Demystifying credit risk measures

Many investors approach fixed income markets with a sense of trepidation as the concepts underlying them appear somewhat arcane. Partly this is due to the nature of fixed income investments and the more formalised dynamics and relationships which drive their returns. To demystify the fixed income markets what follows is a series of primers outlining the key concepts behind fixed income dynamics and portfolio management. The third instalment of this series shall have a closer look at the related concepts of Credit Spread Duration and Duration Times Spread as measures of credit risk.

Defining Credit Spread Duration

Credit spread duration ('CSD') is the sensitivity of the price of a security to changes in its credit spread. Where the credit spread is the difference between the yield on a security incorporating credit or default risk and the yield on a credit or default risk-free rate such as a cash interest rate or government bond yield. In many ways, the concept of CSD is the same as duration with the difference being the specific yield against which the price sensitivity is being measured. 

The approaches taken to calculating CSD are accordingly analogous to those applied to calculating either modified or effective duration. For this reason, the CSD of a traditional fixed-rate security, one without optionality, will be the same as its interest rate duration. For many investors the difference between interest rate and credit spread duration will be most notable when dealing with floating rate credit securities; i.e. securities where the coupon resets periodically to be in line with a particular shorter term reference interest rate. With such securities the interest rate duration will be in line with the frequency of interest rate resets, e.g. every 90 days or 0.25 yrs, while the credit spread duration will be more analogous to the securities term to maturity. 

This highlights the conceptual difference being where interest rate duration is measuring the sensitivity to changes in base interest rates the credit spread duration is measuring the sensitivity to changes in credit spreads. As with duration, CSDs (a) are additive so that the CSD of a portfolio of securities is simply the weighted average of the CSD of the individual securities and (b) can be quoted in terms of either years or as a percentage.

Interpreting Measures Credit Spread Risk

At a literal level, the CSD of a security measures the sensitivity of a security, or portfolio, to a change in the credit spread associated with that security. The relationship, as with duration, is a negative one with rising credit spreads reducing the value of the security.

∆ Value _Security ≈ - CSD _Security * ∆ Credit Spread _Security

Duration and CSD are accordingly complimentary in that they measure the sensitivity of the value of a security to changes in different components of a security’s total yield; i.e. separate sensitivity to underlying interest rates and credit spreads.

CSD as a stand-alone measure of risk is useful but more importantly, it becomes a key input when determining the level of total credit risk within a security or portfolio of securities. This arises from the reference rate, against which credit spreads are calculated, typically being viewed as risk-free from a default risk perspective. The credit spread accordingly becomes a measure of the default risk associated with a particular security. To capture the total risk of a security the CSD and credit spread are often combined into a measure referred to as Duration Times Spread (‘DTS’). This is a standard method for measuring the total credit risk of a security which incorporates exposure to spread duration. The DTS is calculated by multiplying the CSD and credit spread together and provides a simple measure by which to compare the total credit risk associated with different securities and portfolios.

What Factors Impact the Duration Times Spread of a Security?

There are a range of factors that will impact on the DTS associated with a security.

Firstly, the CSD will directly impact on the total risks associated with a security. The higher the CSD of a security the higher the associated credit risk. This follows intuitively as the longer the term of a loan the greater the risk that the creditworthiness of the issuer may be adversely impacted by changing economic/financial conditions. Likewise, it follows that as a security is held over time and moves closer to maturity, term to maturity of a security decays, the risk associated with that security declines.

Secondly, the underlying credit risk of the issuer of the security will determine the credit spread and changes in the credit spread. The level of credit risk is typically captured by the credit rating of the issuer. The lower the credit rating of the issuer the greater the level of credit risk and the higher the credit spread required by investors. Over time as the credit rating of an issuer changes so will the credit spread required by investors.

Thirdly, overall market pricing of credit risk. Credit spreads demanded by investors will change over time in response to the market’s appetite for credit risk. A range of factors may impact on the tolerance of market participants to assume credit risk. In general, the market’s level of risk aversion is often linked to the economic/financial cycle. At a high level, as an economy goes into an economic or financial ‘downturn’, investors will demand a higher credit spread to compensate for the heightened risk that issuers may not be able to honour the payment obligations associated with the securities issued. Such periods also tend to be associated with a higher risk of credit ratings downgrades. The result is that there is a tendency towards a relatively high level of synchronisation between the market pricing of credit risk and the economic/financial cycle.

Pitfalls with Duration Times Spread as a Measure of Credit Risk

It is the linkage to non-default risk factors and their impact on credit spreads which results in one of the major limitations with the use of DTS as a hard risk target. The key limitation arises as the measure assumes that credit spreads are an accurate measure of underlying default risk. Effectively DTS implies that the higher the overall credit spread the higher the level of default risk within a security or portfolio. Though such an assumption may hold at any point in time when undertaking a cross sectional comparison, it can become a more problematic assumption when applied as a risk measure over time. The limitation arises when applied over time as changes in credit spreads can be driven by other non-default risk related factors such as (a) overall market risk aversion, (b) liquidity conditions/liquidity premiums, (c) issuance/supply dynamics, (d) level of interest rates and (d) direct intervention by central banks and other authorities. Many of these factors can be viewed as transitory and unrelated to the underlying creditworthiness of the issuer.

It is the impact on credit spreads of non-default related factors which can create adverse impacts on portfolio management decisions if inappropriately applied. To take an extreme example assume that an investor is managing a portfolio to maintain a particular level of credit risk as measured by the DTS score. As credit spreads move out the investor will offset the increase in DTS by reducing the exposure to credit and, conversely, as credit spreads decrease they will seek to offset the decline in DTS by adding to credit exposures. 

Effectively the investor will be buying high (low credit spreads) and selling low (high credit spreads). Unless default risk is the only risk factor driving the movement in credit spreads the investor is forcing themselves to undertake loss making investment decisions based upon transitory factors. This highlights how care and flexibility must be applied when utilising DTS as a measure of credit risk to ensure that it is being suitably interpreted and utilised. Importantly, when considering changes in DTS investors need to take account of the environment to appropriately interpret portfolio risk factors.

Credit spread duration and duration times spread are two of the cornerstone risk measures utilised within securities and fixed income portfolios. Understanding how to interpret each measure is accordingly one of the key aspects of appreciating the different aspects associated with managing the risk within a fixed income portfolio. Importantly investors need to recognise the limitations of measures which incorporate credit spreads as inputs when managing the credit risk within portfolios. Failure to do so can result in investors making the wrong decisions which may adversely impact on the returns generated by their portfolios over time.