Credit Strategies: The Bottom-Up Approach in Credit Analysis

No. A widening spread would mean a positive delta in the equation, and this has a negative sign in front of it, reducing expected excess return. This would make the other bond a very bad deal.

Some credit portfolios start at the bottom. The bottom-up approach here is similar to what you have seen before: just decide what the "universe" of bonds is, divide by sector and subsector, and then look for relative value from there.

No. The holding period isn't really an issue here. Presumably, you would want to compare two issues with the same holding period in mind.

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Right. That's a logical answer without the equation, but it shows how the breakdown of excess returns can be compared by using the known spreads of each and the estimated credit losses and spread changes (which are related to migration risk) for each bond. Of course there's some estimating to be done here, and of course it's a challenge. It's tough at the bottom.

Then the company-level risks will dominate in your comparisons, and that's what you want. Once you have these groups, what sort of variable do you think is best to keep similar when comparing two bonds in this bottom-up approach?

Not really. Collateral can be different. It's an issue for analysis but not a large one in this effort.

Exactly. This approach is best when credit risk levels are similar. And then you compare them in a couple of ways.

Not really. The coupon really doesn't matter much.

When you're dividing by industry, you might use the benchmark classifications as a start. But then, you might find some way of broadening, narrowing, or "fixing" these classifications in some way. There's no real rule here, but you want to segment companies so that they each contain similar levels of what risk type?

Not really. They should have about the same amount of industry-level risk if they were divided into industry groups well.

Absolutely.

When you're shopping, you compare package sizes and prices to determine the best deal. Relative value analysis is kind of like shopping for risk. As you're comparing the magnitude of the credit risks (including migration, liquidity, default, and spread risks), you're also looking at the compensating premia involved. What sounds like a hot deal that you might want to take advantage of in this shopping experience?

Yes. That's the best deal. Unlike shopping, you want a small "package" of risk for a big "price" that you'll get from the investment. Making these sorts of value determinations isn't easy, but that's why smart people like you are needed for the job. You'll want to use historical default rates and perhaps average spreads by credit rating in order to get a sense of where credit risk is fairly priced, overpriced, or underpriced.

No, that's actually the worst deal. When shopping, you want a low price. As an investor, you want a higher price for a smaller package, really.

Not really. This might be about fairly priced.

Recall the expected excess spread return approximation: $$\displaystyle E[\text{ExcessSpreadReturn}_0] \approx \text{Spread}_0 - ( \text{EffSpreadDur} \times \Delta \text{Spread}) - (\text{POD} \times \text{LGD}) $$ If two bonds are assigned similar credit losses, but one bond has a lower spread, what must be expected about the other bond in order to justify similar prices?

Coupon

Credit spread

Committed collateral

Industry-level risks

Company-level risks

Low credit risk with a high credit spread

High credit risk with a lower credit spread

High credit risk and also a high credit spread

A widening spread

A narrowing spread

A shorter holding period

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