Fixed Asset

CFA Level III Fixed Income
#1

Hello,

Please help me to understand Spread Risk associated with managing a portfolio against a liability structure.

Thank you

#2

I believe that you mean Fixed Income, not Fixed Asset(s).

What, exactly, do you want to know? What do you know already?

#3

What I know is that there are different types of risks associated with LDI strategies.
Credit risk, liquidity risk, Model risk, market risk and spread risk.

Spread risk in LDI strategies arises because it is common to assume equal changes in asset, liability, and hedging instrument yields when calculating the number of futures contracts, or the notional principal on an interest rate swap, to attain a particular hedging ratio.

I am not able to understand this part

  1. The assets and liabilities are often on corporate securities, however, and their spreads to benchmark yields can vary over time.

  2. The liabilities are estimated—that is, calculation of the PBO—using high-quality corporate bonds. The typically wider spreads of lower-quality bonds may underperform the spreads of higher-quality bonds in a market sell-off. Conversely, hedging the liabilities with swaps may not provide enough of a spread risk hedge relative to using corporate bonds such that if spreads tighten, high-quality corporate bonds (used to discount liabilities) may outperform swaps. Model risk refers to making incorrect assumptions regarding future liabilities or approximations being inaccurate. Liquidity risk is associated with exhausting available collateral funds to meet margin calls on derivative positions or to pay benefits.

#4

Point #1 seems straightforward: if spreads change, then the market value of assets and the present value of liabilities will change, which could lead to a mismatch.

Point #2 is simply that the discount rate on liabilities is generally based on the yield on high-quality corporate bonds, whereas the assets may have bonds that are not high-quality corporate bonds (i.e., government bonds, or lower quality corporates). Therefore, their spreads may change by different amounts. If you hedge based on the assumption that the spread changes will be equal, your hedge will likely not work as intended.

Note that there are spread derivatives, so more sophisticated hedging approaches may have the desired effect.

#5

I don’t know if I am still able to sink or not.

I read your explanation though correct, but I am not able to fill the gap I am looking to

The assets and liabilities are often on corporate securities mean the portfolio contains these securities?
spreads to benchmark yields can vary over time means the rate by which they are discounted?

#6

The assets are often corporate bonds.

The liabilities generally aren’t corporate bonds. They’re pension obligations, for example.

Yes.

#7

thank you, now I can connect.

#8

My pleasure.