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Fixed Income (Credit) fair value models in the literature tend to be variations on cross-sectional regressions. For a recent example in a factor-model setting, see here.

My understanding is that this kind of model is not considered state-of-the-art by many buy-side firms, but it is very hard to find literature on these.

I'm familiar with three (broad) additional classes of models:

  1. Stochastic pricing models with two factors, one for the call option, as a function of interest rates (calibrated to swaptions, for example), and one for the "default-option", where credit-quality is a proxy for how out-of-the-money the option is (calibrated to something like a transition matrix based on historical-defaults).
  2. A structural model based on a Merton-type framework.
  3. A combination of the two: for example parametrizing the default space in terms of distance-to-default.

Which relative value models are considered world-class? Are there any good references in this space? What "works"?

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Not a complete answer, but some thoughts below -

First you need to bifurcate the names into two categories - (1) Traded Credit, (2) Illiquid credit.

For Traded credit underliers, fairly reliable market quotes are available for CDS and bonds. These can be used to back out a credit curve, and then you could go with the approach 2 ("Structural Model based on Merton-type framework").

For "illiquid credit", a fundamental / firm valuation analysis is done given the financial statements of the underlier. This approach yields approximate results and is far less reliable than the one described above for "traded credit" underliers.

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  • $\begingroup$ Thanks for the thoughts. Do you have any good references, whether books, articles, white papers or even blog posts, about the approach you've seen work? Are you aware of other approaches, or the virtue of the structural approach vs other approaches? A lot of this knowledge is diffused through the industry, it would be nice to get more transparency about the nature of this problem. $\endgroup$
    – quant_zero
    Jul 24, 2019 at 16:30
  • $\begingroup$ I'm on the sell-side; so less informative about the motivations and approaches preferred on the buy side (indeed, I can only make a guess, what may make sense for the buy-side). For the banks, the issue is to be competitive (against other banks) when making a quote and to be able to mark an "exit price" for the holdings on the book. Marking "traded credit" is easier; we try to limit the inventory of illiquid names and try to keep them moving out of our books as soon as possible. $\endgroup$
    – bhutes
    Jul 25, 2019 at 6:43

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