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vice-versa) in an efficacious way. As stated, two clear differences between a
bond and an equity are the senior standing embedded within the former in
the event of a default and the fact that holders of equity truly own some
portion of the underlying company.
Just as there are varying classifications of bonds in the context of credit
risk (as with senior versus junior classes of bonds), the same is true of equi-
ties. Inevitably, with the evolution of several different layers of bond and
equity types in the market, there emerges a gray area between where one
type ends and another begins. While the philosophical aspect of this phe-
nomenon is of interest, there are some rather practical considerations for
portfolio managers. For example, fund managers in charge of bond funds
will want to have defensible reasons for including products that some cus-
tomers might believe are more equity related. A sensible rationale may be
all that customers require to be assured that their money is being invested
as advertised. To begin to put a sharper point to this discussion, let us take
a specific product example.


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97
Credit



A perpetual bond is a security that has no specified maturity date (like
an equity). However, like a bond, a perpetual pays coupons,6 has a final
maturity value of par (whenever that final maturity may actually come), does
not convey any voting rights, and in many cases is callable (may be retired
at the discretion of the issuer). Therefore, by what criteria ought we decide
that this (or any other hybrid type product) is a bond or equity? By voting
rights? Maturity? How it is taxed? If it comes with the bells and whistles
more commonly associated with an equity or bond (as with a callable fea-
ture)? If it pays a coupon as opposed to a dividend? If its price volatility is
more like a longer-maturity bond than an equity? How far it is removed from
a senior status in event of default? If it trades on an exchange (like most equi-
ties) as opposed to over-the-counter (like most bonds)? Parenthetically, at
least in the experience of this author, perpetuals tend to be considered by
most larger investment firms as more bondlike than equitylike, even though
certain fixed income investors are prohibited from purchasing them due to
in-house restrictions against equity purchases.
Meanwhile, other products variously referred to as equity or bonds
(depending on one™s particular perspective as issuer or investor or rating
agency) include preferred stock and convertibles. Table 3.4 provides a high-
level overview of various points of distinction that might be used for equi-
ties and bonds. Rather than trying to convince anyone that an equity or bond
should always be seen by one and only one set of criteria, the aim here is to
highlight the considerations to evaluate when attempting to make a case for
a product that falls in between a pure equity and a pure bond. The ultimate
categorization of equities, or bonds, or any other product types is best
accomplished on the basis of a thoughtful review of the facts and circum-
stances. Markets evolve much too quickly and with too many innovations
to continue to rely on historical methods that can be expected, out of fair-
ness, only to provide answers of most relevance to a time that has passed.


CREDIT DERIVATIVES
Generally speaking, the development and use of innovative credit-linked
instruments has been the purview of the fixed income arena. The bond mar-
ket has long been devoted to the special considerations involved with seg-
menting and redistributing cash flows and applying this framework to
credit represents both a natural and logical progression. The following sec-
tion provides an overview of fixed income credit derivatives.


6
Coupons of perpetuals generally are paid quarterly, and usually are linked to a
level of some predetermined maturity of Libor plus or minus a yield spread (as
with three-month Libor plus 25 basis points).



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98 PRODUCTS, CASH FLOWS, AND CREDIT



TABLE 3.4 Similarities and Differences between Equities and Bonds
Common Equity Bonds


Voting rights

Maturity dates and values (par)
Taxation
Price Capital gains* Capital gains
Income+
Dividends
Coupons Income

Covenants

Bells and whistles

Coupons

Dividends
√ √
Yields
Price volatility Generally higher Generally lower
than bonds than equities
Default status Low High

Exchange traded

OTC
*A distinction exists between short- and long-term capital gains, with the latter
being a lower rate.
+
With dividends and coupons treated as income, the tax paid is dependent on the
tax bracket of the investor.


Unlike a formula to derive the exact price of something like a Treasury
bill, no such credit risk calculation tells us precisely how a security™s price
will evolve over time in response to credit-related phenomena. However, as
a result of having collected decades™ worth of credit-related statistics,
Moody™s and Standard & Poor™s have assembled an impressive amount of
statistical data that can be used as meaningful guidelines when assessing
credit-related risks and opportunities. These statistics may be of value not
only when evaluating investment exposures to particular issuers, but also
when evaluating counterparties. Two other methods by which credit risk can
be quantified are also presented: guidelines published by the Bank of
International Settlements and the use of option pricing methods.
Table 3.5 provides just one of many statistical guides available with the
benefit of Moody™s and Standard & Poors™ vast statistical data. It presents
a perspective of default rates. As shown, the risk of default clearly increases
as investors dip into lower-rated credits, and this is precisely as is to be
expected. Beginning at less than 1 percent for both Moody™s and S&P for
triple-A securities under a five-year horizon, double digits are approached
at Ba3/double-B minus, and values near 30 percent are reached at B3/B .
Table 3.6 depicts historical drift experiences. “Drift” refers to the fact that
ratings can edge higher or lower from year to year. As shown, a company that


