Fixed Income > Bond Trading 1999 - Rich-cheap & Relative Value

Rich-Cheap and Relative Value Trading Copyright © 1996-2006 Investment Analytics

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Rich/Cheap Analysis & Relative Value Trading „ „ „

Principles of rich/cheap analysis Relative value concepts Total return analysis

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Rich-Cheap Analysis „ „ „

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„

Select the appropriate tax-rate Identify the tax-efficient bonds Estimate the spot tax-yield curve using the efficient bonds Identify the issues which are low yield (‘rich’) or high yield (‘cheap’) relative to the curve Initiate duration-weighted trade

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Rich-Cheap Graphical Analysis

Yield

Cheap Issue

Rich Issues

Maturity

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Problems with Simple Approach „

Coupon „

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Risk-Return „ „

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Issues with different coupons trade at different yields Maturity is an inexact measure of risk Yield is an inexact measure of return

Liquidity „ „

On-the-run vs off-the-run Issues on repo special

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Example: Rich/Cheap Analysis Lab „

Simple Example: Worksheet-Rich Cheap Analysis „ „

Work out spot rates Two 2-year notes: „

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Market Yield „

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Calculate YTM on both bonds, given market prices

Theoretical Price/Yield „

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71/2% trading at par, 15% trading at 113.69

Calculate theoretical price & yield on each note

Conclusion: „

What is the relationship between coupon and yield?

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Solution: Rich/Cheap Analysis Lab „

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7.5% 2-year Note: Market Price Yield 100 7.5% 15% 2-year Note: Market Price Yield 113.69 7.5%

Theoretical Price Yield 100.09 7.45% Theoretical Price Yield 113.87 7.41%

Both issues are cheap, high coupon > low coupon

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 7

Impact of Coupon on Bond Value „

YTM calculation „

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Makes simplifying assumption of constant reinvestment rate

With rising spot rates: „

Low coupon bonds must trade at higher yields than high coupon bonds to compensate

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 8

Iso-Coupon Curves „

Implication „

To judge richness or cheapness of an issue must take account of coupon „

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Coupon adjusted yield

Iso-Coupon Yield Curves „ „ „

Group bonds by coupon Plot YTM vs Maturity (duration) Assess value vs appropriate curve

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Iso-Coupon Curves - Example 0%

5%

10%

15%

Yield

7%

6%

5% 0

5

10

15 Maturity

20

25

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

30

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Bond Stripping & Repackaging „ „

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Trading based on a variant of rich-cheap analysis Replicate the cash flows of inefficient bonds using the efficient bonds Stripping: „

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Buy cheap bond & sell off the cash flows (as ZCB’s)

Repackaging: „

Sell rich bond & hedge with replicating cash flows from efficient bonds

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Relative Value Concepts „

Yield curve as a measure of risk-return tradeoff „ „

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Maturity as a proxy for risk Look at yield pickup on extension to identify value

Example

Settlement Maturity 15-Feb-15 15-Aug-15 15-Nov-15 15-Feb-16 15-May-16 15-Nov-16 15-May-17

2-May-95 Coupon 11 1/4 10 5/8 9 7/8 9 1/4 7 1/4 7 1/2 8 3/4

Clean Price 139 10/32 133 4/32 125 13/32 118 27/32 97 29/32 100 18/32 113 23/32

Acrrued Interest 2.3619 2.2307 4.5829 1.9420 3.3646 3.4807 4.0608

Dirty Price 141.6744 135.3557 129.9891 120.7857 101.2709 104.0432 117.7795

YTM 7.4255% 7.4351% 7.4412% 7.4514% 7.4482% 7.4467% 7.4706%

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Yield Modified Pickup (bp) Duration 9.3628 0.96 9.5637 0.61 9.5491 1.02 9.9062 -0.32 10.2487 -0.14 10.2782 2.38 10.0543 Slide: 12

Yield vs. Maturity YIELD vs. MATURITY 7.48%

15-May-17

7.47% 7.46% 15-Feb-16 15-May-16 15-Nov-15 15-Aug-15

7.45% 7.44% 7.43%

15-Nov-16

15-Feb-15

7.42% 7.41% 7.40% Dec-14

Jul-15

Jan-16

Aug-16

Mar-17

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Sep-17 Slide: 13

Yield Curve Analysis „

Fairly normal yield curve „

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„ „

Yield on the 9 1/4 of Feb ‘16 looks to be a basis point too high 2.4bp pickup on the 8 /4% of May ‘17 indicates value in this sector

Clear relationship between yield and tenor What about relationship between yield and risk? „ „ „

Use duration as a proxy for risk Plot yield vs. duration Makes relative values more distinct

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Yield vs. Duration YIELD vs. DURATION 7.48% 7.47% 7.47% 7.46% 7.46% 7.45% 7.45% 7.44% 7.44% 7.43% 7.43% 7.42% 9.20

May 17

Feb 16

May 16 Nov 16

Nov 15 Aug 15 Feb 15

9.40

9.60

9.80

10.00

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

10.20

10.40 Slide: 15

Yield Enhancement Swap „

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Because it has higher coupon, the 8 3/4 of May ‘17 has lower duration than the 7 1/4 of May ‘16 or the 7 1/2 or Nov ‘16. By trading at slightly higher yield, the market would appear to be underpricing it slightly Bond Swap: Action Maturity Coupon Price YTM Sell 15-Nov-16 7 1/2% 100 18/32 Buy 15-May-17 8 3/4% 11323/32

Duration 7.4467% 10.278 7.4706% 10.054

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 16

Limitations to Traditional Yield Curve Analysis „

Yield curve: „

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A primitive expression of risk/return tradeoff

Drawbacks „ „

Maturity is poor indicator of bond price volatility YTM is not a measure of potential return „

