1 Bond Portfolio & Trading Strategies Nattapol Chavalitcheevin
2 Outline How Bond Price Change Type of Portfolio Strategies How to Predict Key VariablesBasic StrategiesPassive/Active Strategies
3 How Bond Price Change Coupon High / Low Maturity Long / Short Yield Pattern Impact to Bond PriceCouponHigh / LowMaturityLong / ShortYieldYield CurveParallel / FlattenSteepen / Hump
4 Bond Investment Strategies Total Return ApproachBased on Risk FactorsLiability Funding ApproachBased on Funded LiabilityUnified ApproachBased on Risk Disaggregate
5 Bond Trading Strategies Total Return ApproachRisk ExposureType of BetForecast ScenarioDurationMarket DirectionBull , BearCurveSlopeSteepen , FlattenCombinationDirection + SlopeBull / Bear Steepener
6 Bond Trading Strategies Total Return ApproachRisk ExposureType of BetForecast ScenarioCombinationDirection + SlopeBull / Bear FlattenerSpreadCountry / CreditWiden , NarrowVolatilityConvexityHigh , Low
7 Directional Strategies Relative Value Strategies Risk ExposureSummary of Trading StrategiesTotal Return ApproachDirectional StrategiesRelative Value StrategiesDurationSteepenerCombinationSpreadCurveCombinationFlattenerVolatilityTry to Forecast TrendFollow Trend
8 Immunization Strategy Dedicated Portfolio Strategy Bond Trading StrategiesLiability Funding ApproachImmunization StrategyDedicated Portfolio StrategyDuration & Liability MatchingCash Flow & Liability MatchingNote : Immunization based on parallel shift of yield curve assumption but it is not parallel shift in real world. To cope this , M-square / M – vector are the answer .
9 Classical Immunization Port DurationPort MaturityPV of Cash FlowPV of Future ObligationPort DurationPort MaturityPeriodical Rebalancing
10 Classical Immunization TimeDuration43215Note : Instead of periodical port rebalancing , fund manager can use bond derivative to adjust port duration.
11 M-Square developed by Fong & Vasicek M-Square / M-VectorM-Square developed by Fong & VasicekIn order to minimize immunization risk : M-SquareDue to non-parallel shift of yield curveM-Vector developed by several economists :Namely, Navalkha & Chambers
14 Contingent Immunization Modern Immunization Strategies includes M – Square Model andM – Vector Model which cover risk from non-parallel shift of yield curve.Required Assets6080100120140Yield ( % )Bt.’ Million14% Market Rate15% Market RateTrigger PointCondition of Immunization : 1) Market value of assets must be greater than / equal to pv of the liabilities 2) the dispersion of assets ( degree of barbelling ) must be greater than / equal to the dispersion of liabilities.
15 Bond Trading Strategies Unified ApproachBeta PortfolioAlpha PortfolioTotal Return = Total Return of Market + Return Added Through Bond Selection= Beta Alpha
16 How to Construct Beta Exposure Futures ContractsOn an IndexOptions on an IndexSwaps on an Index
17 How to Construct Beta Exposure Alpha PortfolioBeta PortfolioBond PortfolioEquity PortfolioEquity IndexingBond IndexingBond FutureIndex Future
18 Strategies & Investment Types Investor Type Portfolio Strategy Return Objective Curve BiasMutual Fund ( Some)PassiveRelative Return / BenchmarkL/TLife Insurance /Pension FundStructure / ALMIncome Focus on YieldL/TCommercial BankStructure / ALMPositive Spread bet.Lending & FinancingS/THedge Fund /TradersActiveAbsolute , Total ReturnFocus on Capital GainNo
19 Investment of Type of Trades for Different Investors Basic TradeFor more risk-neutral InvestorsConservative TradeFor more risk-averse InvestorsAggressive TradeFor more risk-Seeking Investors
20 Investment of Type of Trades for Different Investors Conservative TradeCash NeutralEarn CashDuration ShortenBasic TradeCash-Duration NeutralAggressive TradeDuration NeutralDuration ExtensionWithdraw / Borrowing
21 Reinvestment of Coupon Income Gain/Loss from Bond Price Change Sources of ReturnInterest Payment( Coupon Income )Reinvestment IncomeReinvestment of Coupon IncomeCapital GainGain/Loss from Bond Price Change
22 Sources of Return Roll Down & Carry - 0.5 = 2.5 – 3.0 Roll Down ReturnCarryRoll down refer to capital gain associated with a falling yield that is typical of a bond approach maturity.Carry is the net financing cost of trade or different between coupon earn & interest paid to finance position ( coupon – repo )iMaturityShort termMedium termLong termCarry = Coupon – Repo RateST= –LT= –
