Why is the probability of default rates of a bond considered a top-down approach and not a bottom-up approach? I mean a company can default for many reasons, one of them being that they can’t repay their debts because they are insolvent for internal financial reasons. So why is top-down?
Where did they say it was top down? Is it from mocks?
Now…… on the subject, Bonds in general have higher impact from systematic risk than the unsystematic ones. Precisely the reason the default correlation more so in stressed times is so prominent.
In valuations of bond, when backsolving for yield at transaction date, you do adjust for unsystematic portion as well.
So I don’t if it is right to call it affected by systematic factors alone. I mean, in equity, it might hold due to CAPM to some extent.
True. Any security will have fair share of Systematic and unsystematic risk. Bonds no exception. However, the concept is incomplete without the mentioning of quality of the securities.
FIIs and Sovereign funds mostly concentrate on high quality and low yield security and but natural will have lesser weight towards the non investment grade bonds. This being the case, the A category bonds are best analysed with the systematic factors of the sovereign ( and hence the macro factors) rather than bottom up analysis. They are rated A means they require much less unsystematic risk analysis.
Not so, when it comes to high yield low quality security. You Level III curriculum also mentions doing an equity like analysis to junk bonds. Bottom up that is.
But NIG or the Junk Bonds May only have 20% or less weightage in the FIIs portfolio this shifting the entire focus on macro analysis.
Another aspect of macro analysis is the likelihood of exhibiting downturn positive correlation especially in the developing markets and smaller economies. Such a scenario would render even the country specific A rated bonds behaving like the lower rated bonds.
Hope it is clear
1 Like