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22a Bonds: Top-down vs.

Bottom-up relative value analysis


Explain classic relative-value analysis, based on top-down and bottom-up approaches to credit bond
portfolio management

Classic Relative-Value Analysis...

...is ranking fixed-income investments by expected return over a future period.

Credit Sector
Allocation
Intra-Sector
Allocation
Issuer
Selection

Counties

Structural
Selection

Currencies

Industrials Financials

Utilities

VW
Toyota
GM

Citigroup
Sumitomo
Deutsche
Bank

Bullets
Puts
Callables
CDSs

Senior
Subordinated
Preferred
Convertible

Scottish
Power
Korea
Electric
Power
Texas
Utilities
High
Coupon
Low Coupon
Zero
Coupon
Floaters

NonCorporates
Mexico
Canada
Thailand
World Bank

Try again, because this is not your best table. And that is saying something because your tables are
awful.

Relative value analysis is simple taking a look at which sectors you think will outperform others,
which issuers you think will outperform others, which structures you think will out perform
others, etc.
Historical analysis is a good way to determine if, for example, credit spreads have deviated from
their long-term trend levels.
It is also useful to analyze the overall level of market liquidity in order to determine which bonds
will outperform others (see 22c).

That's a bit better, but what is the ideal method for conducting Classic Relative-Value Analysis?

It involves a combination of the Top-down an Bottom-up approaches, which are described


below.

Top-down approach:

An analyst uses economy-wide projections to first allocate funds to different countries or


currencies.
He determines what industries or sectors are expected to outperform.
His objective is to beat index with superior over/underweighting decisions.

Bottom-up approach:

An analyst selects undervalued issues based on structure/issuer analysis.


The portfolio that emerges from this process may not be well diversified.
Her aim is to beat index based on her superior selection skills.

These seem a lot like the descriptions of the Top-down and Bottom-up approaches in 17e and 24v.

Probably because they are.

22b Bonds: Primary market dynamics


Discuss the implications of cyclical supply and demand changes in the primary corporate bond market
and the impact of secular changes in the markets dominant product structures

How do short-term economic fluctuations influence prices and spreads in the primary market for
corporate bonds?

In recessions, default risk increases and spreads widen, so risky bonds significantly
underperform risk-free bonds.
By contrast, economic growth causes spreads to narrow and risky bonds significantly
outperform risk-free bonds.

What about the influence of short-term supply and demand factors?

As interest rates drop, corporate issuers may take advantage of this by obtaining debt financing
at lower rates.
An large Increases in the number of new corporate bond issues will cause credit spreads to
narrow.
This is because fixed-income traders like the fact that a flood of new issuances serves to valuate
valuations in the secondary market.

What are the secular (ie. long-term) changes to the primary market for corporate bonds?

As issuers have sought to lower their cost of capital under various yield curve/spread scenarios
and match assets to liabilities, there have been significant changes to bond markets since the
80s/90s:
Structured notes and swap products are now common
High-yield corporate sector is now an accepted asset class
Global origination is now common for US Agencies, large corporates and supra-nationals
Global credit bond market is much more homogeneous
Bullet maturities (not callable, putable, or sinkable) and medium term notes are now
dominant and longer-term notes with call/put/sinking features are much less common
Callable issues still dominate the high-yield segment, but this situation is expected to
change as credit quality improves with lower interest financing and refinancing
In all but the high-yield market, intermediate-term bullets dominate the corporate bond
market

And, what has been the effect of these long-term changes?


1. Scarcity premium is paid for bonds with embedded call/put features
2. Bonds with 20-year+ maturities have all but vanished
3. Massive growth of credit derivatives has led to new strategies for issuers and investors

22c Bonds: Corporate bond liquidity and investor preferences


Explain the influence of investors short- and long-term liquidity needs on portfolio management
decisions

How are portfolio management decisions influenced by, say, short-term liquidity needs?

Some fixed-income managers are willing to give up additional return by investing in issues that
possess greater liquidity such as larger-sized corporate issues (>$1bn) and government issues.
By contrast, other managers are willing sacrifice liquidity for issues which offer a greater yield
such as smaller-sized issues and private placements.

And, how about the influence of long-term liquidity needs?

Liquidity will ebb and flow with factors such as the economic cycle, credit cycle, yield curve
shape, supply, seasonality and market shocks such as a wave of defaults.
However, the overall trend is towards greater liquidity as new technologies are adopted and
markets become truly global as evidenced by decreasing bid/ask spreads - especially for large,
well-known corporate issuers.

22d Bonds: Rationales for secondary market trading

Discuss common rationales for secondary market trading

Rationales FOR trading in Secondary markets include:


1) Yield/spread pickup trades

Most cited reason for secondary trades.


