review by an agency (or agencies). This means that the rating agency is
putting the issuer on notice that it is being watched closely and with an eye
to changing the current rating in one way or another. At the end of some
period of time, the relevant agency takes the issuer officially off of watch or
review with its old rating intact or with a new rating assigned. Sometimes
76 PRODUCTS, CASH FLOWS, AND CREDIT
other information comes out that may argue for going the other way on a
rating (e.g., an issuer originally going on watch or review for an upgrade
might instead find itself coming off as a downgrade).
At essence, the role of the rating agencies is to employ best practices as
envisioned and defined by them to assist with evaluating the creditworthi-
ness of a variety of entities. To paraphrase the agenciesÔÇ™ own words, they
attempt to pass comment on the ability of an issuer to make good on its
Just as rating agencies rate the creditworthiness of companies, rating agen-
cies often rate the creditworthiness of the products issued by those compa-
nies. The simple reason for this is because how a product is constructed most
certainly has an influence on its overall credit risk. Product construction
involves the mechanics of the underlying security (Chapter 1) and the cash
flows associated with it (Chapter 2). To give an example involving the for-
mer, consider this case of bonds in the context of a spot profile.
Rating agencies often split the rating they assign to a particular issuerÔÇ™s
short-term bonds and long-term bonds. When a split maturity rating is given,
usually the short-term rating is higher than the long-term rating. A ratio-
nale for this might be the rating agencyÔÇ™s view that shorter-term fundamen-
tals look more favorable than longer-term fundamentals. For example, there
may be the case that there is sufficient cash on hand to keep the company
in good standing for the next one to two years, but there is a question as to
whether sales forecasts will be strong enough to generate necessary cash
beyond two years. Accordingly, short-term borrowings may be rated some-
thing like double A while longer-term borrowing might be rated single A.
In sum, the stretched-out period of time associated with the companyÔÇ™s
longer-dated debt is deemed to involve a higher credit risk relative to its
Now consider an example of bonds in the context of a spot versus for-
ward profile. As Chapter 2 showed, an important variable distinguishing a
spot and a forward is the length of time that passes from the date of trade
(when a transaction of some type is agreed upon) to the date of actual
exchange of cash for the security involved. With a spot trade, the exchange
of cash for the security involved is immediate. With a forward-dated trade
(which can include forwards, futures, and options), cash may not be
exchanged for the underlying security for a very long time. Therefore, a credit
risk consideration that uniquely arises with a forward trade is: Will the entity
promising to provide an investor with an underlying security in the future
still be around at that point in time to make good on the promise to pro-
vide it?1 This particular type of risk is commonly referred to as counterparty
risk, and it is considered to be a type of credit risk since the fundamental
question is whether the other side to a trade is going to be able to make good
on its financial representations.
When investors select the financial entity with which they will execute
their trades, they want to be aware of its credit standing and its credit rat-
ing (if available). Further, investors will insist on knowing when its coun-
terparty is merely serving as an intermediary on behalf of another financial
entity, especially when that other financial entity carries a higher credit risk.
Let us look at two examples: an exchange transaction (as with the New York
Stock Exchange) and an over-the-counter (OTC) (off-exchange) transaction.
For the exchange transaction example, consider the case of investors
wanting to go long a bond futures contract that expires in six months and
that trades on the Chicago Board of Trade (CBOT, an option exchange).
Instead of going directly to the CBOT, investors will typically make their pur-
chases through their broker (the financial entity that handles their trades).
If the investors intend to hold the futures contract to expiration and take
delivery (accept ownership) on the bonds underlying the contract, then they
are trusting that the CBOT will be in business in six monthsÔÇ™ time and that
they will receive bonds in exchange for their cash value. In this instance, the
counterparty risk is not with the investorsÔÇ™ broker, it is with the CBOT; the
broker was merely an intermediary between the investor and the CBOT.
Incidentally, the CBOT (as with most exchanges) carries a triple-A rating.
For the OTC transaction example, consider the case of investors want-
ing to engage in a six-month forward transaction for yen versus U.S. dol-
lars. Since forwards do not trade on exchanges (only futures do), the
investorsÔÇ™ counterparty is their broker or whomever the broker may decide
It is also of concern that respective counterparties will honor spot transactions.
Accordingly, when investors engage in market transactions of any kind, they want
to be sure they are dealing with reputable entities. Longer-dated transactions (like
forwards) simply tend to be of greater concern relative to spot transactions because
they represent commitments that may be more difficult to unwind (offset) over
time, and especially if a counterpartyÔÇ™s credit standing does not improve.
78 PRODUCTS, CASH FLOWS, AND CREDIT
to pass the trade along to if the broker is merely an intermediary. As of this
writing, the yen carries a credit rating of double A.2 If the broker (or another
entity used by the broker) carries a credit risk of something less than dou-
ble A, then the overall transaction is certainly not a double-A credit risk.
In sum, it is imperative for investors to understand not only the risks of
the products and cash flows they are buying and selling, but the credit risks
associated with each layer of their transactions: from the issuer, to the issuerÔÇ™s
product(s), to the entity that is ultimately responsible for delivering the prod-
Some larger investors (i.e., portfolio managers of large funds) engage in
a process referred to as netting (pairing off) counterparty risk exposures. For
example, just as an investor may have certain OTC forward-dated transac-
tions with a particular broker where she is looking to pay cash for securi-
ties (as with buying bonds forward) in six monthsÔÇ™ time, she also may have
certain OTC forward-dated transactions with the same broker where she is
looking to receive cash for securities (as with selling equities forward). What
is of interest is this: When all forward-dated transactions are placed side-
by-side, under a scenario of the broker going out of business the very next
day, would the overall situation be one where the investor would be left
owing the broker or the other way around? This pairing off (netting) of
trades with individual brokers (as well as across brokers) can provide use-
ful insights to the counterparty credit exposures that an investor may have.