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99
Credit




TABLE 3.5 Default Rates at 1- and 5-Year Horizons by Agency (%)




[Table not available in this electronic edition.]




begins a year with a triple-A rating has an 85.44 percent likelihood of remain-
ing a triple-A firm at the end of a year. Conversely, a single-B rated company
has a 76.12 percent chance of remaining a single-B rated company. Further,
while a triple-A rated company shows a zero percent chance of going into
default over a year, a C-rated company has a 25.16 percent chance of default.
While it may not be terribly surprising to learn that a triple-A rated company
has an extremely low probability of defaulting over a year, Moody™s data allow
for the assignment of specific probabilities to credit-related events. While this
may be valuable for getting an idea for how a portfolio of credits might behave
over time, there are most certainly limitations to such data. For example, the
data have been collected over strong and weak economic environments. All
else being equal, more favorable drift statistics are expected for periods of eco-
nomic strength than times of economic weakness. Nonetheless, generally
speaking, the statistics provide a meaningful set of historical guidelines to help
shape investment decision making. Such guidelines can be particularly useful
with valuing complex credit derivatives.


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100 PRODUCTS, CASH FLOWS, AND CREDIT



TABLE 3.6 Moody™s One-Year Transition Matrices
Corporate Average One-Year Rating Transition Matrix, 1980“1998
Rating to (%)

Initial
Rating Aaa Aa A Baa Ba B Caa”C Default WR*

Aaa 85.44 9.92 0.98 0.00 0.03 0.00 0.00 0.00 3.63
Aa 1.04 85.52 9.21 0.33 0.14 0.14 0.00 0.03 3.59
A 0.06 2.76 86.57 5.68 0.71 0.17 0.01 0.01 4.03
Baa 0.05 0.32 6.68 80.55 5.72 0.95 0.08 0.15 5.49
Ba 0.03 0.07 0.51 5.20 76.51 7.40 0.49 1.34 8.46
B 0.01 0.04 0.16 0.60 6.07 76.12 2.54 6.50 7.96
Caa”C 0.00 0.00 0.66 1.05 3.05 6.11 62.97 25.16 0.00
* WR: Withdrawn rating.
Source: Moody™s Investor™s Service, January 1999, “Historical Default Rates of
Corporate Bond Issuers, 1920“1998.”




Credit
Cash flows
Forwards & futures,
Options
Bonds




A credit derivative is simply a forward, future, or option that trades to an
underlying spot credit-sensitive instrument or variable. For example, if
investors purchase a 10-year bond of the XYZ corporation and the bond is
rated single-A, they can purchase a credit spread option on the security such
that their credit risk exposure is mitigated in the event of a deterioration in
XYZ™s credit standing”at least to the extent that this credit weakness trans-
lates into a widening credit spread. The pricing of a credit spread option
certainly takes into consideration the kind of drift and default data presented,
as would presumably any nonderivative credit-sensitive instrument (like a
credit-sensitive bond). However, drift and default tables represent an aggre-
gation of data at a very high level. Accordingly, the data are an amalgamation
of statistics accumulated over several economic cycles, with no segmentation
by industry-type, maturity of industry-type, or the average age of companies
within an industry category. Thus, by slicing out these various profiles, a more



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Credit



meaningful picture may emerge pertaining to how a credit (or portfolio of
credits) may evolve over time.
In addition to the simple case of buying or selling a credit spread put or
call option on specific underlying bonds, credit derivatives, that account for
a rather small percentage of the overall credit derivatives market, there are
other types of credit derivative transactions. Any non-spot vehicle that can
effectively absorb or transfer all or a portion of a security™s (or portfolio™s)
credit risk can be appropriately labeled a credit derivative instrument.
Consider the case of a credit-linked note.
A credit-linked note is a fixed income security with an embedded credit
derivative. Simply put, if the reference credit defaults or goes into bank-
ruptcy, the investor will not receive par at maturity but will receive an
amount equivalent to the relevant recovery rate. In exchange for taking on
this added risk, the investor is compensated by virtue of the credit-linked
note having a higher coupon relative to a bond without the embedded deriv-
ative. Figure 3.5 shows how a credit-linked note can be created.
A credit-linked note is an example of a credit absorbing vehicle, and an
investor in this product accepts exposure to any adverse move in credit stand-
ing. As a result of taking on this added risk, the investor is paid a higher
coupon relative to what would be offered on a comparable security profile
without the embedded credit risk.
In addition to these issuer-specific types of credit derivative products,
other credit derivatives are broader in scope and have important implica-
tions for product correlations and market liquidity. For example, a simple
interest rate swap can be thought of as a credit derivative vehicle. With an
interest rate swap, an investor typically provides one type of cash flow in
exchange for receiving some other type of cash flow. A common swap
involves an investor exchanging a cash flow every six months that™s linked

Total return on
reference pool
Libor + spread
Libor + spread
Investors SPV Sponsoring entity &
reference pool
Note proceeds


Libor
Note proceeds



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