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Credit Trading

Difficulty expert

Overview

Credit trading involves buying and selling debt instruments and credit derivatives to profit from changes in credit quality and spreads.

Credit Instruments

Bonds

Type Description Risk
Investment Grade BBB-/Baa3 and above Low-Medium
High Yield (Junk) Below investment grade High
Distressed Near or in default Very High
Convertible Bond + equity option Medium

Credit Derivatives

Instrument Description Use
CDS (Credit Default Swap) Insurance against default Hedge/speculate on credit
CDO (Collateralized Debt Obligation) Pooled credit risk Tranche exposure
TRS (Total Return Swap) Exchange total returns Synthetic exposure
CLN (Credit Linked Note) Bond + embedded CDS Credit exposure

Credit Spread

Credit Spread = Bond Yield - Risk-Free Rate

Compensates investor for:
- Default risk
- Liquidity risk
- Recovery uncertainty

where: Bond Yield YTM on the corporate (or sovereign) bond · Risk-Free Rate YTM on the matching-tenor Treasury. does: the premium investors demand for taking credit risk. Used as the headline credit-quality signal — widening spreads price in higher expected default; tightening spreads imply improving credit conditions. Core observable for credit-spread mean-reversion and capital-structure arb.

Credit Default Swaps (CDS)

Mechanics

Protection Buyer:
- Pays periodic premium (spread × notional)
- Receives payment if credit event occurs

Protection Seller:
- Receives premium payments
- Pays if credit event occurs

Credit Events:
- Bankruptcy
- Failure to pay
- Restructuring

CDS Pricing

CDS Spread ≈ (1 - Recovery Rate) × Default Probability

Upfront Payment = PV(Protection Leg) - PV(Premium Leg)

where: CDS Spread annual premium paid by protection buyer (bps) · Recovery Rate expected payout share if default occurs · Default Probability annualized default hazard · Upfront Payment settled today when running spread differs from contract coupon · PV(...) discounted present value. does: the first-order pricing identity for a vanilla CDS — spread reflects loss-given-default times default probability. Used to imply default probabilities from market spreads (and vice versa) and to back-solve recovery assumptions implicit in trading levels.

Credit Strategies

Spread Compression

Buy protection when spreads are tight
Sell protection when spreads are wide
Profit from mean reversion in credit spreads

Capital Structure Arbitrage

Long equity + Short bonds (or vice versa)
When equity and credit markets disagree on company value

Curve Trading

Same issuer, different maturities
Bull steepener: Short short-dated, long long-dated
Bear flattener: Long short-dated, short long-dated

Risk Factors

Risk Description Mitigation
Default Risk Issuer defaults Diversification, credit analysis
Spread Risk Spreads widen Hedging with CDS
Liquidity Risk Can't exit position Trade liquid names
Recovery Risk Unknown recovery amount Conservative recovery assumptions
Counterparty Risk CDS counterparty defaults Use clearinghouse

Practical Guidelines

  1. Credit Cycle Matters — Spreads widen in downturns
  2. Recovery Rates — Critical for pricing credit risk
  3. Liquidity Varies — IG liquid, HY less so
  4. Correlation Risk — Credits correlate in crises
  5. Documentation — ISDA agreements govern derivatives
  6. Rating Agencies — Don't blindly trust ratings
  7. Mark-to-Market — Credit positions can be hard to value

Next Steps