Reading 21 Relative-Value Methodologies for Global Credit Bond Portfolio Management Flashcards
Structure Trades
Structure trades involve swaps into structures (e.g., callable structures, bullet structures, and putable structures) that are expected to have better performance given expected movements in volatility and the shape of the yield curve.
Cash Flow Reinvestment
- Cash flow reinvestment forces investors into the secondary market on a regular basis.
- Some portfolio cash inflows occur during interludes in the primary market or the composition of recent primary supply may not be compatible with portfolio objectives. In these periods, credit portfolio managers must shop the secondary market for investment opportunities to remain fully invested or temporarily replicate the corporate index by using financial futures.
Putables
- Conventional put structures are simpler than callables. Yet in trading circles, put bond valuations often are the subject of debate. American-option callables grant issuers the right to call an issue at any time at the designated call price after expiration of the non-callable or non-redemption period. Put bonds typically provide investors with a one-time, one-date put option (European option) to demand full repayment at par. Less frequently, put bonds include a second or third put option date.
- Rather than incur the risk of refunding the put bond in 5 or 10 years at a higher cost, many issuers would prefer to pay an extra 10 bps to 20 bps in order to issue a longer-term liability.
- Put structures provide investors with a partial defense against sharp increases in interest rates. Assuming that the issuer still has the capability to meet its sudden obligation, put structures triggered by a credit event enable investors to escape from a deteriorating credit. Perhaps because of its comparative scarcity, the performance and valuation of put structures have been a challenge for many portfolio managers.
- Divergence in implied volatility between callables (high) and putables (low) suggests that asset managers, often driven by a desire to boost portfolio yield, underpay issuers for the right to put a debt security back to the issuer under specified circumstances. In other words, the typical put bond should trade at a lower yield in the market than is commonly the case.
In the high-yield market the overriding concern for a putable issue is one of credit concern. Traditional analysis used to quantify the option value which the issuer has granted the investor is overridden by the investor’s specific view of the credit-worthiness of the issuer at the time of first put. Explain why.
Analytical models for valuing bonds with embedded put options assume the issuer will fulfill the obligation to repurchase an issue if the bondholder exercises the put option. For high-yield issuers, there is the credit risk associated with the potential inability to satisfy the put obligation. Thus for high-yield issuers, the credit risk may override the value for a putable issue derived from a valuation model.
Classic Relative-Value Analysis
There are two basic approaches to global credit bond portfolio management—top-down approach and bottom-up approach. The top-down approach focuses on high-level allocations among broadly defined credit asset classes. The goal of top-down research is to form views on large-scale economic and industry developments. These views then drive asset allocation decisions (overweight certain sectors, underweight others). The bottom-up approach focuses on individual issuers and issues that will outperform their peer groups. Managers follow this approach hoping to outperform their benchmark due to superior security selection, while maintaining neutral weightings to the various sectors in the benchmark.
Classic relative-value analysis is a dialectical process combining the best of top-down and bottom-up approaches. This process blends the macro input of chief investment officers, strategists, economists, and portfolio managers with the micro input of credit analysts, quantitative analysts, and portfolio managers. The goal of this methodology is to pick the sectors with the most potential upside, populate these favored sectors with the best representative issuers, and select the structures of the designated issuers at the yield curve points that match the investor’s for the benchmark yield curve.
!!! If bond markets were perfectly efficient then relative-value analysis would not lead to superior returns on a consistent basis.
Bullets
- Front-end bullets (i.e., bullet structures with 1- to 5-year maturities) have great appeal for investors who pursue a “barbell strategy” in which both the short and long end of the barbell are US Treasury securities. There are “barbellers” who use credit securities at the front or short-end of the curve and Treasuries at the long-end of the yield curve. There are non-US institutions who convert short bullets into floating-rate products by using interest rate swaps. The transactions are referred to as “asset swaps,” and the investors who employ this transaction are referred to as “asset swappers.”
