Credit Portfolio Management: Ch 5 Flashcards
Definition of Liquitidy
The cost of a roundtrip institutional-size transaction in a bond
- like a bid-ask spread type cost
Four uses of Liquidity Cost Score (LCS)
- Construction of liquid tracking portfolios
- Identify liquidity cost embedded in credit spreads
- Execution strategies
- Liquid credit benchmarks
Calculation of LCS
Acronyms: DTS, NQAdj, OAS, OASD, TES
- DTS: duration times spread
- NQAdj: non-quoted adjustment factor
- OAS: option adjusted spread
- OASD: option adjusted spread duration
- TES: trade efficiency score
Other Measures of Market Liquidty
- TED spread - short-term Eurodollar deposit rate minus Treasury bill rates
- VIX - volatility index
Pros and Cons of Using Trader Data in Calculation of LCS
- (+) Simultaneity
- (-) Bid-ask spread may not be the “market’s best” bid-ask spread
- (-) Potential that trader’s inventory could influence spreads
- (-) Trader messages only provide bid-ask indications
Bid-Ask Indication for an Actively Traded Bond and for a Seasoned Bond
- Bid-ask trader’s indication for actively traded bond is likely to be close to the bond’s market
- Bid-ask indication of a seasoned bond is considerably less wide than bid-ask market
- Trader willing to sell seasoned bond for less spread
- Seasoned bonds are less liquid than actively traded bonds
Trader-quoted vs non-quoted bonds
- Trader-quoted: bonds that have at least two bid-ask spread indications during a month
- Non-quoted: zero/one bid-ask spread indication during a month
On-the-run bond
Most recent issue of an issuer
Benchmark Bond
- A benchmark bond is a standard measure of a bond’s risk or return against which other bonds are measured.
- Benchmark bonds are typically on-the-run Treasuries, since these are considered the most highly rated and liquid debt.
- Similar to benchmarking stock performance against an equity index, a benchmark bond is used to measure the performance of fixed income investments or portfolio managers.
Adjustement Factor (AdjF)
Reflects how much higher transactions costs are for non-benchmarks bonds than benchmark bonds
Bid-ask Market for Non-Benchmark Trader-Quoted Bonds
AdjF * Bid-ask indication
Bond Attributes Significant for LCS
The lower the LCS, the higher the liquidity
- (-)
- Trading volume: the higher the volume, the lower the LCS
- Amount outstanding: the higher the amount outstanding, the lower the LCS
- (+)
- Age: usually seasoned bonds will have higher LCS than newly issued bonds
- DTS/OAS - bonds with large excess return volatility tend to have larger LCS
Summary of Bid-Ask Market Calculation
- Trader-Quoted Benchmark Bond -> Bid-ask market = Bid-ask indication
- Trade-Quoted Non-Benchmark Bond -> Bid-ask market = AdjF * Bid-ask indication
-
Non-Quoted Bond -> Bid-ask market = NQAdjF * Estimated Bid-ask indication
- NQAdjF is usually greater than 1, and will be closer to 1 for more recently quoted bonds
Trade Efficiency Scores
- TES = Trade Efficiency Scores
- Ranking from 1 (best) to 10 (worst)
- Notice that a lower score is better here, just like for LCS
- LCS will slightly increase over time (on average, all else equal)
- TES is meant to be a relative ranking that is more stable over time
- Purpose of TES - give each bond a monthly liquidity ranking so an investor can quickly determine a bond’s relative liquidity
- LCS tends to increase with duration
- TES combines both LCS and trading volume into a single score that reflect’s relative trade efficiency over time and across bonds
