

Uh, and this had two components, right? The five year government bond yield of 5%, and the credit spread of 1%.

And so all I've done here now so far is just kind of worked out the bonds cash flow 6% after year one, 6% year, 2, 3, 4, and then 106% at the end of year five, simply because the redemption payment happens there as well.

These are future payments, so we need to discount them back to today.

And as we often do in bond world, we use the yield to maturity formula here.

That means we're dividing by one plus yield to the power of T.

And so you can see the present values here, add them up, uh, that gives you the current bond price, and that no surprises there is currently at par, we are not, uh, looking at accrued interest here. We assume it's plain five years.

Nothing, uh, has accrued in interest rate terms as of yet.

Uh, and then because the coupon and the yield of the bond are precisely, uh, the same, now we can say, yes, it makes sense that the bond trades at par.

So if I buy the bond at par and I get a 6% coupon every year, then my return when I get par back in five years would've been 6% per Anup. So that's not really the point, because this is just a standard, um, I don't wanna call it pricing model because it certainly, uh, is, is seems a little bit unnecessarily, uh, impressive or complicated, but that's basically, um, a, a simple bond price right here.

And, um, the reason why I put this together, and the reason why I wanna share this with you is just that when people start thinking about corporate bonds, then yes, of course, um, we focus on, uh, things like default risk and say, okay, if I buy this bond, then I do have actually a risk that I'm not getting my money back.

And that is true, and that's probably the most important thing to think about.

And, and conceptually makes absolute perfect sense.

However, it's also important to understand that you can see p and l volatility when you are, uh, investing in corporate bonds that's not driven by actual default, but by worsening or improving, uh, credit quality of the issuer. And so what I wanted to show here is that when you, um, invest in a fixed coupon corporate bond, you actually have, well, not just two, but two main sensitivities that you, um, need to have on your radar.

The first one is obviously the interest rate sensitivities.

So the rates duration that we already know from the government bond, uh, sessions that we've done here together.

So that means if I buy a fixed coupon bond and subsequently yields, um, of that bond, a let's say government bond, right? We bought a fixed coupon government bond, and then the government bond yields rise, that will lead to a decline in bond price, right? Uh, so let's play through this because here now we're not buying a government bond, but we are buying a corporate bond, and part of the yield of the corporate bond is driven by government yield.

So what happens when we just assume that the five fee government yield is going up? Let's see what happens to the bond price here.

It drops no surprises because the increase in yield to maturity of the Gavi will feed into an increase into the yield to maturity of the corporate bond. Here, you see it, what has changed, the yield has moved from six to six of, uh, 6.5, and that of course leads to a drop, uh, in bond price.

Now, let's assume now that this hasn't happened, but instead the credit spread of the company has widened. So let's say the, um, focus or the, the, the view of the market to that particular, uh, on that credit risk of that particular company has changed, and the market now believes this is a bit of a weak candidate.

So maybe, um, there's a bit more challenge to their business model or anything like that.

And as a result, the credit spread has widened to 1.5%, um, since we bought that bond, when we see here is exactly the same effect, IE the bond price drops to 97.92, same result then earlier.

But this time, the price decrease is not driven by an increase in interest rates, but it's increased or it's driven by an increase in the credit spread.

So, uh, in a way, the impact on the price is exactly the same.

So it doesn't really matter for the p and l necessarily what drove the bond price down.

Um, the result is the same.

But here we need to obviously appreciate that we have, um, now when we're moving from governments into corporates to drivers, that can lead to, uh, a negative p and l impact, and that is an increase in the risk rate.

Uh, and then second of all, uh, increase or a widening of credit spreads.

So this is something to be, um, absolutely aware of that this is giving you this additional, um, risk, I'd say dimension.

And now of course, when you think about many credit investors that are specialized in analyzing credit, looking at spreads and trying to figure out whether or not a spread that's currently, um, on offer.

So let's go back to our 1% here, um, is, is is rich or, or a little bit, um, you know, maybe not too attractive.

Um, you know, that's probably, no, not probably, that's a full-time job, right? So you don't necessarily, uh, want to then in addition to thinking about, is that credit spread relative value or not, or good relative value or not, then want to have to worry about what treasury yields are going to do tomorrow, right? That's sort of maybe for the macro, uh, specialist, you are the credit specialist.

So you should, should have a view on, on the spread whether or not that's attractive or not.

So, but buying this bond, buying this 6% annual coupon fixed, uh, corporate bond will give you these two risks.

And if you don't want to keep these two risks because you're an expert on the credit side, you don't really want to take a view on rates, uh, then you need to obviously hatch this exposure away, for example, using interest rate swaps or doing something on the government bond side that we're going to see, uh, an example very, very, um, uh, soon.

So, but let's just kind of, uh, focus on this and say we have had the view that this credit is trading relatively rich.

IE we feel that the market is currently giving or demanding quite a, um, high spread, um, from this particular company.

We feel that this company is actually better than the market currently believes.

And then for us, we feel that this 1% spread is quite generous.

