Houghton and Atkeson

   

A GAME OF RISK

More-mature companies issue debt, as the various rating agencies require an operating history and capital structure in order to rate the debt to be issued. While not every corporation that issues debt is quoted in the CDS market, every firm in the CDS market has issued debt and equity.

Debt issued by the U.S. government is considered to be the highest credit quality in the U.S. capital markets and is considered to be "risk free" when analyzing the probability of default at any given maturity.

All other debt that's issued is considered to be of less credit quality and trades at a higher yield than U.S. government debt. The lower the rating, the higher the yield.

In other words, the more perceived risk in owning a specific credit, the more the investor wants to be compensated. The difference between the yield of the U.S. Treasury for a specific maturity and the yield of an individual corporate bond for the same maturity is known as the "Spread off of Treasuries."

Individual corporate bonds don't always accurately reflect the correct "spread" because a specific bond might be illiquid and trade at a lower spread than would otherwise be the case.

QUALITY CONTROL

Prices in the CDS market are another way of looking at the credit quality of an individual issuer. More-risky credits trade at higher prices.

Credit-default swaps are considered a better indicator of the credit quality of an individual issuer because they are more liquid and not subject to the same constraints as individual corporate bonds.

Analyzing the historical relationship between the CDS spread of a company and its share price can give valuable information on how a move in one affects the price of the other.

Michael Shulman

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