Rich-Cheap and Relative Value

Trading

Copyright © 1996-2006
Investment Analytics

1
 Rich/Cheap Analysis &
Relative Value Trading
„ Principles of rich/cheap analysis
„ Relative value concepts
„ Total return analysis

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 Rich-Cheap Analysis
„ 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
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 Rich-Cheap Graphical Analysis

Cheap
Issue
Yield

Rich
Issues

Maturity
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 Problems with Simple
Approach
„ Coupon
„ Issues with different coupons trade at different
yields
„ Risk-Return
„ 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

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 Example: Rich/Cheap Analysis
Lab
„ Simple Example: Worksheet-Rich Cheap Analysis
„ Work out spot rates
„ Two 2-year notes:
„ 71/2% trading at par, 15% trading at 113.69
„ Market Yield
„ Calculate YTM on both bonds, given market prices
„ Theoretical Price/Yield
„ Calculate theoretical price & yield on each note
„ Conclusion:
„ What is the relationship between coupon and yield?
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 Solution: Rich/Cheap Analysis Lab

„ 7.5% 2-year Note:

Market Theoretical
Price Yield Price Yield
100 7.5% 100.09 7.45%
„ 15% 2-year Note:
Market Theoretical
Price Yield Price Yield
113.69 7.5% 113.87 7.41%

„ Both issues are cheap, high coupon > low coupon

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 Impact of Coupon on Bond
Value
„ YTM calculation
„ 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

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 Iso-Coupon Curves
„ Implication
„ To judge richness or cheapness of an issue
must take account of coupon
„ Coupon adjusted yield
„ Iso-Coupon Yield Curves
„ Group bonds by coupon
„ Plot YTM vs Maturity (duration)
„ Assess value vs appropriate curve

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 Iso-Coupon Curves - Example

0% 5% 10% 15%

7%
Yield

6%

5%
0 5 10 15 20 25 30
Maturity

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 Bond Stripping & Repackaging
„ Trading based on a variant of rich-cheap analysis
„ Replicate the cash flows of inefficient bonds using
the efficient bonds
„ Stripping:
„ Buy cheap bond & sell off the cash flows (as ZCB’s)
„ Repackaging:
„ Sell rich bond & hedge with replicating cash flows from
efficient bonds

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 Relative Value Concepts
„ Yield curve as a measure of risk-return tradeoff
„ Maturity as a proxy for risk
„ Look at yield pickup on extension to identify value
„ Example
Settlement 2-May-95
Clean Acrrued Dirty Yield Modified
Maturity Coupon Price Interest Price YTM Pickup (bp) Duration
15-Feb-15 11 1/4 139 10/32 2.3619 141.6744 7.4255% 9.3628
15-Aug-15 10 5/8 133 4/32 2.2307 135.3557 7.4351% 0.96 9.5637
15-Nov-15 9 7/8 125 13/32 4.5829 129.9891 7.4412% 0.61 9.5491
15-Feb-16 9 1/4 118 27/32 1.9420 120.7857 7.4514% 1.02 9.9062
15-May-16 7 1/4 97 29/32 3.3646 101.2709 7.4482% -0.32 10.2487
15-Nov-16 7 1/2 100 18/32 3.4807 104.0432 7.4467% -0.14 10.2782
15-May-17 8 3/4 113 23/32 4.0608 117.7795 7.4706% 2.38 10.0543

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 Yield vs. Maturity
YIELD vs. MATURITY

7.48%
15-May-17
7.47%
7.46%
15-Feb-16
7.45% 15-May-16 15-Nov-16
7.44% 15-Nov-15
15-Aug-15
7.43%
15-Feb-15
7.42%
7.41%
7.40%
Dec-14 Jul-15 Jan-16 Aug-16 Mar-17 Sep-17

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 Yield Curve Analysis
„ Fairly normal yield curve
„ 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
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 Yield vs. Duration
YIELD vs. DURATION

7.48%
7.47% May 17
7.47%
7.46%
7.46%
Feb 16 May 16
7.45%
7.45% Nov 16
7.44% Nov 15
7.44% Aug 15
7.43%
7.43% Feb 15
7.42%
9.20 9.40 9.60 9.80 10.00 10.20 10.40

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 Yield Enhancement Swap
„ 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 Duration
Sell 15-Nov-16 7 1/2% 100 18/32 7.4467% 10.278
Buy 15-May-17 8 3/4% 11323/32 7.4706% 10.054

