SS9 - Relative-Value Methodologies for Global Credit Bond Portfolio Management

Question 1

What is relative-value analysis?

Answer 1

In relative-value analysis, assets are compared along readily identifiable characteristics and value measures.

Examples:

sector, issuer, duration, structure

Question 2

What are the two methodologies of relative-value analysis?

Answer 2

1. Top-down approach: manager uses economy-wide projections for asset allocation to different countries and currencies. Then, individual industries or sectors, and then individual issues in those sectors.
2. Bottoms-up approach: manager starts by selecting undervalued individual issues.

Question 3

What are cyclical changes?

Answer 3

Cyclical changes involve looking at supply and demand of bonds to understand their impact on bond prices.

Counterintuitively, increases in new bonds are sometimes associated wtih narrower spreads and releatively strong returns.

Also counterintuitively, corporate bond retuns sometimes decline when supply falls unexpectedely. The explanation is the loss of validation for the prices of existing bonds.

Question 4

What are secular changes?

Answer 4

Secular changes are changes in the popularity of different sectors and attributes of the bond market.

Sectors: treasuries, corporates, soverigns, etc.

Attributes: puttable/callable, short vs long term, bullet vs non bullet.

Question 5

What are the three implications associated with existing bond product structures?

Answer 5

1. Securities with embedded options may trade at premiums due to their scarcity value.
2. Credit managers seeking longer durations will pay a premium price for longer duration securities because of the tendency to move toward intermediate maturities.
3. Credit-based derivatices will be increasingly used to take advantage of return andor diversification benefits across sectors, maturities, structures, etc.

Question 6

What is the relationship between liquidity and bond prices?

Answer 6

As one would expect, investors are willing to pay a premium for more liquid issues.

The overall trend in the debt markets has been toward increased liquidity.

Question 7

What are the common rationales for trading in the secondary market?

Answer 7

1. Yield/spread pickup trades.
2. Credit-upside trades.
3. Sector-rotation trades.
4. Yield curve-adjustment trades.
5. Structure trades.
6. Cash flow reinvestment trades.

Question 8

What are yield/spread upside trades?

Answer 8

The goal of yield or spread upside trades is to get extra yield. An example is a bond portfolio manager who doesnt consider the qualtiy difference between A and BBB to be virtually meaning less so the manager would buy BBB to get the additional yield.

Question 9

What is a flaw of yield/spread pickup trades?

Answer 9

The limitation of yield/spread pickup trades is that it doesnt recognze the limitations of yield measures as an indicator of potential performance.

For example, if spread on an A bond narrowed and the BBB remained constant, the A rated bond would increase in price and outperform the BBB on a total return basis.

Question 10

What are credit-upside upside trades?

Answer 10

A credit upside trade is where the manager attempts to identify issues that are likely to be upgraded and get into them before the upgrade is incorporated into their prices.

Question 11

What are credit defense trades?

Answer 11

Credit defense trades are the opposite of credit-upside trades. The manager is trying to identify which issues are likely to be downgraded so he can short/sell them.

Question 12

What is a sector rotation trade?

Answer 12

A sector rotation trade is when a manager looks to identify sectors or industries that will over/underperform and then position the portfolio to take advantage of those forecasts.

Question 13

What is a yield-curve adjustment trade?

Answer 13

A yield curve adjustment trade attempts to align the portfolio’s duration with anticipated shifts in the yield curve.

Example: if longer-term rates are expected to fall relative to short term rates, the manager might want to go long longer-duration bonds to take advantage of their forecast price increase.

Question 14

What is a structure trade?

Answer 14

The idea behind a structure trades is to swap into structures that are expected to outperform.

Example: in a high volatility rate environment, options become more valuable. For callable bonds, this means the option has more value to the issuer. Thus the price of those callable bonds should fall.

Question 15

What is a cash flow reinvestment trade?

Answer 15

In a cash flow reinvestment trade, the manager needs to seek out bonds to reinvest the coupon/principal from other bonds. The manager would want to identify bond’s that will have the greatest price changes given the manager’s opinion on interest rate forecasts.

Question 16

If interest rates are expected to rise, what should the manager do?

Answer 16

If rates are expected to rise, the manager should buy short duration bonds and sell long duration bonds.

The shorter duration bonds will have less negative price sensitivity from the increase in interest rates.

Question 17

If interest rates are expected to fall, what should a manager do?

Answer 17

If interest rates are expected to fall, the manager should buy longer duration bonds and sell shorter duration bonds.

The longer duration bonds will have greater positive sensitivity to the forecast decrease in interest rates.

Question 18

If yield spreads for a sector are expected to narrow, what should the manager do?

Answer 18

If yield spreads are expected to narrow, the manager should choose longer-duration bonds as they will benefit the most from the decreased rates.

Question 19

If yield spreads for a sector are expected to widen, what should a manager do?

Answer 19

If yield spreads are expected to widen, the manager should buy shorter duration bonds as they will be less sensitive to the negative price effect of increased interest rates.

Question 20

What is the relationship between interest rates and yield spreads?

Answer 20

A yield spread decrease is like the interest rates that apply to that sector decreasing. This is a good thing for bonds in that sector.

A yield spread increase is like the interest rates that apply to that sector increasing. This is a bad thing for bonds in that sector.

Question 21

What are three yield spread measures?

Answer 21

1. Nominal Spread
2. Swap Spread
3. Option-adjusted Spread

Question 22

What is the yield spread?

