The credit spread curve. I: Fundamental concepts, fitting, par-adjusted spread, and expected return

TL;DR

This paper introduces a method for constructing credit spread curves using parametrized survival curves, addressing valuation issues and enabling analysis of bond and CDS relative value and dynamics over time.

Contribution

It proposes a novel approach to credit spread curve construction using survival curves, avoiding the shortcomings of Z-spread fitting and correcting academic misconceptions.

Findings

Provides a valuation formula for risky bonds

Enables calculation of carry, rolldown, and relative value

Facilitates historical analysis of curve movements

Abstract

The notion of a credit spread curve is fundamental in fixed income investing, but in practice it is not `given' and needs to be constructed from bond prices either for a particular issuer, or for a sector rating-by-rating. Rather than attempting to fit spreads -- and as we discuss here, the Z-spread is unsuitable -- we fit parametrised survival curves. By deriving a valuation formula for a risky bond, we explain and avoid the problem that bonds with a high dollar price trade at a higher yield or spread than those with low dollar price (at the same maturity point), even though they do not necessarily offer better value. In fact, a concise treatment of this effect is elusive, and much of the academic literature on risky bond pricing, including a well-known paper by Duffie and Singleton (1997), is fundamentally incorrect. We then proceed to show how to calculate carry, rolldown and relative value for bonds/CDS. Also, once curve construction has been programmed and automated we can run it historically and assess the way a curve has moved over time. This provides the necessary grounding for econometric and arbitrage-free models of curve dynamics, which will be pursued in later work, as well as assessing how the perceived relative value of a particular instrument varies over time.