IBBC CAPITAL ACADEMY / 2027
Credit alpha must survive default and liquidity stress
Independent IBBC Capital draft content for self-study. Not affiliated with or endorsed by CFA Institute. New lessons await subject-matter review. No CFA designation or official PSM credit is awarded.
Learning goals
- Diagnose the case using the stated constraints and quantitative evidence.
- Defend a conditional decision and identify what further evidence could reverse it.
Draft · approximately 65 minutes, excluding further revision.
Decision case · fictional facts
A 20 m credit portfolio has spread duration 4. A recession scenario widens spreads 100 bp while benchmark yields are unchanged. An issuer offers 8% yield versus 3% risk-free; annual default probability is 3% and assumed recovery 40%.The portfolio may buy CDS protection but has limited margin liquidity.
Separate spread compensation from expected loss
Yield spread can compensate default, liquidity, options and risk premia; it is not all expected alpha. Z-spread assumes a static discount curve; option-adjusted spread removes modeled embedded-option value but depends on the model. Top-down credit views allocate cycle, sector and quality; bottom-up views analyze leverage, cash, claims and covenants.
Protect against correlated tails
Liquidity may disappear as downgrades and redemptions rise together. Stress correlated defaults, recovery reductions, spread widening and transaction haircuts. CDS can hedge or express spread views but introduces premium, counterparty, basis and contractual settlement risks. Buying protection is not a free hedge and does not necessarily match a cash bond exactly.
Use diversified tools with explicit assumptions
International credit adds legal, sovereign, currency and settlement differences. Structured credit redistributes cash-flow priority and loss through tranches; it is not simply an ordinary bond with a larger coupon. Analytical tools should disclose default, transition, correlation, prepayment and recovery assumptions as appropriate; review scenario output and data limitations before optimizing portfolio spread.
Issuer research connects cash to claim priority
Bottom-up credit work reconstructs sustainable operating cash, working-capital needs, maintenance investment and debt maturities. Read guarantees, structural subordination, security and covenants rather than relying on the coupon. Spreads should compensate downside after recovery and liquidity; an issuer with improving EBITDA can still lack debt-service cash.
Cycle positioning requires a portfolio view
A recession view may justify reducing cyclical sectors, lower quality or excessive spread duration, but prices may already reflect that scenario. Top-down credit strategy must compare the expected path with market pricing, diversify and define a loss budget. Avoid buying every cheap-looking bond in one economically correlated sector.
International credit risk is more than exchange rates
Foreign creditors face differences in insolvency priority, governing law, capital controls, settlement, tax and sovereign intervention. Local- and hard-currency bonds can have different risk and recovery. Hedge currency where consistent with mandate, but retain explicit country and legal limits because an FX hedge cannot enforce a creditor claim.
Structured credit allocates loss nonlinearly
ABS or CLO tranches redistribute collateral cash according to priority, triggers and credit enhancement. A senior tranche can be protected against initial losses but remains exposed to correlation, collateral deterioration, structural terms and liquidity. Model cash-flow waterfalls and tail scenarios rather than treating a rating as a substitute for collateral analysis.
Model output is conditional on transition and recovery
Credit tools may output expected loss, spread sensitivity, rating transitions, scenario losses or marginal risk contributions. Input quality matters: default probabilities, recovery, correlations, liquidity and option models can all change recommendations. Validate data and stress assumptions independently; optimizer precision does not make an estimated tail probability reliable.
Formula and assumptions
Spread loss≈spread duration×Δspread;expected loss≈PD×LGD
Compare with the model response after drafting
- First-order spread price loss≈4 × 1%=4%, or 800,000. Expected annual default loss≈3%× 60%=1.8%; the 5% yield spread is not a 5% default-free gain.
- Keep liquidity, diversify exposures and size protection against tail scenarios; model the cost and possible bond-CDS mismatch.
Errors to catch
- Interpreting a high yield as expected net return.
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