23 Summary of Sources of Return & Risk Source of Return Return Relationship Sources of RiskCouponLT BondCredit , InflationRoll-downLT BondYield Curve RiskConvexityLT BondVolatility RiskDurationDepend on MKMarket RiskRich / CheapDepend on MispricingMarket RiskCarryDepend on Trade FinancingYield Curve / Liquidity Risk
24 Basic Bond Trading Strategies BulletiMaturityShort termMedium termLong termInterest rates are expected to fall Invest long termInterest rates are expected to rise Invest short term
25 Basic Bond Trading Strategies BarbelliMaturityShort termMedium termLong termInterest rates are not clear Invest both Long termand Short term
26 Basic Bond Trading Strategies LadderiMaturityShort termMedium termLong termInterest rates are not clear Invest in All MaturityShort / Medium / Long
27 Basic Bond Trading Strategies LadderiMaturityShort termMedium termLong termInterest rates are not clear Invest in All MaturityShort / Medium / Long
28 Basic Bond Trading Strategies ButterflyiMaturityShort termMedium termLong termS / T & L/T Interest Rates Short M/T Bulletare expected to fall but M/T and Long BarbellRates are expected to rise
29 Basic Bond Trading Strategies Riding Down the Yield CurveiMaturityShort termMedium termLong termST Yield Curve steepen Invest in 2-3 years& Interest Rate is not Clear Instead of 1 year.
30 Market Direction Bet Assumption i Maturity Profit : interest rates , positive carry ,roll ( curve flatten & volatility )Loss : interest rates , ( enough to offset carry and roll )Anticipated parallel shift in the yield curve.iMaturityShort termMedium termLong termShort en DurationExtend DurationInterest rates expected to fall Extend DurationInterest rates expected to rise Shorten Duration
31 Buying / Selling Interest Rate Futures Using Interest Rate Swaps How to Alter the Duration of a PortfolioSelling or Buying BondBuying / Selling Interest Rate FuturesUsing Interest Rate Swaps
32 Investment of Different Scenario Investor expects the BOT at its next policy meeting to cut interest rate. The investor believe s that the shape of the yield curve will remain the same . The investor is cash constrained in that purchased must be financed by sales of other assets.Cash Neutral Duration Extension1 – 2 Year Bond7 Year BondSellShort term BondThenBuyLong term Bond1 UnitCash NeutralConservative TradeThe Basic StrategyCash Neutral Duration ExtensionSell1 UnitShort term Bond1 – 2 Year BondThenCash NeutralBuy1 UnitLong term Bond10 Year BondDuration Extension1 – 2 Year Bond15 Year BondSellShort term BondThenBuyLong term Bond1 Unit1.5 UnitAggressive TradeBorrowing
33 Yield Curve Bets : Steepeners & Flatteners Neutral Steepener & FlattenerAssumptionProfit : curve flattening , possible positive carry , roll advantage ( alsovolatilityLoss : curve steepeningProfit : significant curve steepening ( also volatility )Loss : curve flattening , possible negative carry , roll disadvantageAnticipated changes in the slope of yield curve.iMaturityShort termMedium termLong termMay have to draw down cash B/L or borrowing & has potential for negative carryNeutral Duration , Sell Long , Buy ShortMay have benefit from roll-up advantage & has potential for positive carryNeutral Duration , Sell Short , Buy LongYield curve expected to steepen Neutral Duration / Sell Long , Buy ShortYield curve expected to flatten Neutral Duration / Sell Short , Buy Long
34 Yield Curve Bets : Steepeners & Flatteners Bear Steepener & Bull FlattenerAssumptionProfit : curve flattening , possible positive carry , roll advantage ( alsovolatilityLoss : curve steepeningProfit : significant curve steepening ( also volatility )Loss : curve flattening , possible negative carry , roll disadvantageAnticipated changes in the slope of yield curve.iMaturityShort termMedium termLong termMay have to draw down cash B/L or borrowing & has potential for negative carryNeutral Duration , Sell Long , Buy ShortNeutral Duration , Sell Short , Buy LongMay have benefit from roll-up advantage & has potential for positive carryYield curve expected to steepen Neutral Duration / Sell Long , Buy ShortYield curve expected to flatten Neutral Duration / Sell Short , Buy Long
