Relative Value Methodologies for Global Bond Portfolio Management
(Inputs from CFA L3 Readings)
In Relative
Value Analysis assets are compared along readily identifiable characteristics
and value measures. For example, we can use P/E ratios for ranking equities. For
bonds we may use, sector, issue and structure which are used to rank bonds
across and within categories. We can use the following two approaches for
ranking bonds:
Two approaches
1.
Top Down
a. Manager uses economy wide projections to first allocate funds to
different countries or currencies
b. The analyst then determines what industries or sectors are expected
to outperform and select individual securities within those sectors
2.
Bottom – Up Approach
a. Analyst selects undervalues securities
3.
Classical Relative Value
a. Combines the best of bottom up and top down
b. The process blends the macro input of chief investment officer with
micro inputs of credit analysis
c. The goal is to pick the sectors with the most upside potential and
pick up undervalued securities in these sectors
Relative Value Methodologies
1. Total Return Analysis
2. Primary Market Analysis
3. Liquidity and Trading Analysis
4. Secondary Trading Rationales
5. Spread Analysis
6. Structure Analysis
7. Credit Curve Analysis
8. Credit Analysis
9. Asset Allocation / Sector Analysis
Total Return Analysis
Focus should be
on total return for markets and individual securities. Study how past
macroeconomic trends affected performance, trends detected are used to estimate
future total returns based upon predictions for those same macro trends
Primary Market Analysis
Cyclical
Changes
. Increases in the number of new bond issues are sometimes associated
with narrower spreads and relatively strong returns. A possible explanation is that the valuation of new issues validates
the prices of outstanding issues which relieves pricing uncertainty and reduces
all spreads
Secular Changes
1. Intermediate term bullets dominate the corporate bond market
2. Callable issues dominate the high yield market, but this situation
is likely to change as credit quality improves and cheap financing is available
3. Implications
a. Securities with embedded options will trade at a premium price due
to scarcity value
b. Credit manager seeking longer durations will pay a premium price for
longer duration securities because of tendency towards intermediate issues
c. Credit based derivatives will increasingly be used to take advantage
of return and /or diversification benefits across sectors, structures and so
forth
Liquidity
1. There is a positive relationship between liquidity and bond prices
2. As liquidity decreases, investors are willing to pay less
(increasing yields) and as liquidity increases, investors are willing to pay
more (decreasing yields)
3. The move in debt markets have been towards increased liquidity
(faster and cheaper trading) mainly due to trading innovations and competition
among portfolio managers
Rationales for Secondary Bond Trading
1.
Yield Pickup Trades
a. Potential flaw in this rationale is that it does not recognize the
limitations of yield measures as an indicator of potential performance
2.
Credit upside trades
a. Attempt to identify issues that are upgradeable before the upgrade
is incorporates into their prices
b. Occur mostly at the juncture of highest speculative rating and
lowest investment rating
3.
Credit defense trades
a. Opposite of credit upside trades, managers reduce exposure to
sectors where they expect a credit downgrade
4.
New Issue Swaps
a. Managers prefer to move to new issues because new issues
particularly on the run new issues are often perceived to have superior
liquidity
5.
Sector rotation trades
a. Idea is to shift out of a sector or industry that is expected to
underperform and into one that is expected to outperform on a total return
basis
6.
Yield curve adjustment trades
a. Attempt to align portfolio’s duration with anticipated changes/
shifts in the yield curve
b. That is when long term interest rates are expected to fall, the
manager may want to shift into longer durations to maximize the positive effect
of the change in interest rates
7.
Structure Trades
a. Idea is to swap into structures that will have a strong performance
given an expected movement in volatility and yield curve shape.
b. Higher volatility tends to result in decreased prices for callable
securities because of the increased value of the embedded option
c. Put structures tend to perform better when interest rates are not
expected to fall
d. If interest rates fall, put able bonds, tends to underperform non
put able bonds as the put feature becomes less valuable
8.
Cash Flow Reinvestment Trades
a. Particularly when primary market does not offer may alternatives
The following general rules apply:
1. If interest rates are expected to rise, buy short duration bonds and
sell long duration bonds
2. If interest rates are expected to fall, buy long duration bonds and
sell short duration bonds
3. If yield spread for the sector is expected to narrow, choose longer
duration bonds in the sector as they will gain most from decreased rates
4. If the yield spread for the sector is expected to widen, choose
shorter duration bonds in the sector
Spread
Analysis
- Mean Reversion Analysis
- Quality Spread Analysis
- Percentage Yield Spread Analysis
Mean Reversion Analysis
- Presumption is that with mean reversion spreads between sectors tend to revert towards their historical means
- Procedure
- If the current spread is significantly greater than the historical mean, buy the sector or issue (if yield is high on relative basis, price is low)
- If the current spread is significantly less than the historical mean, sell the sector or issue (if yield is low on a relative basis, price is high)
- Statistical analysis using S.D and t scores can be used to determine if the current spread is significantly different from the mean
Quality Spread Analysis
- Based on spread differential between low and high quality credits
- Buy an issue with a spread widen than that which is justified by its intrinsic value
Percentage Yield Spread Analysis
- Divides the yield on corporate bonds by the yield on treasuries with the same duration
- If the ratio is higher than justified by the historical ratio, the spread is expected to fall, making corporate bond prices rise
Bond Structures
Structural
analysis is the analysis of the performance of structures on a relative value
basis
Bullet Structures
- Short term bullets
- Have maturities of 1-5 years and are used in the short end of a barbell strategy
- Medium term bullets
- Maturities of 5-12 years and are the most popular sector in the US and Europe
- Long term bullets
- 30 year maturities and are the most commonly used long term security in the global corporate bond market
Early retirement provisions
- Callable bonds
- Difference between callable and non callable identical bond is the value of the option
- Due to embedded option and negative convexity, callable bonds:
- Underperform non callable bond when interest rates fall due to their negative convexity
- Outperform non callable in bear market with rising rates as the probability of being called falls
Sinking Funds
- Provides early retirement of a portion of an issue of bonds
- Sinking funds priced a discount to par have historically retained upside price potential during interest rate declines as long as the bonds remain priced at a discount to par
Putable Bonds
- Due to scarcity it is difficult to reach conclusion regarding their performance and valuation
- Should be considered as an option when there is a strong belief that interest rates will rise
- Valuation options fail to incorporate the probability that the issuer will be unable to fulfill its obligation to repurchase its bonds
Credit Analysis
- Involves examining financial statements, bond documents and tends in credit ratings etc
- Capacity to pay is the key factor in corporate credit analysis
- The quality of collateral and the servicer are important in the analysis of ABS
- The ability to assess and collect taxes is the key consideration for municipal bonds
- Sovereign credit analysis requires an assessment of the country’s ability and willingness to pay