Over 50% of trades seek to add yield within a portfolios duration and credit quality constraints.
Why not hold GM at 10bps above a similar Ford bond? (Because it could be a LOT riskier)
This Yield-first psychology is NOT preferred to Total Return Analysis, which is discussed in 22e.

2) Credit-upside trades

The manager is expecting an issuer will be upgraded.


This trading assumes superior credit analysis skills
Also, PM must identify the opportunity before market prices the possible upgrade into the
bonds yield
Crossover Sector straddles BBB/BB border
Ratings upgrade will improve total return via narrower spread, but also improve price with much
higher liquidity

3) Credit-defense trades

Opposite of Credit-upside trading.


Often based on secular trends and macroeconomic analysis.
For example, a manager might fear that geopolitical or sector-specific risk will cause wideranging downgrades and increasing credit spreads.
Higher-rated bonds will perform better when the economy slows.
This strategy may cause a manager to sell bonds in the aftermath of a downgrade, which is a
good way to ensure large losses.

4) Sector rotation trades

The manager is seeking to take advantage of sectors that are expected to outperform on a total
return basis.
Often based on macroeconomic analysis and economic cycle.
For example, a manager may want to rotate out of bonds issued by cyclical firms as the
economy begins to slow.

5) Structure trades

Trading into structures (callable, bullet, and put) that are expected to outperform due to
movement in volatility and yield curve shape
High-coupon callables do poorly when yields drop
Stable yield curve makes high-quality callables more attractive than high-quality bullets

Putables do poorly when yields drop because investors had decided to sacrifice yield for
protection against higher rates
Callables underperform bullets during high volatility & vice versa.

6) Yield curve adjustment trades

PM wants to alter portfolio duration to be aligned with anticipated yield curve changes
In practice, such adjustments are done via the more liquid Treasuries market, but can be done
via credit market
Also done in anticipation of changes in credit/spread curve

7) New issue swaps (Liquidity)

Large, new issues are perceived to have superior liquidity


Particularly on-the-run Treasuries
New issue swaps provide exposure to a new issuer or structure
Often this strategy is a self-fulfilling prophecy

8) Cash flow reinvestment

Common reason for trading in the secondary market


In 2003, combined incoming coupons, principle and sinking funds were equal to 100% of face
value in new issue market
Cash inflows may occur when new issues are scarce
PMs prefer not to sit on cash

Rationales for NOT trading in Secondary markets (Trading Constraints) include:


1) Portfolio Constraints

Largest contributor to market inefficiencies


Investor such as pensions and insurers may be prohibited by regulators from investing in subinvestment-grade bonds
Commercial banks may be prohibited from holding fixed-rate securities (unless converted via
fixed/floating swaps)
Investors may be confined to investing in their local currency

2) Story Disagreements

Times of low/no consensus produce significant opportunities


But story disagreement can work both ways

3) Buy-and-Hold

Accounting constraints may discourage sales at loss vs. book


Buy-and-hold is not best if defaults are on the horizon

4) Seasonality

Trading in the secondary market slows at the end of months


During these periods, even compelling secondary market opportunities will fail to be acted on

22e Bonds: Relative value of strategies


Discuss corporate bond portfolio strategies that are based on relative value

Relative Valuation
Description
Methodologies

Analysis

Total Return
Analysis

Analyzes how bonds respond to


macroeconomic conditions.

Considers all sources of return from fixedincome securities.

Primary Market
Analysis

Attempts to predict the supply of new


issues (see 22b).

Credit spreads narrow when the market is


flooded with new corporate bond issues.

Liquidity Analysis

Attempts to predict which issuers,


sectors or structures will benefit from
changes in bond market liquidity.

Increased liquidity will lower yields


because many investors shun bonds with
low liquidity.

Spread Analysis

Recall from 21h that the three most


common spread measures are:

The three types of spread analysis are:


- Mean-reversion analysis (how many
standard deviations is a spread above its
long-term trend average?)
- Quality-spread analysis
- Percent yield spread analysis

- Nominal spread
- Static (Z) spread
- Option-Adjusted spread (Note: OAS
does NOT account for default risk and is
therefore inappropriate for analyzing
speculative-grade (high-yield) bonds.
Structural Analysis Considers the relative value of bond
based on their structure.

Largely irrelevant now, as 94% of


investment grade bonds are bullets.

Credit Curve
Analysis

Attempts to generate excess returns by Spreads increase with volatility and


timing investments with expected
maturity.
changes in the business cycle.

Credit Analysis

Attempts to predict credit upgrades and Managers with superior credit analysis
downgrades.
skills will be highly rewarded in the bond
market.

Sector Analysis

Attempts to identify which sectors will


outperform.

Certain sectors may be more susceptible


to "event risk".

Secondary trading Reasons FOR trading


rationales

See 22d

Secondary trading Reasons for NOT trading


constraints

See 22d

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