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 Limitations to Traditional
Yield Curve Analysis
„ Yield curve:
„ A primitive expression of risk/return tradeoff
„ Drawbacks
„ Maturity is poor indicator of bond price volatility
„ YTM is not a measure of potential return
„ 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
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 Total Return

„ Holding Period Return (HPR)

„ 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

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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

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 HPR Example
„ 7%, 30yr T-Bond, priced at par to yield 7%
„ 1 Year HPR:

Falling Constant Rising

Rates Rates Rates
6% 7% 8%

HPR 20.78% 7.12% -4.08%

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 Components of Total Return
„ Price return
„ (ending bond price - beginning bond price)
„ Excluding accrued interest
„ Coupon return
„ Coupon receipts +/- accrued interest
„ Reinvestment return
„ Interest earned on reinvested coupons
Total Return = Price Return + Coupon Return
+ Reinvestment Return

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 Components of Total Return

100%

80%

60%

40%
Price
Coupon
20%
Reinvestment

0%
Short Term Medium Long Term
Term
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 Realized Compound Yield
FV
Pr ice = RCY
T

(1+ )
2
„ RCY is a dollar-weighted average return
„ FV is the future value of the bond
investment over the holding period

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

20% RR
Realized Compound Yield

RCY
15%

10% YTM

5%

0%
0% 5% 10% 15% 20%
Reinvestment Rate

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 Characteristics of Total Return
„ Effect of reinvestment rate on total
return
„ Low vs. high coupon bonds
„ Short vs. long maturity issues
„ Holding period < maturity
„ Lab: Total Return Analysis

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 Total Return vs. Coupon
10%
Total Return

6%

0%

Reinvestment Rate
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 Total Return vs. Horizon
10 year
Total Return

6.23 Year

5 Year

Reinvestment Rate
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 Characteristics of Total Return
- Summary
„ Coupon
„ RR has greater effect for higher coupon issues
„ No effect for ZCB’s
„ Holding period
„ For long holding periods
„ 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

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 Immunized Portfolios and
Total Return

„ Portfolio with Horizon = Duration

„ Coupon reinvestment effect balances price-
discount effect
„ Total return is approximately the same
regardless of reinvestment rate
„ Central concept of portfolio management

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

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 Breakeven RR - Example
Total Return
15%

13%
Total Return

11% 10 year, 5% coupon priced at $94

Break-
even RR
9%
10 year, 10% coupon priced at $113
7%

5%
0% 5% 10% 15% 20%
Reinvestment Rate

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 The Total Return Curve
„ Project returns for a given holding period
„ Plot HPR against duration
„ Return vs. Risk
„ Assumptions
„ 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
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 Total Return Curve Example
Yield and Baseline Total Return Curves

8.0%

7.5% YTM
Yield

7.0%

HPR
6.5%

6.0%
0 2 4 6 8 10 12 14

Duration

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 YTM vs. HPR Pickup
„ Difference due to yield curve roll factor
„ 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
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 Yield and Total Return Pickup
YTM Total Return
Pickup on 1-Year Pickup on
Maturity Duration YTM Extension HPR Extension
2 1.91 6.29% 6.72%
3 2.56 6.42% 13 6.81% 9
4 3.49 6.62% 20 7.10% 29
5 4.23 6.68% 6 6.91% -19
7 5.6 6.98% 30 7.48% 57
10 7.07 7.16% 18 6.96% -52
30 12.12 7.47% 31 6.67% -29

30-year sector preferred on 7-year sector preferred on

YTM basis HPR basis
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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%

8.0%
Off-the-run
HPR

7.5%

7.0%
On-the-run
6.5%

6.0%
0 2 4 6 8 10 12 14
Duration

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 Relative Value & Risk-Return
Tradeoff
„ 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
„ 6-yr, 8-yr, 15-yr maturities
„ Overvalued sectors:
„ All the current coupon issues
„ 5-yr, 7-yr and 29-yr off-the-runs

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 Factors Affecting Relative
Value Trading in Practice
„ Coupon
„ Low coupon issues trade at higher yields to give fair
value (with an upward sloping yield curve)
„ Tax effects
„ Liquidity
„ On-the-run vs. off-the run treasuries
„ Issues on “special” in repo market
„ Call provisions (& other option features)
„ Transaction costs, shorting restrictions
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