As discussed in the previous section, just because an issuer might be rated
double B does not mean that certain types of its bonds might be rated higher
or lower than that, or that the shorter-maturity bonds of an issuer might
carry a credit rating that is higher relative to its longer-maturity securities.
The credit standing of a given security is reflected in its yield level, where
As of November 2002, the local currency rating on JapanÔÇ™s government bonds was
A2 and the foreign currency rating was Aa1. Please see the section entitled ÔÇťCredit:
Products, CurrenciesÔÇŁ later in this chapter for a further explanation.
riskier securities have a higher yield (wider yield spread to Treasuries) rela-
tive to less-risky securities. The higher yield (wider spread) reflects the risk
premium that investors demand to take on the additional credit risk of the
Bonds of issuers that have been upgraded or placed on positive watch
generally will see their yield spread3 narrow or, equivalently, their price
increase. And securities of issuers that have been downgraded or placed on
negative watch will generally see their yield spread widen or, equivalently,
their price decline.
ÔÇťYield spreadÔÇŁ is, quite simply, the difference between two yield levels
expressed in basis points. Typically a Treasury yield is used as the benchmark
for yield spread comparison exercises. Historically there are three reasons why
non-Treasury security yields are quoted relative to Treasury securities.
1. Treasuries traditionally have constituted one of the most liquid segments
of domestic bond markets. As such, they are thought to be pure in the
sense that they are not biased in price or yield terms by any scarcity con-
2. Treasuries traditionally have been viewed as credit-free securities (i.e.,
securities that are generally immune from the kind of credit shocks that
would result in an issuer being placed on watch or review or subject to
an immediate change in the current credit rating).
3. Perhaps very much related to the first two points, Treasuries typically
are perceived to be closely linked to any number of derivative products
that are, in turn, considered to be relatively liquid instruments; consider
that the existence and active use of Treasury futures, listed Treasury
options, OTC Treasury options, and the repo and forward markets all
collectively represent alternative venues for trafficking in a key market
When added on to a Treasury yieldÔÇ™s level, a credit spread represents the
incremental yield generated by being in a security that has less liquidity, more
credit sensitivity, and fewer liquid derivative venues relative to a Treasury
Why would an investor be interested in looking at a yield spread in the
first place? Simply put, a yield spread provides a measure of relative value
(a comparative indication of one securityÔÇ™s value in relation to another via
yield differences). A spread, by definition, is the difference between two
yields, and as such it provides an indication of how one yield is evolving rel-
ative to another. For the reasons cited earlier, a Treasury yield often is used
See Chapter 2 for another perspective on yield spread.
80 PRODUCTS, CASH FLOWS, AND CREDIT
as a benchmark yield in the calculation of yield spreads. However, this prac-
tice is perhaps most common in the United States, where Treasuries are plen-
tiful. Yet even in the United States there is the occasional debate of whether
another yield benchmark could be more appropriate, as with the yields of
federal agency securities. In Europe and Asia, it is a more common practice
to look at relative value on the basis of where a security can be swapped or,
equivalently, on the basis of its swap spread (the yield spread between a secu-
rityÔÇ™s yield and its yield in relation to a reference swap curve).
A swap spread is also the difference between two yield levels, but instead
of one of the yields consistently being a Treasury yield (as with a generic ref-
erence to a securityÔÇ™s credit spread or yield spread), in a swap spread one of
the benchmark yields is consistently Libor. A swap yield (or rate) is also
known as a Libor yield (rate).
As discussed in Chapter 2, Libor is an acronym for London Inter-bank
Offer Rate.4 Specifically, Libor is the rate at which banks will lend one
another U.S. dollars circulating outside of the U.S. marketplace. Dollars cir-
culating outside of the U.S. are called Eurodollars. Hence, a Eurodollar yield
(or equivalently, a Libor yield or a swap yield) is the yield at which banks
will borrow or lend U.S. dollars that circulate outside of the United States.
By the same token, a Euroyen yield is the rate at which banks will lend one
another yen outside of the Japanese market. Similarly, a Euribor rate is the
yield at which banks will lend one another euros outside of the European
Since Libor is viewed as a rate charged by banks to other banks, it is
seen as embodying the counterparty risk (the risk that an entity with whom
the investor is transacting is a reliable party to the trade) of a bank. Fair
enough. To take this a step further, U.S. banks at the moment are perceived
to collectively represent a double-A rating profile. Accordingly, since U.S.
Treasuries are perceived to represent a triple-A rating, we would expect the
yield spread of Libor minus Treasuries to be a positive value. Further, we
would expect this value to narrow as investors grow more comfortable with
the generic risk of U.S. banks and to widen when investors grow less com-
fortable with the generic risk of U.S. banks.
Swap markets (where swap transactions are made OTC) typically are
seen as being fairly liquid and accessible, so at least in this regard they can
take a run at Treasuries as being a meaningful relative value tool. This liq-
uidity is fueled not only by the willingness and ability of swap dealers (enti-
ties that actively engage in swap transactions for investors) to traffic in a
generic and standardized product type, but also by the ready access that
Libor has the word ÔÇťLondonÔÇŁ in it simply because the most liquid market in
Eurodollars (U.S. dollars outside of the U.S. market) typically has been in London.