Bond Portfolio & Trading Strategies Nattapol Chavalitcheevin

Outline How Bond Price Change Type of Portfolio Strategies How to Predict Key Variables Basic Strategies Passive/Active Strategies

How Bond Price Change Coupon High / Low Maturity Long / Short Yield Pattern Impact to Bond Price Coupon High / Low Maturity Long / Short Yield Yield Curve Parallel / Flatten Steepen / Hump

Bond Investment Strategies Total Return Approach Based on Risk Factors Liability Funding Approach Based on Funded Liability Unified Approach Based on Risk Disaggregate

Bond Trading Strategies Total Return Approach Risk Exposure Type of Bet Forecast Scenario Duration Market Direction Bull , Bear Curve Slope Steepen , Flatten Combination Direction + Slope Bull / Bear Steepener

Bond Trading Strategies Total Return Approach Risk Exposure Type of Bet Forecast Scenario Combination Direction + Slope Bull / Bear Flattener Spread Country / Credit Widen , Narrow Volatility Convexity High , Low

Directional Strategies Relative Value Strategies Risk Exposure Summary of Trading Strategies Total Return Approach Directional Strategies Relative Value Strategies Duration Steepener Combination Spread Curve Combination Flattener Volatility Try to Forecast Trend Follow Trend

Immunization Strategy Dedicated Portfolio Strategy Bond Trading Strategies Liability Funding Approach Immunization Strategy Dedicated Portfolio Strategy Duration & Liability Matching Cash Flow & Liability Matching Note : 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 .

Classical Immunization Port Duration Port Maturity PV of Cash Flow PV of Future Obligation Port Duration Port Maturity Periodical Rebalancing

Classical Immunization 1 2 3 4 5 Time Duration 4 3 2 1 5 Note : Instead of periodical port rebalancing , fund manager can use bond derivative to adjust port duration.

M-Square developed by Fong & Vasicek M-Square / M-Vector M-Square developed by Fong & Vasicek In order to minimize immunization risk : M-Square Due to non-parallel shift of yield curve M-Vector developed by several economists : Namely, Navalkha & Chambers

Cash Flow Matching 1 2 3 4 5 Time Obligation 100

Horizontal Matching Payout Cash Matched Duration Matched 1 5 10 15 1 5 10 15 Payout Year Cash Matched Duration Matched

Contingent Immunization Modern Immunization Strategies includes M – Square Model and M – Vector Model which cover risk from non-parallel shift of yield curve. Required Assets 10 15 20 60 80 100 120 140 Yield ( % ) Bt.’ Million 14% Market Rate 15% Market Rate Trigger Point Condition 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.

Bond Trading Strategies Unified Approach Beta Portfolio Alpha Portfolio Total Return = Total Return of Market + Return Added Through Bond Selection = Beta + Alpha

How to Construct Beta Exposure Futures Contracts On an Index Options on an Index Swaps on an Index

How to Construct Beta Exposure Alpha Portfolio Beta Portfolio Bond Portfolio Equity Portfolio Equity Indexing Bond Indexing Bond Future Index Future

Strategies & Investment Types Investor Type Portfolio Strategy Return Objective Curve Bias Mutual Fund ( Some) Passive Relative Return / Benchmark L/T Life Insurance / Pension Fund Structure / ALM Income Focus on Yield L/T Commercial Bank Structure / ALM Positive Spread bet. Lending & Financing S/T Hedge Fund / Traders Active Absolute , Total Return Focus on Capital Gain No

Investment of Type of Trades for Different Investors Basic Trade For more risk-neutral Investors Conservative Trade For more risk-averse Investors Aggressive Trade For more risk-Seeking Investors

Investment of Type of Trades for Different Investors Conservative Trade Cash Neutral Earn Cash Duration Shorten Basic Trade Cash-Duration Neutral Aggressive Trade Duration Neutral Duration Extension Withdraw / Borrowing

Reinvestment of Coupon Income Gain/Loss from Bond Price Change Sources of Return Interest Payment ( Coupon Income ) Reinvestment Income Reinvestment of Coupon Income Capital Gain Gain/Loss from Bond Price Change

