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5.4.3 Building Proxies

What happens when we need to price a truly illiquid bond, a bond on whose issuing entity little information is known in terms of other bond prices, CDS rates, reference spreads, and so on? Here the same principles apply that hold true for any illiquid asset: we try to find a valuation through proxies.

Illiquid assets tend to be worth considerably less than liquid ones in the sense that an investor, if offered the option between two similar products, will choose the one that offers him the possibility of an easy subsequent sale. This is the reason why during a liquidity crisis there is a general tendency to write off assets, that is, to assume a loss. Let us stress here that this might not necessarily reflect the health of the issuer: we have seen that the price of a bond contains a correction driven by credit to the plain discounting of the cash flows. We have also said, however, that a bond price is just a number and many factors can drive it, liquidity being one of them.

A bond price can decrease because of a deteriorating credit standing but it also can decrease because nobody wants to buy it at that time. This implies then a deterioration of credit standing, which might not apply in the first place.[1]

It was rumored that traders at Credit Suisse were paid a bonus in 2008 in illiquid assets. If true, this was a clever move on many fronts. Having written the assets off the bank was giving away something that nominally was worth very little. On a public relations front, traders were made to stand behind their trades (crudely speaking, to put their money where their mouth was). As for the traders, if the problem was really a matter of liquidity, there was a large gain to be made. Imagine that a trader is expecting $1M as a bonus but the bank gives him instead $500,000 in the form of a bond trading at 25 (as a percentage of par). If the problem was only one of liquidity and the issuer honors its obligations then the trader at maturity will receive $2M plus the coupon payments throughout the life of the bond. The question here however is, how do we arrive at the value of 25?

In Section 5.4.1 we explored the concept of trading at recovery, something that, while valid for truly illiquid bonds, holds true in particular for distressed debt. We shall now consider the concept of proxy, which is probably less sophisticated in terms of finance and mathematics but more complex under an economical point of view.

As the name suggests, to build a proxy is to find market data that could apply to our illiquid assets because of similarities between the issuers. We shall explore here some of the possible proxies.

  • [1] Unfortunately for the issuer the two tend to feed off each other: If nobody wants to buy an issuer's bond it means that funding will be difficult, the financing of essential activities will be difficult, and this in turn will affect its credit standing. This is why there is an intense argument as to whether the financial crisis of 2007 to 2009 was principally a liquidity or a credit credit crisis: the two are often indistinguishable.
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