- Intermediate credit bullets (5- to 12-year maturities), especially the 10-year maturity sector, have become the most popular segment of the US and European investment-grade and high-yield credit markets.
- Because new 15-year structures take five years to descend along a positively sloped yield curve to their underlying 10-year bellwether, 15-year maturities hold less appeal for many investors in search of return through price appreciation emanating from benchmark rolldown. In contrast, rare 20-year structures have been favored by many investors. Spreads for these structures are benched off the 30-year Treasury. With a positively sloped yield curve, the 20-year structure provides higher yield than a 10-year or 15-year security and less vulnerability (lower duration) than a 30-year security.
- The 30-year maturity is the most popular form of long-dated security in the global credit market.
- The trend toward bullet securities does not pertain to the high-yield market, where callable structures dominate the market.
Alternative Spread Measures
- Given the rapid reduction of credit structures with embedded options since 1990 (see structural discussion above), the use of OAS in primary and secondary pricing has diminished within the investment-grade credit asset class.
- Starting in Europe during the early 1990s and gaining momentum during the late 1990s, interest rate swap spreads have emerged as the common denominator to measure relative value across fixed- and floating-rate note credit structures.
- Other US credit spread calculations have been proposed, most notably using the US agency benchmark curve.
- Credit-default swap spreads have emerged as the latest valuation tool during the great stresses in the credit markets of 2000–2002. Most likely, credit-default swap spreads will be used as a companion valuation reference to nominal spreads, OAS, and swap spreads.
The market, therefore, has an ability to price any credit instrument using multiple spread references. These include nominal spread, static or zero-volatility spread, OAS, credit-swap spreads (or simply swap spreads), and credit default spreads.
Quality-Spread Analysis
Quality-spread analysis examines the spread differentials between low- and high-quality credits.
Asset Allocation/Sector Rotation
- In the credit bond market, “macro” sector rotations among industrials, utilities, financial institutions, sovereigns, and supranationals also have a long history.
- In contrast, “micro” sector rotation strategies have a briefer history in the credit market.
- Sector-rotation trades are not as popular in the bond market as in the equity market because of less liquidity and higher costs of trading; however, with the expected development of enhanced liquidity and lower trading transaction costs in the future, sector-rotation trades should become more prevalent in the credit asset class.
The annual rotation toward risk aversion in the bond market during the second half of most years contributes to a “fourth-quarter effect”—that is, there is underperformance of lower-rated credits, B’s in high-yield and Baa’s in investment-grade, compared to higher-rated credits. A fresh spurt of market optimism greets nearly every New Year. Lower-rated credit outperforms higher-quality credit—this is referred to as the “first-quarter effect.” This pattern suggests a very simple and popular portfolio strategy: underweight low-quality credits and possibly even credit products altogether until the mid-third quarter of each year and then move to overweight lower-quality credits and all credit product in the fourth quarter of each year.
Callables
- Typically after a 5-year or 10-year wait (longer for some rare issues), credit structures are callable at the option of the issuer at any time. Call prices usually are set at a premium above par (par + the initial coupon) and decline linearly on an annual basis to par by 5–10 years prior to final scheduled maturity. The ability to refinance debt in a potentially lower-interest rate environment is extremely valuable to issuers. Conversely, the risk of earlier-than-expected retirement of an above-current market coupon is bothersome to investors.
- In issuing callables, issuers pay investors an annual spread premium (about 20 bps to 40 bps for high-quality issuers) for being long (from an issuer’s perspective) the call option. Like all security valuations, this call premium varies through time with capital market conditions.
- Callables significantly underperform bullets when interest rates decline because of their negative convexity. When the bond market rallies, callable structures do not fully participate given the upper boundary imposed by call prices. Conversely, callable structures outperform bullets in bear bond markets as the probability of early call diminishes.
Credit-Defense Trades
- Credit-defense trades become more popular as geopolitical and economic uncertainty increase.
