Advanced FixedIncome Trading

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Advanced Fixed-Income Trading

• 26 November 2005
• by
• Sansanee Hutanuwatr

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Content

• Thai Bond Market
• Return vs Risk
• Risk Measurement
• Portfolio Management Strategy
• Active Trading Strategies

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Thai Bond Market
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Registered Bonds in TBMA

• Outstanding as of 31 Oct 05 Issues
  Value (Billion Baht)
• Government Debt Securities 505
  2,559
• - Treasury Bill 39 170
• - Government Bond 34 1,264
• - State Agency Bond 62 644
• - State Owned Enterprise Bond 370 481
• Corporate Bond 194
  422
• Foreign Bond 2
  7
• Total Registered Bonds
  701 2,988

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Registered Bonds by Value
As of 31 Oct 05
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Trading Volume
For period Jan-Oct05
Unit Billion Baht
Average Trading Volume 15.9 Billion Baht/Day
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Corporate Bonds in Focus

• Classified by Issues Value
  (Billion THB)
• Bond Type
• Straight 132 296 70
• Convertible 1 2 1
• Amortised 54 115 27
• Structured 7 8 2
• Issue Rating
• A-rated 132 343 81
• B-rated 46 62 15
• Non-rated 16 17 4
• Coupon Type
• Fixed 166 364 86
• Float 28 58 14

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Bond Symbol

• Government / SOE / Corporate Bond
• LB 08 D A
• Version of bond (1st Issue)
• Maturity month (December)
• Next 2 Maturity year (2008)
• First 4 characters Short name of bond
  (Loan Bond)
• T-Bill, CB
• TB 05 N 23 B

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Return vs Risk
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Current Yield Curve
As of 15 Nov 05
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Duration-Based Rf Yield Curve
As of 15 Nov 05
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Current Spread
Unit bps
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Return

• Return from fixed-income investment
• Coupon
• Coupon Reinvestment
• Capital Gain (Loss)
• Assumptions of Yield-to-Maturity (YTM)
• Reinvestment rate YTM
• Hold-to-Maturity

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Horizon Return

• Step 1 Make assumptions on
• - Time horizon
• - Reinvestment rate
• - Bond yield at end of horizon
• Step 2 Calculate future value of cash flows
  ?
• Step 3 Calculate bond price at end of horizon
  ?
• Step 4 ? ? ?
• Step 5 Period Return ?
• Step 6 Convert to bond equivalent yield (1
  ?)k - 1

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Horizon Return

• 7 Yrs bond, coupon 9, current price 100, YTM
  9
• Step 1 Assuming
• - Time horizon 1 yr
• - Reinvestment rate 5
• - Bond yield at end of horizon 7
• Step 2 Future value of cash flows 4.5x(1.025)2
  4.5x(1.025) 9.3403
• Step 3 Bond price at end of horizon 109.6683
• Step 4 9.3403 109.6683 119.0036
• Step 5 Period Return (119.0036 / 100) ½ - 1
  9.09
• Step 6 Bond equivalent yield (1.0909)2 1
  19.01

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Horizon Return

• Horizon Return gt YTM when
• - Reinvestment rate gt YTM
• - Bond price at end of horizon gt Par
• (Selling YTM lt Invested YTM)
• Coupon reinvestment income has greater effect for
  long time horizon
• Capital gain has greater effect for short time
  horizon

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TBDC Index

• TBMA Government Bond Index
• (Total Return Index, Clean Price Index,
  Gross Price Index)
• Sub group 1 1 lt TTM lt 3 Years
• Sub group 2 3 lt TTM lt 7 Years
• Sub group 3 7 lt TTM lt 10 Years
• Sub group 4 TTM gt 10 Years
• TBMA Corporate Bond Index
• (Total Return Index, Clean Price Index,
  Gross Price Index)

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Yield Curve Movement 4 Jan 31 Oct 05
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Total Return Index
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Risks in Fixed Income Investment