Sources of Return Roll Down & Carry - 0.5 = 2.5 – 3.0 Roll Down Return Carry Roll 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 ) i Maturity Short term Medium term Long term Carry = Coupon – Repo Rate ST - 0.5 = 2.5 – 3.0 LT + 2.5 = 5.5 – 3.0

Summary of Sources of Return & Risk Source of Return Return Relationship Sources of Risk Coupon LT Bond Credit , Inflation Roll-down LT Bond Yield Curve Risk Convexity LT Bond Volatility Risk Duration Depend on MK Market Risk Rich / Cheap Depend on Mispricing Market Risk Carry Depend on Trade Financing Yield Curve / Liquidity Risk

Basic Bond Trading Strategies Bullet i Maturity Short term Medium term Long term Interest rates are expected to fall Invest long term Interest rates are expected to rise Invest short term

Basic Bond Trading Strategies Barbell i Maturity Short term Medium term Long term Interest rates are not clear Invest both Long term and Short term

Basic Bond Trading Strategies Ladder i Maturity Short term Medium term Long term Interest rates are not clear Invest in All Maturity Short / Medium / Long

Basic Bond Trading Strategies Ladder i Maturity Short term Medium term Long term Interest rates are not clear Invest in All Maturity Short / Medium / Long

Basic Bond Trading Strategies Butterfly i Maturity Short term Medium term Long term S / T & L/T Interest Rates Short M/T Bullet are expected to fall but M/T and Long Barbell Rates are expected to rise

Basic Bond Trading Strategies Riding Down the Yield Curve i Maturity Short term Medium term Long term ST Yield Curve steepen Invest in 2-3 years & Interest Rate is not Clear Instead of 1 year.

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. i Maturity Short term Medium term Long term Short en Duration Extend Duration Interest rates expected to fall Extend Duration Interest rates expected to rise Shorten Duration

Buying / Selling Interest Rate Futures Using Interest Rate Swaps How to Alter the Duration of a Portfolio Selling or Buying Bond Buying / Selling Interest Rate Futures Using Interest Rate Swaps

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 Extension 1 – 2 Year Bond 7 Year Bond Sell Short term Bond Then Buy Long term Bond 1 Unit Cash Neutral Conservative Trade The Basic Strategy Cash Neutral Duration Extension Sell 1 Unit Short term Bond 1 – 2 Year Bond Then Cash Neutral Buy 1 Unit Long term Bond 10 Year Bond Duration Extension 1 – 2 Year Bond 15 Year Bond Sell Short term Bond Then Buy Long term Bond 1 Unit 1.5 Unit Aggressive Trade Borrowing

Yield Curve Bets : Steepeners & Flatteners Neutral Steepener & Flattener Assumption Profit : curve flattening , possible positive carry , roll advantage ( also volatility Loss : curve steepening Profit : significant curve steepening ( also volatility ) Loss : curve flattening , possible negative carry , roll disadvantage Anticipated changes in the slope of yield curve. i Maturity Short term Medium term Long term May have to draw down cash B/L or borrowing & has potential for negative carry Neutral Duration , Sell Long , Buy Short May have benefit from roll-up advantage & has potential for positive carry Neutral Duration , Sell Short , Buy Long Yield curve expected to steepen Neutral Duration / Sell Long , Buy Short Yield curve expected to flatten Neutral Duration / Sell Short , Buy Long

Yield Curve Bets : Steepeners & Flatteners Bear Steepener & Bull Flattener Assumption Profit : curve flattening , possible positive carry , roll advantage ( also volatility Loss : curve steepening Profit : significant curve steepening ( also volatility ) Loss : curve flattening , possible negative carry , roll disadvantage Anticipated changes in the slope of yield curve. i Maturity Short term Medium term Long term May have to draw down cash B/L or borrowing & has potential for negative carry Neutral Duration , Sell Long , Buy Short Neutral Duration , Sell Short , Buy Long May have benefit from roll-up advantage & has potential for positive carry Yield curve expected to steepen Neutral Duration / Sell Long , Buy Short Yield curve expected to flatten Neutral Duration / Sell Short , Buy Long

