KYNEX Bulletin                                  

May 2008

 

In this issue we discuss and give insight into our Corp vs. CDS analytic which is intended to detect and quantify differences in the bond market and CDS market.

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Corporate Bond versus Credit Default Swap

The Kynex “Corp Vs CDS” analytic is intended to detect and quantify deviations between the bond market and the CDS market. It is intended to suggest possible trades in the CDS market as well as the bond market for a given issuer or issue. Client feedback regarding our “Corp Vs CDS” analytic, as first presented in our September 2007 Flash Bulletin, has encouraged us to revise the presentation of the results. Functionality is highlighted here, and you can follow the links for additional detail and explanation.

v     Given a bond price and its corresponding CDS credit curve, the fair value of the bond is calculated using the CDS credit curve, and an implied CDS curve is determined based upon the bond price. In this way, you can identify richness/cheapness in bond terms and in CDS terms, and hence potential trades. Richness/cheapness is identified in terms of both dollars and spread.

v     The Kynex bond calculator will now accept a CDS credit curve. The bond price is calculated using the CDS curve, and then all subsequent measures are calculated in the usual way.

v     By definition, all CDS spreads are par spreads. When applying CDS credit curves to discount (bond coupon is less than risk-free plus CDS spread)  or premium (bond coupon is greater than risk-free plus CDS spread) bonds, bond spreads are adjusted for Pull-to-Par using a Kynex algorithm based upon total risk and observed market prices. Please see the Appendix for a complete discussion of Pull-to-Par in both a risky and risk-free environment.

v     Kynex allows you to maintain credit curves in two different ways. You can use our Credit Curve Maintenance Utility on individual credits.  You can also transmit via FTP credit curves for numerous credits on a periodic basis. If you maintain a portfolio on Kynex of corporate bonds with prices as well as credit curves on these credits, we can automate the process of identifying potential trading opportunities. Kynex will do the data maintenance for you, and you can focus on trading. We know that some of our clients prefer one source of credit curves over another, so it is important that you send us your view of the curve. If a bond is subordinated and if Kynex has a subordinated curve, the subordinated curve will automatically be used on the “Corp Vs CDS” analytic and the bond calculator.

v     If you know a bond price but the CDS curve is unknown, you can calculate the implied CDS credit curve consistent with that price. CDS spreads can be specified at multiple tenors to establish curvature.

v     For convertible securities, the coupon is obviously not just determined by a spread over a benchmark curve. A convertible investor will give up coupon in return for more option-value on the underlying stock. Kynex is comfortable using CDS credit curves to evaluate a newly issued convertible priced at par if bankruptcy mode is turned on and a spread decay factor has been assumed. It is less clear how to apply credit curves to convertibles in the secondary market that are no longer at par. Kynex will address this issue in a future bulletin.

v     If the bond market and the CDS market essentially agree, there is no trade. But the unfolding credit crisis (as well as special situations involving specific companies) is providing opportunities.  Generally, bond spreads are widening vis-à-vis CDS spreads since the autumn of 2007. Especially for riskier bonds, we believe that bonds have over-reacted to the credit crisis, while tight credits appear to have widened to a lesser extent.  The current inconsistency between the bond market and the CDS market can also be seen in newly issued bonds.  A “credit crunch” premium of 50-75 bps seems to be added to the coupon (e.g. BMY, DELL).

COMPLETE ARTICLE

 

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