• Market / Interest Rate Risk
• Reinvestment Risk
• Credit / Default Risk
• Marketability / Liquidity Risk
• Inflation / Purchasing Power Risk
• Call Risk
• Exchange Rate / Currency Risk
• Event Risk
• Political / Legal Risk
• Black-Box Risk

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Risk Measurement
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Price-Yield Relationship
Convexity
Duration
Price-Yield Curve
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Price Volatility Measurement

• Price Change

- Modified Duration x ?Yield x 100 0.5 x
Convexity x (?Yield)2 x 100
Remark ?Yield shown in decimal point
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Duration

• Macaulay Duration Weighted average of times
  until each payment is made

Modified Duration Estimates Price change given
small change in Yield
Where
k period / yr
n
period until maturity (yrs to maturity x k)
t Period of
to-be-received cash flow (t 1,..,n)

PVCFt Present value of cash
flow in period t discounted at YTM

PVTCF Total PVCFt
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Price Volatility Measurement

• Modified Duration

Zero-coupon Bond
T 1 2 3 4 5 6 7 8
Coupon Bond
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Factors Affecting Duration

• (All other things held constant)
• Maturity Long gt
• Coupon High Coupon gt
• Zero coupon
• Floating rate
• Amortising More principle prepayment gt
• YTM High YTM gt

High Duration
Low Duration
Time to Maturity
Coupon Period
Low Duration
Low Duration
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Rearrange from highest to lowest duration
a) Zero coupon, 10 year maturity b) Zero
coupon, 20 year maturity c) 8 coupon, 10 year
maturity d) 8 coupon, 20 year maturity
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Price Volatility Measurement

• Convexity
• Measure how convex the curve is (2nd Dif)
• Convexity - Prices rise at increasing rate as
  yield fall
• - Price decline at decreasing rate as yield
  rise.
• Positive attribute of bond
• The more money exposed to bigger exponents, the
  greater the convexity

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Price Volatility Measurement

• Example We invest THB 10,825,000 in LB08DA _at_
  YTM 5.5 Modified Duration 2.6
• Convexity 8.7
• Question How would our investment value change
• if YTM of LB08DA increases 10 bps to 5.6?

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Price Volatility Measurement
Price Change - (2.6 x 0.001 x 100) 0.5 x
8.7 x (0.001)2 x 100 -0.2596 Our
investment value decreases 0.2596 or 28,101.70
Baht (from THB 10,825,000 to 10,796,898.30)
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Price Volatility Measurement
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Credit Risk Measurement

• Credit Scoring Model
• In-House Model
• Market Model
• Altman Z-Score
• Springate Model
• Logit Model

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Altman Z-Score

• Z 1.2X1 1.4X2 3.3X3 0.6X4 1.0X5
• Where X1 Working capital / Total assets
• X2 Retained earnings / Total assets
• X3 EBIT / Total assets
• X4 MV of equity / BV of long term debt
• X5 Sales / Total assets
• Higher Z, lower default risk
• Use by credit officer when judge corporate
  borrowers
• Ex. If Z lt 1.81, reject the loan

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Springate Model

• Z 1.03A 3.07B 0.66C 0.4D
• Where A Working capital / Total assets
• B Net profit before interest and tax / Total
  assets
• C Net profit before tax / Current
  liabilities
• D Sales / Total assets
• If Z lt 0.862, Fail

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Logit Model

• Y 0.23883
• - 0.108 x Investment / Sales
• - 1.583 x Receivable / Investment
• - 10.78 x (Cash Marketable security) / Total
  asset
• 3.074 x Quick asset / Current Liability
• 0.486 x Operating income / (Total asset -
  Current liabilities)
• - 4.35 x Long term debt / (Total asset-Current
  liability)
• 0.11 x Sales / (Net working capital Fixed
  asset)
• Probability of bankruptcy 1/(1eY)

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Portfolio Management Strategy
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Portfolio Management

