Until recently, many companies limited stochastic valuation of options and guarantees to interest rate risk and equity risk. In reality, credit risk is an important risk factor that has often been neglected. The volatility of credit spreads can be an important contributor of the cost of options and guarantees, particularly for products with guaranteed surrender values. In many countries, regulators used to look at this issue quite liberally, but this attitude has started to change, which has led to an increased focus on this risk.
In this episode of Critical Point, Milliman consultants Chris Harner and Michael Schmitz discuss mortgage credit risk and market trends in light of the COVID-19 pandemic. This episode is the first in a two-part series on credit risk. The next episode will look at the potential that cyberattacks may increase within the financial sector as a result of the pandemic.
To listen to other episodes of Critical Point, click here.
The market for credit risk transfer (CRT) transactions continues to grow and diversify, providing institutional investors with valuable options to consider as part of their investment portfolios. In this article, Milliman’s Jonathan Glowacki and Rehan Siddique, explain CRT bonds and provide a risk profile for them. The authors also discuss how CRT bonds offer investors diversification to corporate bonds, comparing the two securities.
Here is an excerpt from the article:
Institutional investors are large investors in the corporate bond space. CRT bonds could offer diversification to corporate bonds. The table in Figure 4 compares corporate bonds with CRT bonds:
Spreading the underlying exposures for CRT bonds across many geographic areas allows for a diversification of exposures (i.e., thousands of individual borrowers) as compared with corporate bonds, which is a single entity. In addition, for a portfolio of 1,000 corporate bonds, an investor might expect 50 to default, for a default rate of 5%. With CRT bonds, you may have an expected default rate of 5% weighted across all economic scenarios, but in most of the scenarios you would experience a 0% default rate.
In terms of performance, as of February 2017, most of CRT bonds have shown positive movement in their credit ratings since issuance with none showing an unfavorable movement.
The table in Figure 6 provides a comparison of the average initial spread with corporate option-adjusted spread (OAS) over the last five years as of May 31, 2017. We can see that, historically, CRT bonds tend to have higher comparable spreads than corporate bonds. As the market for CRT bonds continues to grow and interest rates continue to rise in the short term, we can expect similar trends in spread.
In a global practice focused on managing credit risk, Michael Schmitz uses Amy Wilkinson’s framework for fostering innovative thinking. Those skills include finding the gap, driving for daylight, flying the OODA loop, failing wisely, networking minds, and giving small gifts. This Actuarial Review article offers more perspective.
Required cookies help make a website usable by enabling basic functions like page navigation and access to secure areas of the website. The website cannot function properly without these cookies.
Analytics & Performance Cookies
Analytics cookies are used to collect information about how visitors use our site. The information gathered does not identify any individual visitor and is aggregated. It includes the number of visitors to our site, the sites that referred them to our site and the pages that they visited on our site. We use this information to help operate our site more efficiently, to gather broad demographic information and to monitor the level of activity on our site. Performance cookies are used to enhance the performance and functionality of our services but are non-essential to their use. However, without these cookies, certain functionality like videos may become unavailable.
These cookies are used when you share information using a social media sharing button or “like” button on our sites or you link your account or engage with our content on or through a social networking site such as Facebook, Twitter or Google+. The social network will record that you have done this. This information may be linked to targeting/ advertising activities.