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. Sell Long term Bond Then Buy Short term Bond 7 Year Bond 2 Year Bond 1 Unit 1.15 Unit Draw Cash Duration Neutral Steepener Conservative Trade The Basic Strategy Duration Neutral Steepener Sell 1 Unit Long term Bond 10 Year Bond Then Draw Cash Buy 1.35 Unit Short term Bond 2 Year Bond Sell Short term Bond Then Buy Draw Cash / Borrowing Long term Bond 15 Year Bond 2 Year Bond 1 Unit 1.35 Unit Duration Neutral Steepener Aggressive Trade

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. Sell Short term Bond Then Buy Long term Bond 2 Year Bond 1 Unit 0.65 Unit Earn Cash 7 Year Bond Duration Neutral Flattener Conservative Trade The Basic Strategy Cash-Duration Neutral Flattener Sell 1 Unit Short term Bond 2 Year Bond Then Cash Neutral Buy 1.0 Unit Long term Bond 10 Year Bond Duration Neutral Flattener Sell Short term Bond Then Buy Draw Cash / Borrowing 2 Year Bond 15 Year Bond 1 Unit 1.35 Unit Long term Bond Aggressive Trade

Combination : Bull & Bear Steepener Assumption Profit : significant curve steepening ( also volatility ) Loss : curve flattening , possible negative carry , roll disadvantage May have to draw down cash B/L or borrowing & has potential for negative carry Anticipated changes in the slope of yield curve. i Maturity Short term Medium term Long term Bear Steepener Shorten Duration , Sell Long , Buy Short Bull Steepener Extend Duration , Sell Short , Buy Long May not to draw down cash B/L or borrowing & has potential for positive carry Yield curve expected to bear steepen Shorten Duration / Sell Long , Buy Short Yield curve expected to bull steepen Extend Duration / Sell Short , Buy Long

Combination : Bull & Bear Flatteners Assumption Profit : curve flattening , possible positive carry , roll advantage ( also volatility Loss : curve steepening Anticipated changes in the slope of yield curve. May have to draw down cash B/L or borrowing & has potential for negative carry i Maturity Short term Medium term Long term Bear Flattener Shorten Duration , Sell Long , Buy Short Bull Flattener Extend Duration , Sell Short , Buy Long May have benefit from roll-up advantage & has potential for positive carry Yield curve expected to bear flatten Shorten Duration / Sell Long , Buy Short Yield curve expected to bull flatten Extend Duration / Sell Short , Buy Long

Yield Curve Shift Summary Bull Steepener Bear Flattener Neutral Steepener Bear Steepener Bull Flattener Neutral Flattener

Combination : Bull & Bear Flatteners Duration Strategy Bull Neutral Bear Short LT & Long ST Steepener Short ST & Long LT Flattener

Yield Curve Bets : Rising Curvature Assumption Profit : curvature , ( also volatility ) Loss : curvature , negative carry , roll disadvantage Anticipated non-uniform changes in the slope of yield curve. Maturity Short term Medium term Long term i 2 5 10 B Duration-neutral butterfly , sell barbell , long bullet of intermediate bond. A Yield curve expected to be rising using duration-neutral butterfly by short humped barbell & long a duration match bullet.

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. Sell Then Buy 1 Unit 2.0 Unit Cash neutral Barbell 2 & 20 Year Bonds Bullet 5 Year Bond Cash-neutral Butterfly Conservative Trade The Basic Strategy Duration-neutral Butterfly Sell 1 Unit Barbell 2 & 10 Year Bonds Then Earn Cash Buy 1.0 Unit Bullet 5 Year Bond Sell Then Buy Bullet 5 Year Bond Barbell 2 & 10 Year Bond 1 Unit 2.0 Unit Cash-neutral Butterfly Cash neutral Aggressive Trade

Yield Curve Bets : Falling Curvature Assumption Profit : curvature , carry , roll ( also volatility ) Loss : Curvature Anticipated non-uniform changes in the slope of yield curve. Maturity Short term Medium term Long term i 1 5 10 B A Duration-neutral butterfly , sell bullet of intermediate , long barbell bond. Yield curve expected to be falling using duration-neutral butterfly by short humped bullet & long a duration match barbell.