So what are we going to do? Let's say we're going to buy this corporate bond, we're locking in this 1% credit spread over the next five years, and let's say we were right. And over the next couple of um, hours, the market gets to the conclusion that this is indeed a much safer credit.

And as a result, people will buy the corporate bond, right? What happens then to the corporate bond price? It goes up.

Uh, if the treasury yield has not changed, then as a result, the credit spread is going to tighten.

And let's say at the end of today, it trades at 0.8% credit.

And that also makes a simplifying assumption that treasury yields have done nothing.

So treasury yields 5% credit spread.

Now, 0.8, meaning this bond now trades at a yield of 5.8%, and that means it has dropped 20 basis points in yield terms, and it has increased about 85 cents, um, uh, here, um, uh, in, in, in price terms.

And so what I, what I want to, um, obviously show with this is that, um, you know, this is not, not just an investment for, from buy and hold point of view, IEI wanna increase the return on my investment portfolio, and therefore I'm just going to pick a corporate bond and buy it and hold it to maturity.

Credit is something that can be traded quite dynamically.

IE you see a spread that you feel is quite generous, you buy that spread.

If you think a spread is maybe, uh, a little bit too tight and the market is too optimistic about this company, and the next move will be a widening of spreads, you can either take the other position, right? You could short sell this corporate bond.

It's a little bit more tricky, I guess from a, um, mechanical point of view, but you could short sell the corporate bond, uh, and then, uh, you would have a short credit position that will benefit from, uh, widening, um, in credit spreads. But remember, if you don't do any other hedge, you will always have some sort of interest rate risk attached to this position as well.

Uh, with that though, um, let's go back to our slides and, um, start kind of looking at things, um, from a slightly different angle now, because what we have, uh, talked about so far is that investors, um, always, not always, but you know, fairly easily can work out, um, what the extra compensation is that they receive for entering into specific, uh, bond position where it's quoted directly as we said, t plus a hundred basis points, right? Um, but that's, you know, while, while this is obviously a hundred percent critical information, uh, it's not everything we need to know because obviously it tells us the reward, but what we now have to do is obviously get a view on the risk that we're actually taking, right? We can never look at reward in isolation.

We always need to, uh, link the reward back to the risk that's required, uh, that we are required to take, to get this, uh, reward.

So while it's relatively straightforward to figure out the spread IE the extra compensation, I think the difficult part in credit is what's the risk, or how big is the risk, right? And therefore, back linking it back to how much reward should we actually receive? And this of course, is a whole, um, very complex topic, and I'm not, uh, claiming that I can teach you much about this, but I at least wanted to, um, sort of showcase or focus here on, on the general, uh, questions we need to answer when we're trying to assess, uh, credit risk of an issue, right? And, um, in general, I think it's, um, very much about getting the answers to two questions.

First question is, what are the chances that something goes wrong? IE what are the chances that there is a problem with the repayment of this, um, money that we have lent to, um, a particular bond issue? And then the second question is, if something goes wrong, how much will we actually lose, right? So, and then the technical ways of phrasing these two questions is basically we want to understand the probability of default, are the chances of something going wrong and then the loss given default, LGD, and that is how much will we lose if actually something goes wrong, right? That's the two things that we need to basically answer to get a fair view about the risk that we're taking.

And then we can compare risk and reward and get a better sense whether or not the spread is actually, um, generous or, um, very, very tight.

And that's conceptually very straightforward.

But to find the answers is obviously here.

The, the, the complexity, right? So when you're thinking about the probability of default, for example, right? Which are the points to, to look at? And there's a huge array of things that we need to, uh, look into.

For example, the business risk, right? So what kind of company is this? Which industry are they in? Are they leading the industry? Is this an industry with high entry barriers, or is this something where competition is huge and margin pressures are, um, very, very, uh, severe, et cetera, et cetera. So this is, um, you know, one set of factors to think about. Second set is obviously the financial risk in that company, how much leverage is there, right? How much debt versus equity, um, and you know, how say free cash flow looking like, is the free cash flow enough to repay, um, debt? Is it enough to pay the interest on debt? And all those sort of factors.

And these are very company specific, uh, factors that require already a lot of insight into a specific company.

And then you also should of course, look at the outside world and think a little bit about the macro environment in which we're making this decision, right? Because obviously, if this is a very cyclical business that we're looking at, uh, this will be very closely linked to the overall, uh, macroeconomic activity.

And if we expect, for example, that, you know, things are going to be a little bit challenging from an economic point of view over the next couple of quarters, uh, then maybe it's not the best time to buy that specific credit, right? Um, those are company specific factors and mostly, uh, although not exclusively try to answer the question, what's the probability of default are either chances of something going wrong.

Um, but then we also have, um, you know, the other part to answer loss given default.

And that is, again, going back to the financial risk and also the, the business risk and stuff.

But it also, uh, requires us to take a look at the specific debt issuance that we're looking to invest in.

And why is that relevant? Well, because, um, not every bond issued by the same legal entity has the exact same credit risk.

How can they differ? Well, first of co uh, first, um, uh, of all, they can differ by the fact that one debt issuance or one debt instrument might be collateralized, IE secured, secured with, uh, some sort of, um, valuable, um, asset.