35 Yield Curve Bets : Steepener Investor expects the ThaiBMA yield curve will steepen over the investment horizon , with no overall bias on whether market direction will be up or down.SellLong term BondThenBuyShort term Bond7 Year Bond2 Year Bond1 Unit1.15 UnitDraw CashDuration Neutral SteepenerConservative TradeThe Basic StrategyDuration Neutral SteepenerSell1 UnitLong term Bond10 Year BondThenDraw CashBuy1.35 UnitShort term Bond2 Year BondSellShort term BondThenBuyDraw Cash /BorrowingLong term Bond15 Year Bond2 Year Bond1 Unit1.35 UnitDuration Neutral SteepenerAggressive Trade
36 Yield Curve Bets : Flattener Investor expects the ThaiBMA yield curve will flatten over the investment horizon , with no overall bias on whether market direction will be up or down.SellShort term BondThenBuyLong term Bond2 Year Bond1 Unit0.65 UnitEarn Cash7 Year BondDuration Neutral FlattenerConservative TradeThe Basic StrategyCash-Duration Neutral FlattenerSell1 UnitShort term Bond2 Year BondThenCash NeutralBuy1.0 UnitLong term Bond10 Year BondDuration Neutral FlattenerSellShort term BondThenBuyDraw Cash /Borrowing2 Year Bond15 Year Bond1 Unit1.35 UnitLong term BondAggressive Trade
37 Combination : Bull & Bear Steepener AssumptionProfit : significant curve steepening ( also volatility )Loss : curve flattening , possible negative carry , roll disadvantageMay have to draw down cash B/L or borrowing & has potential for negative carryAnticipated changes in the slope of yield curve.iMaturityShort termMedium termLong termBear Steepener Shorten Duration , Sell Long , Buy ShortBull Steepener Extend Duration , Sell Short , Buy LongMay not to draw down cash B/L or borrowing & has potential for positive carryYield curve expected to bear steepen Shorten Duration / Sell Long , Buy ShortYield curve expected to bull steepen Extend Duration / Sell Short , Buy Long
38 Combination : Bull & Bear Flatteners AssumptionProfit : curve flattening , possible positive carry , roll advantage ( alsovolatilityLoss : curve steepeningAnticipated changes in the slope of yield curve.May have to draw down cash B/L or borrowing & has potential for negative carryiMaturityShort termMedium termLong termBear Flattener Shorten Duration , Sell Long , Buy ShortBull Flattener Extend Duration , Sell Short , Buy LongMay have benefit from roll-up advantage & has potential for positive carryYield curve expected to bear flatten Shorten Duration / Sell Long , Buy ShortYield curve expected to bull flatten Extend Duration / Sell Short , Buy Long
40 Combination : Bull & Bear Flatteners DurationStrategyBullNeutralBearShort LT & Long STSteepenerShort ST & Long LTFlattener
41 Yield Curve Bets : Rising Curvature AssumptionProfit : curvature , ( also volatility )Loss : curvature , negative carry , roll disadvantageAnticipated non-uniform changes in the slope of yield curve.MaturityShort termMedium termLong termi2510BDuration-neutral butterfly , sell barbell , long bullet of intermediate bond.AYield curve expected to be rising using duration-neutral butterfly by shorthumped barbell & long a duration match bullet.
42 Yield Curve Bets : Rising & Falling Curvature Investor expects the ThaiBMA yield curve will shift temporarily from normal shape to concave or humped shape. Specifically, 5 year bond looks cheaper than 2 and 10 years bond.SellThenBuy1 Unit2.0 UnitCash neutralBarbell2 & 20 Year BondsBullet5 Year BondCash-neutral ButterflyConservative TradeThe Basic StrategyDuration-neutral ButterflySell1 UnitBarbell2 & 10 Year BondsThenEarn CashBuy1.0 UnitBullet5 Year BondSellThenBuyBullet5 Year BondBarbell2 & 10 Year Bond1 Unit2.0 UnitCash-neutral ButterflyCash neutralAggressive Trade
43 Yield Curve Bets : Falling Curvature AssumptionProfit : curvature , carry , roll ( also volatility )Loss : CurvatureAnticipated non-uniform changes in the slope of yield curve.MaturityShort termMedium termLong termi1510BADuration-neutral butterfly , sell bullet of intermediate , long barbell bond.Yield curve expected to be falling using duration-neutral butterfly by shorthumped bullet & long a duration match barbell.