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For Buy and Hold investor, assumes coupons are reinvested at YTM For Active investor, assumes that if bond is sold prior to maturity, it is sold at same yield as on purchase date

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Total Return „

Holding Period Return (HPR) „ „

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Measures bond’s total return over given period HPR is a time-weighted average return

HPR = ending market value + income receipts -1 beginning market value

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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HPR Example „ „

7%, 30Yr T-Bond, priced at par to yield 7% 1-year HPR: [($1000 + $35 + $35 + $1.23*) / $1000] -1 = HPR = 7.12% * $35 x 0.07 x 0.5 = $1.23

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 19

HPR Example „ „

7%, 30yr T-Bond, priced at par to yield 7% 1 Year HPR: Falling Rates 6% HPR

20.78%

Constant Rates 7% 7.12%

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Rising Rates 8% -4.08%

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Components of Total Return „

Price return „

(ending bond price - beginning bond price) „

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Coupon return „

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Excluding accrued interest

Coupon receipts +/- accrued interest

Reinvestment return „

Interest earned on reinvested coupons

Total Return = Price Return + Coupon Return + Reinvestment Return Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Components of Total Return 100% 80% 60% 40%

Price Coupon

20%

Reinvestment

0% Short Term

Medium Term

Long Term

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 22

Realized Compound Yield

Pr ice = „

FV T

RCY (1+ ) 2

RCY is a dollar-weighted average return „

FV is the future value of the bond investment over the holding period

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Reinvestment Rate and Realized Compound Yield Return on 30-Year 10% Coupon Bond

RR RCY

Realized Compound Yield

20% 15%

YTM

10% 5% 0% 0%

5%

10%

15%

20%

Reinvestment Rate Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Characteristics of Total Return „

Effect of reinvestment rate on total return „ „ „

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Low vs. high coupon bonds Short vs. long maturity issues Holding period < maturity

Lab: Total Return Analysis

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Total Return vs. Coupon Total Return

10% 6% 0%

Reinvestment Rate Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Total Return vs. Horizon Total Return

10 year

6.23 Year 5 Year

Reinvestment Rate

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Characteristics of Total Return - Summary „

Coupon „

RR has greater effect for higher coupon issues „

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No effect for ZCB’s

Holding period „

For long holding periods „ „

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Total return rises with RR Reinvestment of coupon cash flows dominates return

For short holding periods „ „

Total return falls with RR Bond price at horizon dominates return „

Greater RR implies lower price, hence return falls

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 28

Immunized Portfolios and Total Return „ „

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Portfolio with Horizon = Duration Coupon reinvestment effect balances pricediscount effect Total return is approximately the same regardless of reinvestment rate Central concept of portfolio management

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 29

Breakeven Reinvestment Rate „

RR at which TR on two bonds is the same over given horizon „

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Used to decide which of two bonds is more attractive For some bonds, may not be a breakeven RR „

One bond totally dominates the other „

Total return is always greater

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Breakeven RR - Example Total Return Total Return

15% 13% 11%

10 year, 5% coupon priced at $94

Breakeven RR

9% 10 year, 10% coupon priced at $113

7% 5%

0%

5%

10%

15%

20%

Reinvestment Rate Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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The Total Return Curve „ „

Project returns for a given holding period Plot HPR against duration „

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Assumptions „ „ „

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Return vs. Risk Interest rates Sector spreads (quality, maturity, coupon, issuer) Reinvestment rate

Baseline Total Return Curve „ „

1 Year horizon, yield curve shape unchanged All reinvestments made in the middle of the curve

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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Total Return Curve Example Yield and Baseline Total Return Curves 8.0%

Yield

7.5%

YTM

7.0% HPR 6.5%

6.0% 0

2

4

6

8

10

12

14

Duration Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 33

YTM vs. HPR Pickup „

Difference due to yield curve roll factor „

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„

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As bond ages, it rolls down to new, lower yield Also, moves from on-the-run to off-the-run

Long duration bonds are especially sensitive to roll factors: % change in price: (∆P/P) = -D* x ∆Y „

D* is modified duration

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 34

Yield and Total Return Pickup Maturity Duration 2 1.91 3 2.56 4 3.49 5 4.23 7 5.6 10 7.07 30 12.12

YTM 6.29% 6.42% 6.62% 6.68% 6.98% 7.16% 7.47%

30-year sector preferred on YTM basis

YTM Pickup on Extension 13 20 6 30 18 31

1-Year HPR 6.72% 6.81% 7.10% 6.91% 7.48% 6.96% 6.67%

Total Return Pickup on Extension 9 29 -19 57 -52 -29

7-year sector preferred on HPR basis

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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On-the-Run vs. Off-the-Run HPR’s HPR for On-the-Run vs. Off-the-Run Treasuries 9.0% 8.5%

HPR

8.0% Off-the-run

7.5% 7.0% On-the-run

6.5% 6.0% 0

2

4

6

8

10

12

14

Duration Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 36

Relative Value & Risk-Return Tradeoff „

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Market does not seem to appraise risk in a consistent fashion Attractive issues: „

Off the run issues with 4-5 years and 8-9 years in duration „

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6-yr, 8-yr, 15-yr maturities

Overvalued sectors: „ „

All the current coupon issues 5-yr, 7-yr and 29-yr off-the-runs

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

Slide: 37

Factors Affecting Relative Value Trading in Practice „

Coupon „

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Tax effects Liquidity „ „

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Low coupon issues trade at higher yields to give fair value (with an upward sloping yield curve)

On-the-run vs. off-the run treasuries Issues on “special” in repo market

Call provisions (& other option features) Transaction costs, shorting restrictions

Copyright © 1996-2006 Investment Analytics Rich-Cheap and Relative Value Trading

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