Um, whereas other instruments are unsecured, IE basically, as an investor in the unsecured instrument, you only have this general claim on, um, you know, on the assets of, of the issuing company.

And that could of course be, um, meaning a very meaningful difference in the credit risk that you're taking.

If you bought, for example, would find a bond that's backed by an extremely valuable piece of, um, a land or real estate or anything like that, that is, you know, way worse, way more than the notional amount of the outstanding bond, you could argue that yes, there's a certain chance of things going wrong, but because if something goes wrong, I just get this very, you know, valuable piece of real estate, um, you know, chances of something going wrong out there. But if it goes wrong, I'm not going to lose anything.

So you can be fairly relaxed about the credit risk, right? On the other hand, if this is an unsecured instrument, then say, okay, that's just a chance that something is going wrong, and if something goes wrong, I might actually lose at least part of my money.

Uh, and then in those instances, uh, the next thing you need to look at, okay, what is the exact seniority level of this particular debt issuance that I'm looking at? Now, what's do we mean by that? Generally, what happens in case of a bankruptcy event? Well, you know, very simplistic view on things, but we have liquid error moving in, selling all the assets that are not, uh, ring-fenced for, for any collateral purposes or something.

So they're selling all the assets, they collect the cash, and then they start repaying in a particular order.

And that's a waterfall structure.

So only if the first, uh, sort of, um, layer has completely been repaid, then we pay the second layer, et cetera.

Now, the particular order, you know, uh, so who gets paid first? Probably sort of taxes, salaries and all these sort of things.

But then at some point, debt will be, uh, repaid.

And the general rule here is that, you know, not every debt holder gets paid at the same with the same priority, because there might be different tranches of debt, there might be senior debt, there might be junior debt, and within junior there might be several, uh, different layers.

Um, and the more senior, the debt you hold is, um, the earlier in the queue you are to when it gets to repayment.

So if you, for example, have a senior charge, uh, and then there's still some money left, once all the previous, um, invoices have been paid, you will receive a certain amount of money.

So if there was, for example, a hundred million of that senior bond outstanding, um, and, um, there was 40 million left in the liquidators, um, cash pile, then there would be a 40% recovery, as we call it.

So basically from the a hundred that investors are owed, they get 40% IE 40 million, then the cash is gone. And if there's now other, um, levels of debt, IE junior debt, then they will not get a single sense simply because the senior part has not repaid in full, therefore no money left for the junior debt.

So you can own the same or bonds from the same company, but the credit risk is actually dependent on, um, other factors like secured, unsecured, and the seniority levels.

So we need to look at these things, um, with a great amount of detail, think about who's the issuer, and then think about what particular issuance am I buying here, and are there any specific risks, uh, attached to this? And then that gives us, um, a probably relatively clear view on the risk we're facing, and we can now compare this with a reward and make our investment decision.

As I said, it's a very lengthy, very complex process, requires a lot of expertise, and so not every investor will be able to, you know, uh, have that experienced team of credit analysts and, and, and there are some investors that still want to, uh, invest in credit, um, to some degree more maybe on a macro basis.

But, um, you know, and, and they understand that they need to have some idea about the credit risk that they're about to take.

Um, but where do they get it from? And here's where credit ratings, for example, come into play, which are basically opinions by the rating agencies here. We show Moody's s and p Fitch, there's others, of course, um, and they do exactly what we have discussed. They talk to management, they look at the financials, they look at the business models, they attend all the investor calls, et cetera, and then form their view on the underlying credit risk of a particular company, and they give issuer ratings.

Then, um, on the back of this, which are qualitative statements really on, you know, how likely it is that something might go wrong.

It's not a hard relationship between AA means x percent, uh, probability of default or anything like that.

But of course here you see, you see sort of like the, the verbal, uh, translations there.

Um, you can see that there's differences in the different, um, rating categories.

So that's a good place to start.

And this is what obviously many investors, um, will do, uh, look at on a very, very, um, frequent basis.

And then when you see at the, at the rating scale here, there's obviously a specific point, uh, in which, um, we're changing terminology.

So everything above triple B minus if we're using the fetch and s and p uh, scale here, um, is classified I as investment grade ig.

And everything below that, uh, point is then high yield debt.

Sometimes we use other terms for it, but I think high yield is the, uh, most relevant one.

And, uh, now of course sometimes people wonder, okay, why was it decided to draw the line there? Um, you know, uh, I'm sure I wasn't part of the discussion, so I don't really know, but obviously, you know, you could think it's about halfway point, right? So maybe that's, um, something you can also, uh, look at the right hand side here where you see, okay, um, you know, we have the default rates here over five years, um, over different rating categories, and we see a triple A double, a single A, really nothing.

Um, and then triple B, we have a tiny bit, so a very, very small, um, default rate there, but then it really accelerates.

So maybe that's it. On the other hand, you could also make the argument that it probably accelerates because the line is there simply because many investors, um, are restricted in investing in credit to investment grade, right? There's obviously growing interest in high yield as well, and that's, um, useful, but I think there's still a lot of investors out there that can invest in investment grade credit only.

