Spread Primer

How CEC Works – The Theory Behind the Model

  1. Debt issued by the US Government is considered to be the highest credit quality in the US Capital Markets and considered “Risk Free” when analyzing probability of default at any given maturity.
  2. All other Debt issued is considered to be of less credit quality and trades at a higher yield than US Government.
  3. The lower the rating the higher the yield.  In other words, the more risk there is perceived in owning a specific credit, the more the investor wants to be compensated.
  4. The difference between the yield of the US Treasury for a specific maturity and the yield of and individual Corporate bond for the same maturity is known as the “Spread off of Treasuries”.
  5. Individual Corporate Bonds do not 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.
  6. Prices in the Credit Default Swap (CDS) market are another way of looking at the Credit Quality of an individual issuer. More risky Credits trade at higher prices.
  7. CDS 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.
  8. 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 effects the price of the other.
  9. The relationship between CDS Spread and Share price is different for each company and may vary over time.
  10. In a number of cases a dramatic increase in the CDS spread predates an equally dramatic decrease in the Share price of a specific credit.
  11. You should become familiar with these relationships for the stocks your customers trade.
  12. The CEC model can become a powerful tool in opening new accounts and strengthening existing relationships but only if it is used correctly. If you have any questions on this explanation or any of the terms or topics covered please ask.  Your wallet will be happy you did.

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