Credit and Structured Products
What to know
Credit analysis prices expected loss: EL = PD × LGD, where LGD = 1 − recovery, and the spread also compensates for liquidity and risk premium. Distinguish nominal spread from option-adjusted spread (OAS strips out embedded option cost), and spread duration from effective duration. Compare instrument types: high yield bonds (fixed, unsecured, call features), bank loans (floating, secured, covenant-lite), direct lending (private, illiquid), and distressed debt (fulcrum security, loan-to-own). Structured products rely on tranching and subordination, overcollateralization and interest coverage tests, excess spread, and a defined waterfall. MBS add prepayment modeling (CPR, PSA, CDR) and negative convexity; ABS add asset-level collateral analysis. CDS provide single-name and index exposure and a basis trade versus cash bonds.
Traps
- Using nominal spread when embedded options materially affect value.
- Treating recovery rates as fixed - they vary by seniority, collateral, and cycle.
- Ignoring that faster prepayments shorten MBS duration in rallies, producing negative convexity.
- Describing CLO equity as safe: it is first-loss, leveraged residual.
Worked example
A BB-rated loan has PD 3% and recovery 60%, so LGD = 40% and EL = 1.2%. The loan yields 7.5% versus a 4.5% risk-free rate, a 300 bp spread that covers the 120 bp expected loss and leaves 180 bp for liquidity and risk premium. Rule: always compare spread to expected loss, never to zero - and check whether the spread compensates for the loss you actually bear.