Meaning the moment a company, um, gets downgraded from investment grade two below investment grade IE high yield the pool, the, the universe of investors that's able to invest in their credit shrinks quite substantially, which of course will have a significant impact potentially on the demand for those debt instruments on the price of those debt instruments. And that translates into a credit spread.

And if you then, uh, have a company that's already struggling financially, and now, uh, they are also, um, seeing this downgrade, um, pushing up their financing costs even more and, and shrink the universe of investors that are willing to provide them with financing that might exactly be what pushes them, um, over the brink. Now, I'm not saying that's what happens, it's a bit of a hand and egg discussion, I guess.

Um, but it's, it's something that one should definitely, um, have in mind. This is not just some arbitrary line here with no meaning. This could have actually, um, you know, consequences. Okay? Uh, this one we have already talked about that just is a little bit more information about what happens in the, uh, liquidation waterfall process, et cetera.

I leave this, um, up to you guys, uh, to read in your own time any questions, happy to answer them, of course, at a later, um, stage.

But I wanted to at least show one or two, um, stats and charts here to really remind everybody that this credit analysis is important to be done because default risk is real, right? As we see here, um, you know, it varies over time quite significantly, but there are certainly points in time where reasonable number of default has occurred.

Um, mostly of course, in the high yield space, which is what you would expect, right? That the riskier part of credit should see higher default rates than the, uh, safe place, which means then the ratings are sort of, um, conceptually accurate.

Um, but it also, uh, shows here very clearly that, um, there is a certain degree of variance in, in those default rates, right? And we see sort of things almost, uh, peaking in, in different time intervals. So we have here the nineties, there was obviously quite significant increase in, uh, high yield defaults.

We had, um, the same thing then in the two thousands, which we remember is the.com, um, bubble that had also a little bit of an impact on investment grade.

Then we had, uh, 2008, 2009, the financial crisis, right, where we saw some, um, defaults in the investment grade space as well.

Uh, we had then most recently COVID, which again, obviously stressed a lot of companies, um, and led to an increased range of default. And then we had 2016, uh, when we saw oil prices collapsing, um, relatively significantly, and then a lot of high yield, um, rated debt issuers in the, in the oil industry, um, went bus.

So, you know, it's something that, uh, is not necessarily the same, um, degree of concern here, uh, over time, but certainly there are then, according to this, um, better and worse times to be invested in credit, which I think is, uh, rather intuitive.

Uh, and linking this back to what we said before, and that is that when you invest in corporate credit in corporate bonds, you take some sort of like sensitivity risk on credit spreads.

Um, this has, you know, obviously, uh, practical consequences because when default rates change over time, uh, and the market is somewhat forward looking and sees a, um, you know, deterioration of the economic situation on the horizon, then would you hold corporate bonds? Would you be very bullish on corporate bonds, or would you maybe sort of turn a little bit defensive and start selling them? In other words, would spreads remain the same, uh, if there was an expected, uh, worsening in the economic landscape, or would they move? And the answer here we can see on the next slide, um, is that obviously spreads respond, uh, to those changes environments. Here the scale is something different.

We're looking at the financial crisis as a first starting point, because I couldn't get the stats from all the way back to 1990.

But you see here the same points in time, right? Where we see here, um, the three main outliers that we talked about before we had the, um, financial crisis, we then had, uh, the, the 2016, um, global economic growth and oil price decline.

And then we had COVID, uh, so spreads respond to that.

And if you held corporate debt going into the, um, into COVID, for example, and you were not selling them quickly enough, then of course you saw a widening of spreads on your bond holdings translating into actual p and l losses.

Now, these are obviously mark to market losses, just to, uh, make sure we're all on board with that idea.

This is not a definite loss. If you are holding this bond to maturity and there's no default, um, of the issuer, then of course this is just a paper loss, if you wish.

But of course, as most of us will be, uh, measured on the mark to market basis, um, the pain is real.

Okay? Um, so this leads us then to a slightly different dimension, because so far we said, okay, yes, of course, credit spreads are different, dependent on the issuer, dependent on if it's secured or unsecured, and also dependent on, you know, junior and senior tranches.

Um, but of course, even if you had the same issuer and you had the same level of seniority, uh, in bond issue, that could still be different spreads.

And that is most likely then, uh, driven by the time to maturity.

And I think that's very intuitive because I think it sits very well with me at least that I, when I say that I would expect a one year corporate bond, um, that on a specific company to have a lower spread than a 30 year corporate bond issued by the same company, uh, with the same level of uncertainty.

And the reason for that simply is 30 years is so much longer.

I might have a relative clear view on the risk of this company over the next 365 days, but over the next three decades, that might be, uh, slightly harder to, um, forecast.

And therefore I think there's a risk premium, uh, that needs to be paid for longer, uh, term corporate debt.

And therefore, what one would expect actually is that the term structure of credit spreads should be upward sloping under normal circumstances, right? And so what we've done here is we look at two yield curves, we look at a government yield curve, that's the blue dotted, uh, line here, well, the blue dots.

And then we have taken a investment grade, um, corporate bond issue and just sort of, uh, plotted the yield to maturities of those bonds to the time to maturity.

