Uncommon Investments: How To Isolate A Bond's Credit Risk

by: Matthew Allbee

Summary

While many bond investors choose common strategies based around the income that bonds generate, there are a number of other ways for the investor to profit from their bond expertise.

One of the more common "exotic" strategies is to isolate a certain type of risk that the investor feels more comfortable predicting than they do the bond's overall performance.

I will lay out a simple instance of these strategies: isolating the credit risk of a non-callable U.S. company bond.

While many investors stick to simple, fixed-income investing with bonds, these securities actually carry many interesting qualities that make them suitable for a variety of strategies - from those with almost no risk to more risky than betting on a beanie baby resurgence.

The strategy I will lay out in this article is somewhere in the middle; certainly more risky than simply holding bonds for the cash payments. The actual level of risk in this and basically any strategy that involves holding bonds for less than their maturity is closely related to the bond's duration, a measurement of how sensitive a bond will be to a change in interest rates.

A bond's duration, technically is an estimate of the change in the bond's price for a change in the yield on the bond. It measures how much of a price swing to expect if the market decides a bond's yield should change. Because the yield is largely a function of the riskiness of holding the bond, it will fluctuate in relation to a change in the risks.

If we can isolate out just one of these risks by hedging away the others we will only need to successfully how this one type of risk will play out, often a much simpler task than predicting how all of a bond's risks will intermingle.

For investors most familiar with analyzing companies based on their fundamental merits, learning to assess a company's credit health will probably be the easiest of the different bond risks to figure out. Luckily, this is a fairly easy risk to isolate.

How to Isolate Credit Risk

Bonds have two major risks that separate them from other types of investments, credit risk and interest rate risk. By hedging away the interest rate risk, we will have an investment that almost exclusively tracks the market-percieved credit health of the issuer.

The simplest way to hedge against a certain characteristic is to short a related security that, as exclusively as possible, is only affected by the type of risk we are hedging away.

A natural selection in this instance would be U.S. Treasuries. Because Treasuries are thought to carry virtually zero risk of default, They can serve as a very pure interest rate play, exactly what we're looking for.

Not all Treasuries are created equal, though. To be sure that you are hedging away all interest rate risk by shorting Treasuries, rather than only some or possibly even speculating that rates will fall, you will need to match the interest rate sensitivity of your Treasury hedge to the volatility of the bond.

A good estimate under most conditions can be achieved by comparing the duration of the bond in relation to the Treasuries' duration. The closer the duration, the more hedged you will be.

Finding the duration for a bond should be extremely simple, many bond brokers list them right alongside the yield. If you can find a treasury with a similar duration, congratulations because that's all the info you need to.

Especially in the current bond market, there's a fair chance that there will be no Treasuries with close enough duration to your bond. You can use the following formula to find a basket of Treasuries which have the same duration as your bond.

Click to enlarge

Source

Where:

t = the current payment period

r = the current yield of the bond

C = the interest, or coupon, payment that they bond makes during each payment period

n = the total number of payment periods before the bond matures

M = the amount that the bond will pay at maturity

Plugging this into excel or equivalent, you can fiddle with the weights of whatever Treasuries you'd like to short until you find a duration that matches the bond's.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.