Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives

CHAPTER 12

How Much Should You Get Paid to Take Risk?

In this chapter, we look at trading strategies in the leveraged finance ■ market. Specifically, we describe the following four key risks and and consider ways to determine how much investors should be paid to take these risks:

• Single-name credit risk or compensation for exposure to a particular issuer.

• Curve risk or compensation for long/short contributions on the same issuer’s credit curve.

• Basis risk or compensation for long/short combinations expressed in the cash and synthetic markets.

• Capital structure risk or compensation for long/short combinations among different liabilities of the same issuer.

SINGLE-NAME CREDIT RISK

Single-name credit picking is a critical component of investing in the corporate market in general, and certainly in the leveraged finance space. In this regard, a deep understanding of company fundamentals is needed when making investment decisions, but not at the expense of a reference point by which to assess the relationship between company fundamentals and valuations.

In this section, we focus on evaluating a cash bond issued by Company N. Note that Company N had been covered by UBS credit analysts (coverage since dropped), and we draw upon work done by these analysts as it captures key considerations that investors may want to take into account when assessing single-name credit risk.

This company was initially recommended with a buy rating across the structure. The credit team highlighted ...