44 Yield Curve Bets : Rising & Falling Curvature Investor expects the ThaiBMA yield curve will shift temporarily from normal shape to reverse concave or humped shape. Specifically, 5 year bond looks rich than 1 and 10 years bond.The Basic StrategyDuration-neutral ButterflySell1 Unit5 Year BondBulletThenCash withdrawBuy1.0 UnitBarbell1 & 10 Year Bonds
45 Spread Bets Type of Spread Type of Spread Bets Profit : Narrowing credit spreads, positive carryLoss : Widening credit spreads Spread narrowing tradeProfit : Widening credit spreads Spread widening tradeLoss : Narrowing credit spreadsType of SpreadType of Spread BetsIndividual Securities SpreadIndustry SpreadBond Market SpreadRotation / change to new bondSector RotationMarket RotationSpread narrowing tradePosition Structure Weight MatchingLong Spread prod % Cash, durationShort Benchmark % Cash, durationSpread widening tradePosition Structure Weight MatchingLong Benchmark % Cash, durationShort Spread prod % Cash, duration
46 Spread Change Determinants It depends on changing of risk premiumEconomic CycleRelative DemandRisk Appetiteof InvestorsLiquidityIssuer CreditWorthinessStructure
47 Spread Bets Conservative Trade The Basic Strategy Aggressive Trade Investor expects the spread between corporate and government bond yield to narrow as a result of an overall economic recovery .SellThenBuy1 Unit1.0 UnitCash neutralGovernment Bond10 Year BondsState-own Bond10 Year BondCash / Duration-neutralConservative TradeThe Basic StrategyCash / Duration-neutralSell1 UnitGovernment Bond10 Year BondsThenCash neutralBuy1.0 UnitCorporate Bond10 Year BondSellThenBuyCorporate Bond10 Year BondGovernment Bond1 Unit1.5 UnitCash / Duration-neutralCash withdrawAggressive Trade
48 Volatility Bets How to Bets ? Straight Bond By Convexity Selection Bond withEmbededOptionDerivativesVia Swaps /OptionsCredit SpreadTrade
50 Volatility Bets How to Bets ? Trade Buy Volatility Sell Volatility Straight BondLong term BondShort term BondBond with OptionLong Bond with PutLong Bond with CallOptionsLong StraddleShort Straddle
51 Volatility Bets How to Bets ? Short-end Intermediate Long-end Straight BondShort-end Intermediate Long-end- 100%+ 100%OR+52%- 100%+ 48%
52 Other Relative Value Strategies Market NeutralArbitrage bt.Arbitrage along Yield CurveArbitrage bt. Cash & FuturesSimilar BondConvertible ArbitrageTED Spread Trade
53 Other Relative Value Strategies Non Market NeutralYield CurveArbitrageCreditArbitrageOther SpreadTrading
54 Other Relative Value Strategies Reactive StrategiesMomentumDuration-basedMeanReversion
55 Passive Strategy Buy and hold Strategy Easy to adjust port with buy / sellWe can call as Modified Buy and Hold StrategyIndexingInvest based on selected bond indexPort performance depends on tracking error during bond selection processStratified Sampling ApproachOptimizationVariance MinimizationShort falls of MPT : 1) Risk is symmetry bt. upside & downside risk . 2) Return is average return not minimum acceptable return ( MAR ) .
56 Bond Price Determinants FundamentalsSentimentBond PriceTechnicalWildcardsFactors
57 An Integrated Approach to Bond Strategies EconomicFundamentalsSeasonalFactorsPoliticalBusiness CycleCentral BankStatus / PolicyTransientSupply/DemandInterest RateFlowDemographicsTechnicalAnalysis
58 An Integrate Approach to Bond Strategies MarketTime HorizonMarket ContextBiasEconomicFundamentalsL / TDeep , orderly &Efficient MarketsPrice = FundamentalsonlyPolitical BusinessCyclesM / T & L / TDisorderly &Inefficient MarketsGrowth during election,; Inflation afterwardMultiple CentralBank TargetsM / T & L / TAllInflation if have growthAnd employment targetsCentral BankIndependenceM / T & L / TAllMore Inflation if lessIndependentDemographyL / TAllDepends on Spending& Saving of PopulationTechnicalAnalysisS / TTrending , Inefficient &Volatile Forecasts in S/TExtend Trend in L/TOrderly MarketsFlowS / TThin or Small MarketNoneTransient Supply& DemandS / TThin or Small MarketNoneSeasonal FactorsS / TThin or Small MarketHistorical Bias
59 Flattening or Steepening A View on Which to TradeMarket DirectionUp or DownYield CurveFlattening or SteepeningYield SpreadWidening or NarrowingVolatilityRising or FallingTurning PointImminent or Not