And so basically the difference between these points is then the credit spread, and as you see, um, as time to maturity increases, credit spreads, um, widen, which is, uh, absolutely in line with, um, what I, what I said.

Now, there are circumstances under which, um, this credit, well, the term structure of credit spread might look different.

Uh, and that's an interesting one to think about.

I think we probably don't have time, um, but should we have left a, a minute or two at the end? I'm, I'm coming back to this.

Um, but that's how the spread curve normally would look like.

And now we need to go back and just shed some light on the different spreads there are.

And, um, as you can see here, there's actually quite a significant, um, range.

But, um, you know, we won't only, we will only have time to discuss, uh, these two here in in more detail.

Uh, and maybe for next year, we're going to, um, run a little bit more specific session on credit. Should interest be there, remember put it in the, um, feedback form as that should be, uh, of interest.

Um, but that's the two we wanna, uh, talk about today.

And the first one here, g spread, that's already something where you need to be super careful because it's easy, uh, to have, um, I'd say misunderstandings about what we're, what we're actually talking about.

So, so far, um, the spread we have, um, used in our, um, presentation here today is what I would refer to as a traditional credit spread.

Um, how's that measured? You just take the yield to maturity of a corporate bond, and you take the yield to maturity of a government benchmark bond with the closest maturity.

Um, so here a practical example, we're looking at a des telecom, uh, bond maturing in Jan 2028.

It was 2.43, uh, 2% yield at the time we created this example.

And then at the same time, the two, um, bonds that were, uh, the relevant benchmarks here, and this is obviously the German government bond as we're thinking about a European, uh, denominated bond issued by a German company.

So we're taking bonds as the benchmark, uh, and here we had maturities that were closed, but not perfect match.

So we have one 15th of October, 2027, and then we have 15th of August, 2028.

None of them matches perfectly. So what do we do? We take the closest one, which is the 15th of October 27, uh, and then that had a yield to maturity of 1.089.

And then we take 2.432 minus 1.089 result is 1.343, uh, percent.

That would be the traditional credit spread. When you, for example, uh, check on Bloomberg, the, the various functions, that's usually, uh, the way this is calculated. You see all the other spread measures, um, below, but that's usually the one that you see, um, and that investors look at.

And the reason obviously is that if you wanted to isolate credit risk, as we said before, many investors would be looking for, um, how could you do this? You could, for example, isolate the credit risk by buying the corporate bond.

And then short selling are the relevant, um, government bond benchmark, which means if rates now go up, yes, you lose on the corporate bond side, but you will gain on your short position on the gove, and therefore you have isolated credit risk because the interest rate risk has been, uh, immunized, right? And, um, or eliminate.

And so that is, uh, an often looked at measure.

It has just one conceptual problem, and that is that we are not comparing the same maturities with each other.

And, um, it could be now of course, that the two bonds that we're looking at are having very similar yields, as in our, uh, example here, 1 0 8 or 1 0 9 really to 1 0 11 is to one 11 is not really that big difference.

But, um, what if the yield curve was looking like this, right? If it was much steeper, and then we would kind of have a, have the, a corporate bond here, and we would compare it to that, um, government bond. And you can see that, you know, if we would compare it to this one, we get a very different credit spread.

And the difference in credit spread is, is mostly driven by, um, the, the steepness of the risk-free yield curve.

So in a way, this might not be the best, uh, way of looking at it simply because it ignores the fact that the yield curve, um, might have some steepness as well, and we're not, um, picking up on this one.

Um, so therefore we have, uh, an, a slightly different version, which then is called the G spread.

And, and G obviously stands for government bonds.

So that's why it's easy to, um, get confused there.

Um, but the difference between the traditional spread and the G spread is that instead of using the closest benchmark, we're now using an inter interpolated rate, right? So we take these two, um, benchmarks around one shorter, one longer, and then we use some interpolation technique.

Next slide shows you how it's done using linear, but you know, whichever, uh, technique you want to use.

And then we're calculating the inter interpolated government yield for the maturity of the corporate bond.

So attempting to solve the question, what would be a yield of a government bond issued by the German government, if there was one, was the maturity of the 17th of Jan 2028, um, mathematically then we get a one slightly different results than before.

And, uh, the G spread is slightly different, uh, to the traditional spread.

Um, and of course, you know, conceptually that is in a way better because it now would sort of factor in the, the, the steepness of, of the yield curve.

Um, the problem is though, we cannot really trade it because yes, this government bond, as we said, doesn't exist.

So I cannot sell it, right? I cannot short sell a 17 of gen 2028 German government bond.

So then in a way, what's the point of looking at the spread if I cannot trade it, right? Um, so you see pros and cons on all these things, and that's why there is so many different credit spreads.

And the one last one we wanna have a look at is the ice spread, which is, um, ICE stands for interpolated spread.

So it sounds a bit similar to what we've done before.

The difference now is we're not using government bond yields, but we're using swap rates.

So we are going into the interest rate swap curve, and we say, okay, obviously I'm having a 17th of Jan, 2028 telecom bond.

I could also basically eliminate or hatch my interest rate exposure by entering into an interest rate swap.

