The Journal of Fixed Income

An Esscher-based algorithm for computing default probabilities in structural Lévy models

Jean-Philippe Aguilar — 2025-01-14

Structural credit risk modeling is a commonly used risk-management approach for fixed-income, with Lévy models offering more realistic tail behavior than assumed in the classical Merton formulation. This paper presents an innovative Esscher-based algorithm for computing default probabilities in structural credit risk models driven by Lévy processes. The algorithm starts by matching the moments of observed equity values to infer model parameters. Using the cumulant generating function, it then computes the risk-neutral characteristic function and derives asset values through inversion of a Fourier option pricing formula. The physical parameters are updated by matching the moments of these asset values, iterating until convergence. As an illustration, the algorithm is applied to multiple issuers with various ratings, and to three Lévy models: Merton, Variance Gamma, and Bilateral Gamma. As expected, the Merton model consistently underestimates default probabilities for short maturities, while the Bilateral Gamma model provides more conservative estimates. The empirical analysis demonstrates the robustness of the algorithm across different market conditions, highlighting its ability to provide valuable insights for both academic research and practical risk management. This approach therefore offers a complimentary risk-modeling perspective to the traditional Merton framework. For reader's convenience, calibration code is made publicly available.

Is There Value Generation by Sustainability-Linked Bond Issuances?

Christian Pohl — 2025-01-14

Amid increasing capital needs to finance sustainable transitions and growing investor interest in generating sustainable impact with their investment decisions, several sustainable bond products have emerged. Besides the well-known green bonds, sustainability-linked bonds (SLBs) have gained recent popularity. To assist companies and investors in understanding the implications of issuing SLBs, this study analyses value generation, measured by stock market reactions, around their announcements and documents a positive wealth effect. However, abnormal positive stock price changes persist only for specific subgroups of companies that (i) have not already issued a use-of-proceeds bond and (ii) for companies with high environmental standards. Overall, the results suggest that SLB issuances are not universally value-generating, but benefit specific firms, only.

A Terminal Rate Approach to Dissecting Term Premia

Ken Nyholm — 2025-01-14

We parameterize the yield curve using four factors that capture the term structure of term premia and the risk-free expectations curve. By explicitly integrating a convergence point (terminal rate) for the short rate our model is uniquely positioned to provide more insightful reflections on the state of the economy, capturing investors' risk tolerance, and expectations regarding inflation, monetary policy shifts, and other macroeconomic factors. Its robustness and reliability is demonstrated by accurately replicating term premia from established models such as Joslin, Singleton and Zhu (JSZ.2011) (JSZ), Adrian, Crump, and Mönch (2013) (ACM), and Diebold and Li (2006) (DNS), while revealing that these models imply significant volatility in estimated real terminal rates over the past four decades. The Terminal Rate Model (TRM) that we propose aligns closely with the r* gauge (Holston, Laubach, and Williams 2017) pre-2008 recession, indicating its effectiveness in capturing economic developments. The comparative performance of the TRM against ACM, JSZ, and DNS models underscores its potential utility in forecasting and policy analysis, particularly in understanding the impact of significant economic shifts.

The Improvements in Global Bond Portfolio Risk Management and Performance by Hedging the Components of Total Risk with Derivatives

Frank J. Fabozzi — 2025-01-14

In this article, we provide an in-depth illustration of how to use derivatives for hedging foreign exchange (FX) risks in global bond portfolios. It focuses on a yield curve-based approach, using factor models to effectively decompose and manage both currency and interest-rate exposures. The central methodology illustrated is the analysis of yield curves to comprehensively assess and mitigate the FX risks embedded within global bond portfolios. Employing a seven-factor model, which incorporates FX carry, value, and momentum among other factors we illustrate how to explain portfolio returns and manage the associated currency risks. Considerable emphasis is placed on understanding the interplay between bond pricing, currency volatility, and the strategic use of FX options to mitigate risk. This approach described is crucial for portfolio managers seeking to optimize their management of multi-currency exposures, by aligning hedging strategies with the portfolio's base currency to improve both performance and risk control. The illustration clearly demonstrates the complexity of FX hedging and the critical role of integrated yield curve analysis in global investment strategies.

Climate Policy Performance Bonds

John Finnerty — 2025-01-14

This paper explains how the bond market can play an important role in furthering the transition to zero carbon emissions through the issuance of sovereign climate bonds whose interest rate is tied to government climate policy commitments. The bond rewards the issuer if it attains its commitments but penalizes it if its policies fall short. The paper describes three climate bond designs built on the TIPS structure. Two tie bond performance to climate transition risk, and the third ties it to physical risk. The paper explains how each bond can be priced, how investors can use them to hedge climate risk exposure, and how investors can use their market price to infer bond market investors’ assessments of the likely future path of carbon emissions or carbon prices. Firms could also issue these climate bonds.