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Reading 22 Relative Value Methodologies www.irfanullah.co Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents – Relative Value Analysis Introduction Credit Relative-Value Analysis Total Return Analysis Primary Market Analysis Liquidity and Trading Analysis Secondary Trade Rationales Spread Analysis Structural Analysis Credit Curve Analysis 10 Credit Analysis 11 Asset Allocation Sector Rotation www.irfanullah.co Relative Value Methodologies Introduction Relative Value Methodologies For Global Credit Bond Portfolio Management Superior credit analysis has been and will remain the most important determinant of the relative performance of credit bond portfolios, allowing managers to identify potential credit upgrades and to avoid potential downgrades The “corporate asset class” includes more than pure corporate entities; this segment of the global bond market is more properly called the “credit asset class,” including sovereigns, supranationals, agencies of local government authorities, nonagency mortgage-backed securities, commercial mortgage- backed securities, and asset-backed securities www.irfanullah.co Credit Relative Value Analysis 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 interval Relative value analysis helps answer questions such as… www.irfanullah.co Objective of Relative Value Analysis • Identify sectors with the most upside potential • Populate favored sectors with best representative issuers • Select structures at yield curve points that match investor’s outlook for the benchmark yield curve www.irfanullah.co www.irfanullah.co Exhibit 4: Credit Sector Portfolio Management Process Classic relative value analysis combines the best of top-down and bottom up approaches www.irfanullah.co Total Return Analysis • Goal of global credit portfolio management: optimize riskadjusted total return of credit portfolio • Analyze components of total return – Treasury – Credit – Liquidity • Understand how components are impacted by macroeconomic variables – During recessions credit spreads widen • For brief periods non-cyclic technical factors can offset fundamentals www.irfanullah.co Primary Market Analysis (Impact of Supply Demand Changes) • Heavy increase in supply often reduces spreads (increases prices) – Prices validated – Demand goes up even more than supply • Global bond markets have become more homogenous – Intermediate (MTN) and bullet (non-callable) securities dominate – High yield bonds still mostly callable; greater acceptance for HYBs • Structural changes driven by issuers’ desire to reduce funding costs • Portfolio Implications of Structure Changes – Dominance of bullet securities creates scarcity value for callable/putable bonds – Bonds with maturities > 20 years have become a smaller part of credit market; asset liability managers with long term horizons place greater value on long maturity bonds – Use of credit derivatives has increased since 1990 new strategies www.irfanullah.co Liquidity and Trading Analysis • Short term and long term liquidity needs influence portfolio management decisions – Relationship between liquidity and yield – Investors with short-term liquidity needs will avoid small issues – Investors will long horizons might be comfortable with lower liquidity in exchange for higher yields • Credit market liquidity changes over time, varying with the economic cycle, credit cycle, shape of the yield curve and supply • Unknown shocks temporarily impact liquidity • Technological innovation and competition is leading to greater liquidity and transparency of the global credit market www.irfanullah.co 10 Secondary Trade Rationales Portfolio managers trade in response to new information • Yield/Spread Pickup Trades – Most common – Two bonds with roughly same credit rating; go for higher yield • Credit-Upside Trades – Expect upgrade not reflected in current yield spread – Popular in crossover sector (ratings between Ba2/BB and Baa3/BBB) • Credit-Defense Trades – Reduce exposure if credit downgrade is expected – Trade up in credit quality economic or geopolitical uncertainty increases – Investors relatively quick to sell after high number of ‘fallen angels’ in 2002 (WorldCom) www.irfanullah.co 11 Secondary Trade Rationales (Cont…) • New Issue Swaps – Because of perceived superior liquidity, portfolio managers prefer to rotate their portfolios into more current and usually larger sized on-the-run issues • Sector-Rotation Trades – Shift portfolio from a sector or industry that is expected to underperform to a sector or industry which is expected to outperform on a total return basis – Less popular in bond market relative to equity market • Curvature-Adjustment Trades – Reposition portfolio duration – Could be based on interest rate forecasts or simply to match benchmark www.irfanullah.co 12 Secondary Trade Rationales (Cont…) • Structure Trades – Swaps into structures that are expected to have better performance given expected movements in volatility and the shape of the yield curve – If you expect interest rate to become more stable are you more likely to increase position in callable bonds? – More examples in curriculum • Cash Flow Reinvestment www.irfanullah.co 13 Trading Constraints Review rationales for not trading Bad investment decisions emanate from dated and anachronistic constraints (ex: avoid investing in bonds rated below AA) • Portfolio Constraints – Portfolio constraints are the biggest contributor to persistence of market inefficiency across global credit markets – Example: only hold investment grade; more in the curriculum • “Story” Disagreement – Failure to act when there are arguments for trading and not trading – Ex: Asia debt performed poorly in 1997; good buy in 1998 but most investors avoided Asian debt – Enron in 2001 www.irfanullah.co 14 Trading Constraints (Cont…) Review rationales for not trading Bad investment decisions emanate from dated and anachronistic constraints (ex: avoid investing in bonds rated below AA) • Buy and Hold – Better to act when there are signs of trouble rather than holding on • Seasonality – More trading during quarter end and year end www.irfanullah.co 15 Spread Analysis • HYB and EMG debt markets generally use total yield/price • Rest of the global credit market uses nominal spread as the basic unit for price and relative-value analysis • Option Adjusted Spread (OAS) – Less popular because fewer callable/putable bonds • Interest rate swap spread have become popular for European credit, Asian credit, and U.S MBS, CMBS, agency and ABS sectors • Credit-default swap spreads are sometimes used in addition to nominal spreads, OAS and swap spreads www.irfanullah.co 16 Example of how a bond manager can use the interest rate swap spread framework Ford’s 5-year bond has spread of 113 bps; 5-year Treasury bonds at 6.43% 5-year swap spread (to 5-year Treasury) is 83bps www.irfanullah.co 17 Spread Tools • Mean Reversion Analysis – Compare current spread with historical mean – Statistical analysis to determine whether difference is meaningful – Can be misleading because the mean value is highly dependent on the time period analyzed (time period bias) • Quality Spread Analysis – Examine spread difference between low- and high-quality credits – What will you if spread is relatively high as the economy is turning around from a recession www.irfanullah.co 18 Structural Analysis Analyze performance of different structures (bullet, callable, putable and sinking fund) Front end bullets (1 – years) good for investors pursuing a barbell strategy Intermediate bullets (5 – 12 years) increasingly popular What structure will you prefer if you expect sharp increase in interest rates (bearish) Structural analysis less important now than in 1990… www.irfanullah.co 19 Credit Curve Analysis Study credit curves Credit curves are almost always upward sloping Increased uncertainty higher spreads Higher maturity higher spreads To moderate portfolio risk many credit managers take credit risk in short and intermediate securities; long-duration govt securties credit barbell strategy Credit spread curves change with economic cycle Higher uncertainty and credit risk steeper www.irfanullah.co 20 10 Credit Analysis • Study issuer financial statements, accounting techniques, interview management, evaluate industry, read indentures and charters, understand credit ratings • Determine whether credit spread is appropriate • Advantages of analytical rigor might clash with rapid expansion of credit bonds www.irfanullah.co 21 11 Asset Allocation/Sector Rotation Macro sector rotation: overweight sectors expected to outperform Micro sector rotation: rotate between sub-sectors www.irfanullah.co 22 Conclusion • Learning objectives • Summary is exceptionally good • No Examples… • … but lots of good practice problems www.irfanullah.co 23 ... Credit Analysis 11 Asset Allocation Sector Rotation www.irfanullah.co Relative Value Methodologies Introduction Relative Value Methodologies For Global Credit Bond Portfolio Management Superior...Contents – Relative Value Analysis Introduction Credit Relative- Value Analysis Total Return Analysis Primary Market Analysis Liquidity... mortgage- backed securities, and asset-backed securities www.irfanullah.co Credit Relative Value Analysis Relative value refers to the ranking of fixed-income investments by sectors, structures,