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 Strategy Duration-neutral Butterfly Sell 1 Unit 5 Year Bond Bullet Then Cash withdraw Buy 1.0 Unit Barbell 1 & 10 Year Bonds

Spread Bets Type of Spread Type of Spread Bets Profit : Narrowing credit spreads, positive carry Loss : Widening credit spreads Spread narrowing trade Profit : Widening credit spreads Spread widening trade Loss : Narrowing credit spreads Type of Spread Type of Spread Bets Individual Securities Spread Industry Spread Bond Market Spread Rotation / change to new bond Sector Rotation Market Rotation Spread narrowing trade Position Structure Weight Matching Long Spread prod. +100% Cash, duration Short Benchmark - 100% Cash, duration Spread widening trade Position Structure Weight Matching Long Benchmark +100% Cash, duration Short Spread prod. - 100% Cash, duration

Spread Change Determinants It depends on changing of risk premium Economic Cycle Relative Demand Risk Appetite of Investors Liquidity Issuer Credit Worthiness Structure

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 . Sell Then Buy 1 Unit 1.0 Unit Cash neutral Government Bond 10 Year Bonds State-own Bond 10 Year Bond Cash / Duration-neutral Conservative Trade The Basic Strategy Cash / Duration-neutral Sell 1 Unit Government Bond 10 Year Bonds Then Cash neutral Buy 1.0 Unit Corporate Bond 10 Year Bond Sell Then Buy Corporate Bond 10 Year Bond Government Bond 1 Unit 1.5 Unit Cash / Duration-neutral Cash withdraw Aggressive Trade

Volatility Bets How to Bets ? Straight Bond By Convexity Selection Bond with Embeded Option Derivatives Via Swaps / Options Credit Spread Trade

Volatility Change Determinants Volatility Increase Volatility Decrease When trend becomes unclear When trend becomes clear When option volatility is dear (Implied > Historical) When option volatility is cheap (Implied < Historical)

Volatility Bets How to Bets ? Trade Buy Volatility Sell Volatility Straight Bond Long term Bond Short term Bond Bond with Option Long Bond with Put Long Bond with Call Options Long Straddle Short Straddle

Volatility Bets How to Bets ? Short-end Intermediate Long-end Straight Bond Short-end Intermediate Long-end - 100% + 100% OR +52% - 100% + 48%

Other Relative Value Strategies Market Neutral Arbitrage bt. Arbitrage along Yield Curve Arbitrage bt. Cash & Futures Similar Bond Convertible Arbitrage TED Spread Trade

Other Relative Value Strategies Non Market Neutral Yield Curve Arbitrage Credit Arbitrage Other Spread Trading

Other Relative Value Strategies Reactive Strategies Momentum Duration-based Mean Reversion

Passive Strategy Buy and hold Strategy Easy to adjust port with buy / sell We can call as Modified Buy and Hold Strategy Indexing Invest based on selected bond index Port performance depends on tracking error during bond selection process Stratified Sampling Approach Optimization Variance Minimization Short falls of MPT : 1) Risk is symmetry bt. upside & downside risk . 2) Return is average return not minimum acceptable return ( MAR ) .

Bond Price Determinants Fundamentals Sentiment Bond Price Technical Wildcards Factors

An Integrated Approach to Bond Strategies Economic Fundamentals Seasonal Factors Political Business Cycle Central Bank Status / Policy Transient Supply/Demand Interest Rate Flow Demographics Technical Analysis

An Integrate Approach to Bond Strategies Market Time Horizon Market Context Bias Economic Fundamentals L / T Deep , orderly & Efficient Markets Price = Fundamentals only Political Business Cycles M / T & L / T Disorderly & Inefficient Markets Growth during election, ; Inflation afterward Multiple Central Bank Targets M / T & L / T All Inflation if have growth And employment targets Central Bank Independence M / T & L / T All More Inflation if less Independent Demography L / T All Depends on Spending & Saving of Population Technical Analysis S / T Trending , Inefficient & Volatile Forecasts in S/T Extend Trend in L/T Orderly Markets Flow S / T Thin or Small Market None Transient Supply & Demand S / T Thin or Small Market None Seasonal Factors S / T Thin or Small Market Historical Bias

Flattening or Steepening A View on Which to Trade Market Direction Up or Down Yield Curve Flattening or Steepening Yield Spread Widening or Narrowing Volatility Rising or Falling Turning Point Imminent or Not