THE CHALLENGE OF MANAGING CREDIT SPREADS: NEW TOOLS ON THE HORIZON

Authors

  • Andrew Kalotay,

    1. is the founder of Andrew Kalotay and Associates, a New Yorkbased debt management advisory firm. Dr. Kalotay is also a member of the Fixed Income Analysts Society Hall of Fame. While at Salomon Brothers, he pioneered the concept of liability management as a formal discipline. Among his other innovations are the concept of call efficiency, the Ratchet bond, as well as the recently announced Standard & Poor's Credit Indices discussed here.
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  • Lesil Abreo,

    1. is a Senior Financial Analyst at Andrew Kalotay Associates.
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  • Michael Darigan

    1. is a Senior Associate at Andrew Kalotay Associates.
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Abstract

Broadly speaking, “credit spread” is the excess of a bond's yield over the appropriate Treasury rate that is necessary to compensate lenders for the perceived risk of default. In the primary market, credit spreads can significantly increase a corporation's borrowing cost. In the secondary market, the effect of fluctuating spreads is of material concern to investors and traders.

Credit spreads have exhibited considerable volatility in recent years, particularly during the fall of 1998. Although the absolute levels of spreads have ranged widely in recent years, from a few basis points to several hundred depending on rating category, their volatilities have been remarkably similar—about 25 to 39% on an annual basis. In spite of this high volatility, there are currently no cost-effective means of hedging credit spreads.

The recently announced S&P Credit Indices presage a leap forward in credit derivatives. Computed from the prices of selected liquid bonds, these indices can serve as a basis for exchange-traded futures contracts and options—tools that are in great demand for managing credit spread exposure.

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