- Ironically once a credit is downgraded by the rating agencies, internal portfolio guidelines often dictate security liquidation immediately after the loss of single-A or investment-grade status. This is usually the worst possible time to sell a security and maximizes losses incurred by the portfolio.
When interest rates fall, contingent immunization switches to more active or passive management? Why?
- When interest rates fall, contingent immunization switches to more active management because the dollar safety margin is higher.
- This is true only if the duration of the Asset is greater than the duration of the Liab. Without comparing durations of Assets and liab, we cannot figure out PV of assets will be greater or less than teh PV of liab.
Relative value
Relative value refers to the ranking of fixed-income investments by sectors, structures, issuers, and issues in terms of their expected performance during some future period of time.
For a day trader, relative value may carry a maximum horizon of a few minutes. For a dealer, relative value may extend from a few days to a few months. For a total return investor, the relative value horizon typically runs from 1–3 months. For a large insurer, relative value usually spans a multi-year horizon.
Accordingly, relative-value analysis refers to the methodologies used to generate such rankings of expected returns.
Spread Tools
Spread valuation includes:
- mean-reversion analysis,
- quality-spread analysis, and
- percent yield spread analysis.
Credit Analysis
- Credit analysis is both non-glamorous and arduous for many top-down portfolio managers and strategists, who focus primarily on macro variables.
- Unfortunately, the advantages of such analytical rigor may clash with the rapid expansion of the universe of issuers of credit bonds.
Primary Market Analysis
The analysis of primary markets centers on new issue supply and demand. Supply is often a misunderstood factor in tactical relative-value analysis. Prospective new supply induces many traders, analysts, and investors to advocate a defensive stance toward the overall corporate market as well as toward individual sectors and issuers. Yet the premise, “supply will hurt spreads,” which may apply to an individual issuer, does not generally hold up for the entire credit market.
Credit spreads are determined by many factors; supply, although important, represents one of many determinants. During most years, increases in issuance (most notably during the first quarter of each year) are associated with market-spread contraction and strong relative returns for credit debt. In contrast, sharp supply declines are accompanied frequently by spread expansion and a major fall in both relative and absolute returns for credit securities.
In the investment-grade credit market, heavy supply often compresses spreads and boosts relative returns for credit assets as new primary valuations validate and enhance secondary valuations. When primary origination declines sharply, secondary traders lose reinforcement from the primary market and tend to reduce their bids, which will increase the spread. Contrary to the normal supply-price relationship, relative credit returns often perform best during periods of heavy supply.
Curve-Adjustment Trades
- Yield curve-adjustment trades, or simply, curve-adjustment trades are taken to reposition a portfolio’s duration. For most credit investors, their portfolio duration is typically within a range from 20% below to 20% above the duration of the benchmark index.
- Although most fixed-income investors prefer to alter the duration of their aggregate portfolios in the more-liquid Treasury market, strategic portfolio duration tilts also can be implemented in the credit market.
- This is also done with respect to anticipated changes in the credit term structure or credit curve. For example, if a portfolio manager believes credit spreads will tighten (either overall or in a particular sector), with rates in general remaining relatively stable, they might shift the portfolio’s exposure to longer spread duration issues in the sector.
Consider the relationship between the term structure of interest rates and implied forward rates (or simply forward rates). What is a “forward spread” and why can it be viewed as a breakeven spread?
How can implied forward spreads be used in relative-value analysis?
- Forward rates were explained as basically hedgeable or breakeven rates — rates that will make an investor indifferent between two alternatives. For example, for default-free instruments a 2-year forward rate 3 years from now is a rate that will make an investor indifferent between investing in a 5-year zero-coupon default-free instrument or investing in a 3-year zero-coupon default-free instrument and reinvesting the proceeds for two more years after the 3-year instrument matures.
- The forward spread is a breakeven spread because it is the spread that would make the investor indifferent between two alternative investments with different maturities over a given investment horizon.
