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In this issue we explain how we incorporated financing
into our Corp vs. CDS analytic.
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Corporate Bond (with Financing) versus Credit Default Swap
Since the release of our first “Corp Vs CDS” analytic (May 2008 Kynex
Bulletin), the credit
markets have changed dramatically. Even by the end of April, 2008, we noted
that a “credit crunch” premium of 50-75 basis points was added to the coupon
suggested by the CDS credit curve on newly issued bonds. Investors were
paying additional financing costs, so they demanded an additional premium on
top of the coupon suggested by the CDS market. Our model had no way of
reflecting this additional premium. We are pleased to announce the following
enhancements in response to the dynamics in the market.
- You can now specify your financing assumption in
basis points over 3-month LIBOR. This assumption reflects the borrowing
cost associated with financing the cost of purchasing the bond long.
Since the CDS is an unfunded transaction, the relative value comparison
to the bond must be funded regardless of whether the investor is hedging
or is investing outright. However, you can specify no financing by
“blanking” the financing input (a zero assumption will use financing at
Libor).
- We
have developed a new model based on a Zero P&L Basis Trade. The Zero P&L Basis Trade Model
uses a carefully
constructed basis trade
consisting of a long
bond position, long CDS protection and an interest rate swap. The price of the bond is determined so
that the expected aggregate P&L of the basis trade is zero on the
maturity date of the bond regardless of whether default occurs. The
previous model based on Pull-to-Par is available as an option. A
detailed description of the Pull-to-Par
Model can be found in the May 2008 Kynex Bulletin. A comparison of
the two models for a five year bond assuming a range of flat CDS spreads
and bond coupons is shown in the Appendix as well as a discussion of the
advantages and disadvantages of each model.
- Trading
opportunities in the investment grade, primary market appear to be few
and far between suggesting the CDS market and financing requirements
drive new issue pricing. Pricing irregularities in the secondary market
seem to be relatively common, resulting in a bond price disconnected
from the CDS market. We present a basis
trade taking advantage of such a situation.
- The
shape of the CDS credit curve and hence the default probability path
will affect the fair value calculation of the bond. Wider spreads and/or
inverted curves will increase the deviation in results from a credit
curve vis-à-vis a flat spread. We present an illustration in the Appendix.
Currently, we do not support the upfront loading of the probability path
corresponding to a “running + upfront points” CDS quotation.
- If you maintain credit curves on Kynex and/or send
us your credit curves periodically, the “Corp Vs CDS” analytic conveniently starts with your
assumptions. If you send us a list of bonds with their prices and credit
curves, we can automatically search for those bonds with a pricing
disagreement between the bond market and the CDS market, thus
significantly enhancing the productivity of your team.
COMPLETE
ARTICLE
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