May 2008 |
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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. Visit us on the web:E-Mail your suggestions and comments to: Copyright © 1996 - 2008 |
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). |
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