- Because a forward spread is one that will make an investor indifferent between two alternatives, a manager must compare his or her expectations relative to the forward spread. Relative-value analysis involves making this comparison between expected spread and what is built into market prices (i.e., forward spread).
What is the limitation of a yield-pickup trade?
Yield measures are poor indicators of total return realized by holding a security to maturity or over some investment horizon. Thus, an asset manager does not know what a yield pickup of, say, 20 basis points means for subsequent total return. A bond manager can pick up yield on a trade (holding credit quality constant), but on a relative value basis underperform an alternative issue with a lower yield over the manager’s investment horizon.
Sinking Funds
A sinking fund structure allows an issuer to execute a series of partial calls (annually or semiannually) prior to maturity. Issuers also usually have an option to retire an additional portion of the issue on the sinking fund date, typically ranging from 1 to 2 times the mandatory sinking fund obligation.
Yield/Spread Pickup Trades
- Yield/spread pickup trades represent the most common secondary transactions across all sectors of the global credit market. Historically, at least half of all secondary swaps reflect investor intentions to add additional yield within the duration and credit-quality constraints of a portfolio.
- Despite the passage of more than three decades, this investor bias toward yield maximization also may be a methodological relic left over from the era prior to the introduction and market acceptance of total-return indices. Yield measures have limitations as an indicator of potential performance. The total return framework is a superior framework for assessing potential performance for a trade.
The Effect of Product Structure
Partially offsetting this proliferation of issuers since the mid-1990s, the global credit market has become structurally more homogeneous. Specifically, bullet and intermediate-maturity structures have come to dominate the credit market. A bullet maturity means that the issue is not callable, putable, or sinkable prior to its scheduled final maturity. The trend toward bullet securities does not pertain to the high-yield market, where callables remain the structure of choice.
There are three strategic portfolio implications for this structural evolution:
- First, the dominance of bullet structures translates into scarcity value for structures with embedded call and put features. That is, credit securities with embedded options have become rare and therefore demand a premium price. Typically, this premium (price) is not captured by option-valuation models. Yet, this “scarcity value” should be considered by managers in relative-value analysis of credit bonds.
- Second, bonds with maturities beyond 20 years are a small share of outstanding credit debt. This shift reduced the effective duration of the credit asset class and cut aggregate sensitivity to interest-rate risk. For asset/liability managers with long time horizons, this shift of the maturity distribution suggests a rise in the value of long credit debt.
- Third, the use of credit derivatives has skyrocketed since the early 1990s. The rapid maturation of the credit derivative market will lead investors and issuers to develop new strategies to match desired exposures to credit sectors, issuers, and structures.
Structural Analysis
While evaluating bond structures was extremely important in the 1980s, it became less influential in credit bond market since the mid-1990s for several reasons:
- First, the European credit bond market almost exclusively features intermediate bullets.
- Second, the US credit and the global bond markets have moved to embrace this structurally homogeneous European bullet standard.
Still, structural analysis can enhance risk-adjusted returns of credit portfolios. In the short run and assuming no change in the perceived credit-worthiness of the issuer, yield curve and volatility movements will largely influence structural performance. Investors should also take into account long-run market dynamics that affect the composition of the market and, in turn, credit index benchmarks. Specifically, callable structures have become rarer in the US investment-grade credit bond market with the exception of the 2000 inversion.
Increases in investment-grade credit securities new issuance have been observed with contracting yield spreads and strong relative bond returns. In contrast, spread expansion and a major decline in both relative and absolute returns usually accompanies a sharp decline in the supply of new credit issues. These outcomes are in stark contrast to the conventional wisdom held by many portfolio managers that supply hurts credit spreads. What reason can be offered for the observed relationship between new supply and changes in credit spreads?
The reason suggested as to why heavy supply of new investment-grade credit issues will help spreads contract and enhance returns is that new primary bond valuations validate and enhance secondary valuations. In contrast, when new issuance declines sharply, secondary traders lose confirmation from the primary market and tend to require higher spreads.