Uh, and the beauty of interest rate swaps now is obviously, um, that the OTC instruments. And that means if I want to have a swap that matures exactly on the 17th of, uh, January, 2028, then I can get this done right? I just may need to pay a little bit wider bit offer, um, because I'm trading a five point something year, uh, swap rather than a plane five or plane six. Well, it could tends to, uh, be a little bit higher, but it can be done.

So in a way, now we have a tradable rate interpolated, so that gets around this issue that the G spread had.

Um, so what's not to love about the ice spread then? Well, the benchmark that we're looking at here is not the classic credit risk-free government bond yield, but it's some sort of a swap rate.

Now, of course, in the new world where we're using OIS and, and, and those, uh, sort of things, silver swaps, uh, I think the credit risk component has decreased, uh, obviously quite significantly.

But when we're thinking about euros and we're still trading a lot of swaps on your, or for example, that means there's some sort of, um, three months or six months term premium built into swap rates.

So it's a little bit, well, not, not messy, but inconsistent at least. So swap rates might be driven by, um, you know, concerns in the, uh, financial stability of the financial system.

Uh, and so that might be driven by not just the, uh, change in credit quality of the company.

So you have some, um, other factors that could potentially provide some, um, p and l noise here.

So just something, um, to be aware of.

And with that, ladies and gentlemen, um, pretty much spot on.

Uh, last quarter, we're going to talk a briefly about credit derivatives.

Um, not really, uh, need to discuss this slide here, but the point is, as any other derivatives, they can be used to, uh, hatch existing risk, and they can also, uh, be used to, um, take speculative positions.

We're going to apply, or we're gonna look at CDS here, mostly from a hedging point of view, simply because a, that's what they have been designed to do originally.

Uh, and also because the intuition is, is just easiest, uh, to explain.

And we're also going to, uh, look at this from a single name CDS basis, which means the risk that we're trading here in this contract is a single, uh, legal entity, not a basket of companies or anything like that.

Okay? So let's start with terminology.

In a CDS contract, uh, we don't have payout receivers, uh, like we do in rates, but we have actually protection bias and protection, uh, sellers.

And if you hear this, you automatically think about insurance, right? And I think that's conceptually a very good thing of, um, a very good way of approaching CDS. They are not insurance contracts, but there are certainly some, uh, similarities.

And so the, the best way to think of a CDS is then maybe when you start looking at those things as follows, the protection buyer is basically the party that pays a premium to the protection seller, and in return receives protection, which is basically a contingent payment.

IE if something goes wrong, then the protection seller will have to make a compensation payment to the protection, um, buyer.

And that compensation payment is usually determined by a 100 min or one 100%, or one minus recovery.

So we're going to, we're gonna see an example of what exactly that means and what this looks like.

Uh, in a minute, the protection seller is then simply the party that receives, uh, the premium and is obliged to make this, uh, compensation payment should a credit event occur. So really like an insurance contract where you pay, uh, a quarterly fee, and if some accident occurs, you get a compensated.

Now, um, important, as I said already, they are not insurance contracts.

Not only insurances can, uh, sell protection, investors can sell protection as well.

There's also mark to market value, which insurances, uh, usually don't come with.

Uh, and also, uh, we can buy insurance, uh, in the CDS market on risk that we don't have.

Uh, and that's very different from insurances where, you know, usually you can only buy insurance if you have the insurable risk.

So you cannot buy life insurance on, uh, your neighbor, for example, for obvious reasons, right? In CDS markets, you can buy protection on a company where you don't have a corporate bond, um, on, and therefore a benefit then almost in a way from, uh, this, uh, credit event if there was one, right? Anyway, it's a OTC instrument, uh, although there's a certain degree of standardization, um, nowadays.

Uh, and so counterparties need to agree on a range of things.

And here, just a couple of them, notional is obviously the insured amount, if you wish.

Um, then the maturity is how long this contract or the insurance, um, is going to last.

Uh, then we need to really define what exactly is insured, IE which company, and be, we need to be precisely, is it the holding, is it the financing part? Is it, you know, the US or the, the, um, European, uh, entity or whatever.

Uh, and then also we need to, um, set a reference obligation.

That doesn't mean that only this particular bond will be insured, but it's, uh, used to absolutely, uh, crystal clearly determine what, um, type of security, what type of seniority level, um, do you have, uh, insured here.

So if, for example, the reference obligation here was the 4%, 21st of May, 2035, senior unsecured bond, then, and the credit event occurs, and you were to physically, um, settle this, you can deliver any bond of that legal entity that has the same para passio credit level, IE as senior unsecured, not just this particular, um, one.

And then we need to think about what credit events are actually insured.

IE um, bankruptcy and failure to pay usually is, uh, always included.

And then depending on the jurisdiction you are in, uh, there might be coverage for, um, restructuring, uh, and, and other things as well.

And then when we have discussed all the terms, we need to think about the price.

And the price is then basically in simplified terms, the premium that will be paid.

And here, our example, it was in quarterly payment of a hundred basis points, of course, not for the whole notional amount and for the whole year, but we are basically breaking this down in quarters by multiplying days over basis, right? The actual 360 day count would be applied here.

