Corporate Bond and CDS

Posted: Jun. 29, 2017 -

This blog demonstrates some properties from our fixed income asset classes. Specifically we will show how Everysk can capture intricate correlation effects between a corporate bond and a credit default swap.

First, let's build a portfolio in Dashboards containing $1M face of a hypothetical 5 year bond issued by Chesapeake and a hypothetical 5 year CDS.

Security Quantity
CORP:CHK 20220628 6.77 100 $1,000,000
CDS:CHK 20220628 P5 $1,000,000

The corporate bond above matures on june 2022, has a 6.77% coupon and is priced at par. The CDS has the same maturity and buyer of credit protection pays 500 basis points annually. See all supported symbology here.

By stress testing this portfolio against a credit index, such as the Merrill Lynch US Corporate Bond BB Total Return Index, we get the following expected PL (for a 2% drop, which is in the range of weekly movements that this index can experience):

Portfolio CDS Bond
Expected Value (EV) 0.06% 0.76% -0.70%

We can see that the risk of the portfolio is largely hedged.

A more interesting stress test that captures some correlated effects is to shock the SP500. Below, we include a dynamic visualization whereby SP is being shocked from -1.2% (leftmost grey bar) to +1.2% (rightmost grey bar). This range is automatically calculated by Everysk and reflects the expected range of SP moves in a week:

The leftmost bar is highlighted to show it is the "active" bar. Move your mouse over the bar and you will be able to see the expected PL for the portfolio in that scenario, 0.22%. We also show low probability, high impact positive profit and loss (PL) of +1.09% and negative of -0.67%. These extreme PLs, specially the negative one, are generally called Conditional Value at Risk (CVaR) or expected shortfall. Then move the mouse over the 2 securities on the right: in a scenario of SP falling 1.2%, the corporate bond tends to lose money and the CDS tends to make. The contributions from each security to the overall portfolio properties are shown when you move the mouse over the securities. The summary is provided below:

Portfolio CDS Bond
CVaR+ 1.09% 0.76% 0.33%
EV 0.22% 0.47% -0.25%
CVaR- -0.67% 0.05% -0.72%

To visualize what happens when SP is up, just unselect the leftmost bar by clicking on it and then click on the rightmost bar. As you move your mouse over the other scenarios, you will realize that the right visualization changes accordingly. The summary for a +1.2% SP shock:

Portfolio CDS Bond
CVaR+ 0.68% -0.49% 1.16%
EV -0.21% -0.66% 0.45%
CVaR- -1.15% -0.90% -0.25%

So why is that the the CDS is expected to make more money (+0.47%) when the markets drops than the corporate bond is expected to lose (-0.25%), if the payer CDS is an exact short of the bond?

The main reason for this (expected) behavior is that corporate bonds have a credit spread risk factor that is positively correlated to the markets and an interest rate risk factor that is negatively correlated with the markets. When the markets are falling, the rate sensitivity helps immunize some of the pain, which is not present in the CDS. Therefore the CDS is expected to make more money. Conversely, when the markets are up the reverse happens: CDS is expected to lose more money (-0.66%) than the bond makes (+0.45%).

We can easily eliminate the interest rate effect described above by adding a payer swap to the portfolio:

Security Quantity
CORP:CHK 20220628 6.77 100 $1,000,000
CDS:CHK 20220628 P5 $1,000,000
SWAP:US 20220628 P1.77 $1,000,000

The resulting behavior for SP500 shocks would be:

We have largely eliminated the behavior (note small value for grey bars).

Capturing these correlated effects via visualizations can be a powerful metaphor to engage an existing and/or prospective client. You can find some code that replicates these results using our PortEngine API here. Check the symbology of fixed income securities here.