Answer 22

The yield spread is simply the differences between the yield on corporates and the yield on govt bonds of the same maturity.

Question 23

What is the swap spread?

Answer 23

The swap spread is the spread paid by the fixed rate payer over the rate of the OTR Treasury with the same maturity.

Swap spreads are widely used in Europe as an indication of credit spreads.

Question 24

What is the option-adjusted (OAS) spread?

Answer 24

The option adjusted spread is the effective spread for a class of bonds after removing the effect of embedded options.

Often used when comparing investment grade corporates to MBS and US Agency issues.

Use of OAS is declining because fewer and fewer corporate bonds are being issued with embedded options.

Question 25

What are the three types of spread analysis?

Answer 25

1. Mean-reversion analysis
2. Quality-spread analysis
3. Percentage yield spread analysis

Question 26

What is mean reversion analysis?

Answer 26

Mean reversion analysis is based on the fact taht spreads between sectors tend to revert toward their historical means.

Procedure:

1. If current spread is a lot higher than historical, buy. (if yield is high on a relative basis, price is relatively too low)
2. If current spread is a lot lower than historical, sell (if the yield is low on a relative basis, price is relatively too high)

Question 27

What is quality-spread analysis?

Answer 27

Quality spread analysis is based on the spread differential between low and high quality issues.

Manager would want to buy issues with a spread that is wider than is justified by its intrinsic value (if spread is wide, price is low)

Question 28

What is percentage yield spread analysis?

Answer 28

Percentage yield spread analysis divides yield on corporate by yield on treasurey with same duration.

If ratio is higher than historical, the ratio will most likely fall (which means prices would rise).

If ratio is lower than historical, the ratio will most likely rise (which means prices would fall).

Question 29

What is the main drawback of percentage yield spread analysis?

Answer 29

The main drawback of percentage yield spread analysis is that it assumes that the yield of the government issue (in the denominator) is the only factor that effects the yield on the corporate (in the numerator).

In reality, other things besides the yield on the govt bond matter including:

• supply and demand
• profitability
• default
• liquidity

Question 30

What is the trend in terms of structure of US and global bond markets?

Answer 30

The trend in bond markets is toward the homogeneous bullet structure of the European corporate bond market.

Question 31

What are the three types of bullet structures?

Answer 31

1. Short-term bullets
   * maturities 1-5 years
2. Medium-term bullets

• maturities 5-12 years
• most popular structure in US and Europe
  
  • when the YC is positively sloped, medium term offers higher yields thatn 10-15 year structures buy lower duration than 30 year structures

3. Long-term bullets

• most commonly used long-term security in corporate bond market
• offer investors additional positive convexity at the cost of higher effective duration

Question 32

What is a barbell structure?

Answer 32

A barbell strucutre is a portfolio with both short-term and long-term bonds.

Short-term treasuries are not usually used on the front end of the yield curve, corporates are.

Long-term treasuries are used at the long end of the yield curve.

Question 33

What accounts for the difference between a non-callable bond and an otherwise similar callable bond? Which one has a higher price?

Answer 33

The difference between a callable and a non-callable is the value of the option.

The value of the option is value to the issuer, so investors in that issue would demand a higher price in return. Thus, the non-callable bond’s price should be higher.

Question 34

Under what market conditions to callable bonds underperform?

Answer 34

Callable bonds tend to underperform when interst rates fall.

This happens because as rates fall, the issuer is more likely to recall the bond.

Question 35

Under what market conditions to callable bonds outperform?

Answer 35

Callable bonds outperform when interest rates rise.

This happens because as interst rates rise, the callable bond is less likely to be recalled by the issuer.

Question 36

Is a callable or non-callable bond more sensitive to interest rate changes?

Answer 36

Any time an option has value, that callable bond will have less interest rate sensitivity than a comparable non-callable.

This happens because the callable bond has negative convexity. In certain areas of the yield curve, the response in the price of a callable will not be as great as the sensitivity of a non-callable.

Question 37

In what ways can be bond be retired early?

Answer 37

1. callable bonds
2. putable bonds
3. sinking funds

Question 38

What happens to sinking funds when interest rates rise?

Answer 38

A sinking fund means the issuer has to repurchase a certain percentage of the bonds each year. This purchase keeps the price up, so in higher rate environments when the bond prices are expected to fall, the sinking fund bond will not fall as much.

Question 39

When is the only time an investor should consider a putable bond?

Answer 39

An investor would consider a putable bond when interest rates were expected to rise.

This is the case because when rates rise, the price of the bond falls. But, since it is putable, the investor can put it back to the issuer, persumably at a higher price than is warranted by the rate increase.

Question 40

What things are looked at in typical credit analysis?

Answer 40

1. capacity to pay
2. quality of collateral (important for ABSs)
3. ability to assess and collect taxes (important for munis)
4. assessment of a county’s ability and willingness to pay (important for soverigns)

Question 41

What are some reasons for not trading bonds?

Answer 41

1. trading constraints
2. story disagreement
3. buy and hold
4. seasonality

Question 42

What are some common trading constraints that would cause an investor/manager to not trade bonds?

Answer 42

• quality constraints. some investors can only by investment grade bonds
• restrictions on structures some investors cant by callables, convertibles, or foreign bonds
• high-yield exposure limits for insurance companies
• in some countries, banks can only own floating rate securities