Uh, and then that means four payments a year of, in total 1% of the notional IE at $10 million.

So that's the contract.

Now, um, let's see what the impact of this is.

And let's say we're the bond holder here. We bought that corporate bond that we looked at on the first slide.

Uh, and so we basically locked in the yield of 6% here that we're going to get over the next five years.

We bought 10 million notional.

And for whatever reason, we're now immediately concerned about, uh, the spread to widen. Don't ask the question as to why we did buy the bond in the first place.

That's, uh, irrelevant.

We just bought the bond, uh, and now we want to ensure it.

Uh, and so we can obviously go to a protection seller, uh, and we ask for a price of protection.

And let's say, uh, they say, okay, you know, on the previous slide we said the, the price is a hundred basis points, um, per quarter, which basically translates to 1% that we're going to pay, um, per annum.

And what we receive in return for that is the contingent, um, protection.

So let's see what that then means, um, for the two outcomes, because there's two, um, things that can happen.

A, there's no default or there is a default, right? So let's see what happens if there's no default.

Well, we've simply received the yield from the bond for the next five years, and that is 6%, uh, per annum.

We are also paying the 1% insurance premium to our counterpart.

So that's, uh, 1% less.

And that means we're net receiving 5%.

And you remember this number from somewhere because that's basically where we said the risk free rate of return, um, was for a five year period, the government bond yield, is it coincidence? Not really, because in a way, um, it is very intuitive that we should end up approximately, at least there are some technical factors, of course.

But you know, when we just look at this from an intuitive point of view, you say, okay, if I buy a corporate bond and then I hedge weigh the credit risk, I don't have credit risk anymore. All I'm left with is interest rate risk. And so I should get the same reward then someone that only, um, bought the government bond to start with and has only credit or interest rate risk, right? So it does make sense that these two are somewhat aligned, they don't match perfectly always in reality.

Other factors, um, certainly have a role to play here as well. But just for introductory point of view, conceptually, this hopefully, uh, makes a lot of sense.

Another question is obviously, well, do we not have credit risk, right? So let's see what happens in case of a default.

Well, um, as we said, um, once the credit event becomes known, bond prices, uh, obviously will respond to that.

The interesting thing to note is, so they don't necessarily drop to zero, right? As many of us would expect, when you kind of think, okay, this bond is, this company has defaulted, why would anybody still pay, um, money to get their bond? Well, if the bond trades at, uh, 10 cents to the dollar, right? So you can buy at 10%, um, of the notional, and you expect a recovery of 40%, let's say, um, then this bond at 10% might actually be a very, very attractive, uh, investment, right? So you buy it at 10, you then hopefully get the 40% through the recovery process, you have basically generated, uh, a quite juicy return, um, for your portfolio there, right? And so if then the whole market were to believe that the recovery is going to be 40%, let's say on average, right? Um, then the bond price after the credit event has occurred should be around 40%, right? Um, and so let's say the market, uh, expects recovery to be 40%.

What would happen the moment the, um, default becomes known? Bond prices drop to, and let's simplify here, really 40, um, percent.

So now the bond price is trading at 40%.

We bought 10 million at par, right? What does that mean? Now we can sell this bond at 40, um, cents to the dollar, meaning we have lost 6 million.

And then we need to see, well, what do we get from our recovery of, from our protection, uh, contract? Well, we get one minus recovery, which is one minus 40%, which is 60% on 10 million. Notional is 6 million.

So basically we get 6 million from our counterpart on the CDS. We have 4 million from selling the bond in the secondary market after default.

And we have the 10 million we started with, and if, um, uh, that, and that is basically a, uh, flat, um, outcome.

And so we bought insurance, the insurance, uh, was needed and it covered us, of course.

And here's just, uh, one, uh, thing that points towards as to why this is not always a hundred percent, uh, accurate, is there may be obviously a bit of a risk that the insurance seller, uh, is defaulting as well, because that is, uh, one of the factors that one needs to take into consideration. That's why we might just, uh, approximately reach the 5%, but don't have to be there necessarily.

Um, exactly. So just, uh, as a, um, food for thought there.

Now, then of course it's like, okay, the mass is relatively straightforward, but where does this recovery rate actually come from? Because the point is, when there is this in, uh, credit event, it can potentially take many, many years until all the court cases are, uh, over and until we actually know the final realized recovery rate of a company that has gone into bankruptcy.

And of course, you know, the problem is that as we've seen, when you hold a bond and the company defaults, now your loss is imminent, right? The price drops from a hundred to to 40, you are down 6 million and you want to get them now. So you don't really want CDS payments to come in a decade from now, right? So how have we solved this, uh, through an auctioning process, uh, which is organized by ista, so the international swaps and derivatives as associations. So they've put this auction protocol together and effectively is when the credit event gets confirmed.

We're holding this auction, uh, which market makers and, and, and, and, and financial market participants can participate.

And basically what we're they, they put buying and selling prices in? And we just kind of calculated clearing price here.

And that clearing price is then, um, equal to the bonds recco or to the recovery that we are determining by auction.

