Consulting Corner - Credit Focused

The Implied Expected Defaults of ABX 06-2
by Andrew Davidson

During the past three months, the price of ABX 06-2 BBB- has fallen from 100.5 to 98.3. While this may seem like a significant decrease in value, ABX may still be priced to a lifetime expected loss of under 4%, and does not appear to be priced to an expected loss above 5%.

Let’s unpack this statement.

ABX is an index based upon Credit Default Swaps on Sub Prime Mortgage securitizations. The index is composed of CDS on bonds at the rating categories AAA, AA, A, BBB and BBB- coming from 20 deals originated during the first half of 2006.

Credit default swaps (CDS) have cash flows that closely mimic the cash flows of the underlying bonds, with some exceptions. For example, CDS differ from cash bonds in terms of financing cost (CDS have financing built in) and in terms of the treatment of certain interest shortfalls.

To perform this analysis, we used the implied default methodology described in The Pipeline in March 2006.

Figure 1 shows the averaged price profile of the bonds making up the A, BBB and BBB- indices. From this figure we can see that the higher rated bonds can withstand a higher level of collateral loss before experiencing write-downs.

 

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