Relative Value Methodologies for Bonds

Cyclical Change: Bond has higher return when more new bonds are issued due to more certainty of price

Secular Change:

Mainly the intermediate bullets dominates the market

1. Security with embedded options traded at premium due to scarcity
2. Less long durations products. Managers willing to pay premium for
3. Credit-derivative is increasing used

Liquidity: Bond Markets is moving towards increased liquidity due to innovation of trading and competition between portfolio managers

Rationales for trading in secondary bond markets:

1)    Yield/Spread Pickup Trade – swapping A-rated bonds for BBB bonds for large yield basis. But this does not include the potential yield narrowing in A-rated bond as measured in total return approach

2)    Credit upside trades – spot for upgradable bonds (occurs most between BB and BBB)

3)    Credit-defense trade: reduce exposure to sector expecting downgrade

4)    New Issue Swaps: New issues have higher liquidity so higher price

5)    Sector-rotation trade: switch from underperform sector to outperform sector

6)    Yield Curve Adjustment Trade – shift portfolio to match the expected yield curve change

7)    Structure Trade: swap the structures (callable, putable etc) at different yield, volatility and interest rate expectation

8)    Cash Flow reinvestment trade: Due to extra cash flow and no coincidence of bonds from primary market, need to trade in secondary market

If interest rate expected to rise, sell long duration bonds

If yield spread expected to be narrowed in a sector, buy long duration bonds in that sector

Rationales for Not Trading:

1. Trading constraints:
2. Story disagreement: Buy-side and Sell-side have different opinions
3. Buy-and-hold: reluctant to recognize lost or want to reduce turnover rate
4. Seasonality: managers are occupied in report writing at the end of quarters and years

Nominal Spread: just yield differences between the bond and treasury with the same maturity

Swap Spread: Difference between the fixed rate payer rate and treasury of the same maturity

OAS: with embedded option value removed. It is becoming smaller due to less embedded structures

Mean-reversion Analysis: Believe if too far away, the yield should revert to the historical mean (so buy when spread is high, using t-score to determine if significant)

Quality Spread Analysis: Buy low quality bonds if the spread between it and high quality ones is too large

Percentage Yield Spread Analysis: yield of bond/ yield of treasury

Callable Bonds:

1. When yield is much higher than the coupon rate, no differences between the callable and non-callable
2. When yield is smaller than the coupon rate:
1. Outperform non-callable when interest rise
2. Underperform non-callable when interest reduces

Putable Bonds:

1. Rare, difficult to evaluate
2. Credit risk from issuer should be the main focus

Sinking Fund:

Issuers have funds to retire portions of the bond

When discount at par, there is potential to rise because the firm has to purchase at par.

Does not fall as much as callable and putable bonds when interest raises

because the issuer has to retire a certain portion every year

Credit Analysis

1. Corporate Bonds – ability to pay
2. ABS – quality of servicer and collaterals
3. Municipal bonds – ability to collect tax
4. Foreign Bonds – ability (economic risk) and willingness (political risk) to pay