And that's then the recovery rate that we use to settle all the, um, CDS payments against.

And of course, that can be different to the actual realized, um, recovery rate that might be known couple of years later.

Okay, so that's the, um, conceptual idea.

And then of course, you know, just to, uh, complete this, um, what's a settlement going to look like? And as any other derivative really, we can theoretically choose two forms.

We can have a physical settlement, we can have a cash settlement.

It depends really a little bit what your use case is for this, um, particular CDS protection that you might have bought.

So if you, for example, were holding the bond and you wanted the protection, then you probably would, um, not mind to have physical settlement. And the idea is you just send the bond over to your protection seller and you get the notional back, and you don't have to worry about selling the bond at any particular price.

If, however, this was a speculative position, you didn't have the bond to start with, you just bought protection because you thought there would be a credit event, uh, then you would probably prefer the cash settlement simply because then you get the economic value of the contract without the need to go into the market, buy the corporate bond, then deliver it to your seller of protection, and to get the, uh, notional back.

So it's just a much clearer, um, way to have the cash settlement.

And then the last, uh, thing, and I skipped these, uh, things, we're going to come back to that in a, in another session, but, um, here I just wanted to keep this materials in, uh, for your benefit if you, um, really want to read up on this.

But, you know, the, the last point I want to briefly touch upon, as I said, are credit indices, right? And the idea here is that, um, we want to be able to trade, um, you know, protection on baskets, um, of, uh, companies.

And that's what these credit indices have been developed for. There's a popular couple of popular families here, ira, XCDX, and we're just kind of using the, um, IRA X Europe as an example.

Uh, and what this is, is basically a basket of 125 liquidly traded single name, uh, CDS is in one particular basket.

And now you can buy protection on the, uh, IRAs, Europe, uh, in particular, uh, size.

So for example, let's say we buy five year protection on the IRAs Europe, uh, total notional of 125 million.

And what this effectively means is we have bought 1 million protection each on those 125 names.

So it's not a first loss basket or anything like that. It's really just one trade 125 CDSS on 125 different names.

And the consequence of that is that when there is a default in one of those basket names, yes, there's going to be a settlement, but not on the whole notional that we traded. So remember, we traded 125 million notional to start with, but instead on the notional that, uh, is applicable to each of the basket members, which was 1 million in our case.

So here, uh, we bought 125 million protection on 125 names, IE 1 million.

Each one of the names default.

We're settling, um, 1 million notional by one minus recovery determined again through the auction process.

And then we continue with this swap, but not on the full 124 5 million, but rather on 124 because one of the CDSS has already been settled and is therefore terminated.

And so the best way to think about it is really a very efficient way of trading a large number of CDSS in one goal.

Uh, the only limitation this has, it's limited to the index that is out there. So you cannot choose the 125 names, um, freely, but nonetheless, it's certainly a good way to get a broad exposure in either way, uh, to credit.

And with that, ladies and gentlemen, I'm at the end of what I wanted to share with you today. Thank you so much for your participation here.

Remember to fill out the feedback and the, uh, let us know about the topics.

Have a great, uh, rest of your, uh, Friday Fantastic weekend, had any questions, uh, please, um, let them, uh, route them through the q and a function because I cannot unmute or anything like that, and I don't see the chat.

So anything that you want to ask, um, then please, um, put it in the q and a. And of course, it was an absolute pleasure.

So you have a great weekend.

Hope to see you again or have you, because I'm not seeing you unfortunately, but hope to have you on these sessions, um, very, very soon.

I'm staying another minute so in case something comes up.

Um, but if I don't hear, have a fantastic weekend and take care of yourselves. Bye-bye.

Um, so, so just, um, attempt to answer this question briefly.

If the CDS index movement always reflect the fundamental credit risk, I mean, it, it, it is a bit, uh, obviously driven by, you know, ultimately by supply and demand dynamics, right? So it should be linked to the 125, if we stick with that example, underlying names here.

Uh, and of course, if now there's an increase or a, a spread widening of all those 125 names, or most of them at least, then this should translate into an increase in, um, the index as well, because as we said, it's basically just an equally weighted index of those 125 names.

So if there's an increase in spreads on a single name basis, that should, uh, drive or find its way into the, uh, index itself.

But, you know, the thing is that credit to some degree is obviously also a macro trading tool, as I said.

So there are environments where people are maybe a little bit more constructive on credit.

There's, um, moments where they are, um, more, um, pessimistic and that obviously positioning will flow into the, the, the, the single name spreads and also then make its way into the industry. So I would say, um, that, you know, of course the main driver of index levels is probably the view of the market on credit and the demand for protection, et cetera, et cetera.

Um, but of course there's always other factors at work that, uh, you know, like structure products and, and things of, uh, those sort of nature that, you know, make a clear cut answer to this.

Um, always very, very, uh, difficult. Okay.

So that was, um, hopefully, uh, and an answer that, um, you know, uh, was sufficient.

But as I said, feel free to get in touch, um, offline.

Always happy to have a chat. That's it for me.

I have no further questions.

Take care and see you very soon. Bye.