If you don't understand credit & distressed debt, you don't understand markets.
Particularly today.
Like & comment if you want the excel.
6 topics, from simplest --> most complex:
*1) Bond math 101: Yields & prices*
Basic bond math attached.
Yield is the IRR of buying a bond at market, assuming no default.
Sensitivity shows yields vs. price & maturity
If yield rises, the price falls.
All things equal, longer maturities mean lower yields (if price is below par).
*2) Bond math 201: Yield to worst*
Many bonds have a “call feature.“
Meaning:
The borrower can pay the bond back before it's due.
To get out early, the borrower usually pays a premium.
E.g. they can repay at year 5 if they return 110% of par.
But this makes calculating yield complicated.
Will they exercise this call? Which date/price to use?
The bond market has a simple convention: “yield to worst.“
Which means: pick the the 'worst case scenario' to the lender.
In math: run the yield to maturity, run the yield to the first call.
And pick the lowest.
For sophisticated investors, the most accurate yield to refer to is the “yield to worst.“
*3) Treasuries & the yield curve*
US Treasury rates form the basis for all other debt.
Which is priced at this “risk free rate“ plus a spread for its credit risk.
In most markets, the yield curve slopes upward:
Long term rates exceed short rates.
But today we are in the less-common “inverted yield curve,“ which the market interprets as a bearish indicator.
Simplifying: the Fed is tighting, but the market expects it to ease and inflation to slow.
*4) Credit risk*
Credit risk is priced on top of Treasuries to calc the “correct“ yield of a bond.
The math is simple:
The probability the company doesn't pay back (“probability of default“) per year.
Multiplied by:
How much money you'll lose in that case (“loss given default“).
Average default rates by credit rating for the past 50 years in the attached.
*5) Distressed debt*
Recoveries in a bankruptcy are a function of the enterprise value of the company, and paying out that value creditors in order of their legal priority in a direct “waterfall.“
This is the theory, but the real world of distressed becomes messy as competing opinions on value, uncertainties in the relative priorities, competing creditor interests, and shifting business dynamics make that “distribution of value“ much more complex than a simple waterfall.
But that's also what makes it interesting.
*6) CDS markets*
CDS math attached.
Key is that CDS is the inverse of the bond math above, with no bond face value and therefore no risk free rate in the 'yield.'
CDOs/CLOs/CDX discussion for another time.
Many more nuances in each of these.
But it's a start.
As in every area, you need a strong grasp of the core principles.
Without that, you have no hope of matering the nuances.
That's all for now.
Like & comment if you want the excel.
Particularly today.
Like & comment if you want the excel.
6 topics, from simplest --> most complex:
*1) Bond math 101: Yields & prices*
Basic bond math attached.
Yield is the IRR of buying a bond at market, assuming no default.
Sensitivity shows yields vs. price & maturity
If yield rises, the price falls.
All things equal, longer maturities mean lower yields (if price is below par).
*2) Bond math 201: Yield to worst*
Many bonds have a “call feature.“
Meaning:
The borrower can pay the bond back before it's due.
To get out early, the borrower usually pays a premium.
E.g. they can repay at year 5 if they return 110% of par.
But this makes calculating yield complicated.
Will they exercise this call? Which date/price to use?
The bond market has a simple convention: “yield to worst.“
Which means: pick the the 'worst case scenario' to the lender.
In math: run the yield to maturity, run the yield to the first call.
And pick the lowest.
For sophisticated investors, the most accurate yield to refer to is the “yield to worst.“
*3) Treasuries & the yield curve*
US Treasury rates form the basis for all other debt.
Which is priced at this “risk free rate“ plus a spread for its credit risk.
In most markets, the yield curve slopes upward:
Long term rates exceed short rates.
But today we are in the less-common “inverted yield curve,“ which the market interprets as a bearish indicator.
Simplifying: the Fed is tighting, but the market expects it to ease and inflation to slow.
*4) Credit risk*
Credit risk is priced on top of Treasuries to calc the “correct“ yield of a bond.
The math is simple:
The probability the company doesn't pay back (“probability of default“) per year.
Multiplied by:
How much money you'll lose in that case (“loss given default“).
Average default rates by credit rating for the past 50 years in the attached.
*5) Distressed debt*
Recoveries in a bankruptcy are a function of the enterprise value of the company, and paying out that value creditors in order of their legal priority in a direct “waterfall.“
This is the theory, but the real world of distressed becomes messy as competing opinions on value, uncertainties in the relative priorities, competing creditor interests, and shifting business dynamics make that “distribution of value“ much more complex than a simple waterfall.
But that's also what makes it interesting.
*6) CDS markets*
CDS math attached.
Key is that CDS is the inverse of the bond math above, with no bond face value and therefore no risk free rate in the 'yield.'
CDOs/CLOs/CDX discussion for another time.
Many more nuances in each of these.
But it's a start.
As in every area, you need a strong grasp of the core principles.
Without that, you have no hope of matering the nuances.
That's all for now.
Like & comment if you want the excel.
