Fixed Income Analysis, Second Edition

CHAPTER 24

CREDIT DERIVATIVES IN BOND PORTFOLIO MANAGEMENT³⁶⁸

I . INTRODUCTION

Derivatives are financial instruments designed to efficiently transfer some form of risk between two parties. Derivatives can be classified based on the type of risk that is being transferred. In the fixed-income market, derivatives include interest rate derivatives which transfer interest rate risk and credit derivatives which transfer credit risk. With credit derivatives, a portfolio manager can either acquire or reduce credit risk exposure. Many managers have portfolios that are highly sensitive to changes in the spread between riskless and risky assets and credit derivatives are an efficient way to manage this exposure. Conversely, other managers may use credit derivatives to target specific exposures as a way to enhance portfolio returns. In each case, the ability to transfer credit risk and return provides a tool for portfolio managers to improve performance.

Credit derivatives can be classified as follows:

• total return swaps

• credit default products

• credit spread options

Credit derivative products used in structured credit products include synthetic collateralized debt obligations and credit-linked notes. In this chapter we will review each type of credit derivative describing their structure and how they can be used by portfolio managers. After reviewing credit derivatives, we will explain synthetic credit debt obligations.

We begin this chapter with a short discussion about the participants ...