• Setting Objectives
• Establishing Investment Policy
• Time horizon, Risk tolerance, Liquidity needs,
  Regulatory constraints, Tax
• Selecting Portfolio Strategy
• Selecting Individual Bond
• Maturity, Credit quality, Embedded option,
  Convexity
• Measuring Evaluating Performance

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Core Portfolio Setup

• Forecast yield curve movement
• Calculate Horizon Return of each bond
• Optimization
• SHARPE (Expected Return-Rf)/sp

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Portfolio Structuring
Bullet Portfolio
Barbell Portfolio
Ladder Portfolio
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Active Portfolio Management

• Anticipation
• 1. Changing Interest Rate Level
• 2. Changing Yield Curve Shape
• 3. Changing Spread
• - Between bond sector
• - Between individual bond
• 4. None

Strategy Interest rate Expectation
Yield Curve
Intermarket Spread Swap
Pure Yield Pickup Swap Substitution Swap
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Changing Interest Rate Level

• Expect interest rate
  Duration
• Expect interest rate Duration

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Factors Affecting Yield Curve

• Interest Rate
• Inflation
• Economic Growth
• Demand
• Supply

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Factors Affecting Yield Curve
20 Jul 05 MPB raised Rp 14 days 25 bps, less
than market expectation of 50 bps
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Factors Affecting Yield Curve
7 Sep 05 MPB raised Rp 14 days 50 bps (from
2.75 to 3.25) vs market expectation of 25 bps
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Factors Affecting Yield Curve
3 Oct 05 Sep CPI highest level in 7 yrs BOT
Governor said real interest rate will be positive
by Q205
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Changing Yield Curve Shape

• Parallel Shifts (Upward / Downward)

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Changing Yield Curve Shape

• Twists (Flattening / Steepening)

Steepening
Flattening
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Changing Yield Curve Shape

• Humps (Butterfly Shifts)

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Yield Curve Strategy

• Parallel Shift (Upward / Downward)

Bullet portfolio for small parallel shift Barbell
portfolio for big parallel shift
Barbell
Bullet
Barbell
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Yield Curve Strategy

• Flattening (Bullish / Bearish)

Barbell only!
Bullet-Barbell
0
-2
-4
-6
-8
-10
-12
0.00
1.00
2.00
3.00
4.00
5.00
-5.00
-4.00
-3.00
-2.00
-1.00
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Yield Curve Strategy

• Steepening (Bullish / Bearish)

Bullet portfolio for small shift Barbell
portfolio for big shift
Bullet
Barbell
Barbell
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Yield Curve Strategy

• Humps / Butterfly Shifts

• Negative Butterfly Sell Body, Buy Wings
• Positive Butterfly Sell Wings, Buy Body

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Trading Strategies
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Intermarket Spread Swap Strategy

• Between Bond Sectorswap)
• Quality Spread
• - Widen as economy deteriorate (Flight to
  Quality)
• - Narrow as economy improve (Flight from Quality)
• - Buy improved industry, sell deteriorate
  industry
• Callable vs Non-callable Bond Spread
• - Widen in high interest rate volatility
• - Narrow in low interest rate volatility
• Between Individual Bond
• Temporary divergence Buy cheaper one
• Credit Buy better perform one

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Bond Swap

• If no anticipation
• Pure yield pickup swap
• Buy bond with higher YTM, given same duration
• Buy bond with lower duration, given same YTM
• Bullet - Barbell
• Substitution swap
• Buy bond with higher YTM, given identical
  features (Due to market imperfection, temporary
  imbalance)

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Bond IRS

• We can use IRS (Interest Rate Swap) with
  fixed-income portfolio
• - to hedge or
• - to enhance return

Port
Bond
5.0
T0
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IRS Transaction
T0
Port pay fixed, receive float
Port
Swap Dealer
Port pay float, receive fixed
THBFIX
Port
Swap Dealer
5.7
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For Hedging

• If expect yield to increase
• Enter pay fix, receive float
• Duration of portfolio will reduce

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IRS for Hedging
Bond
TT
5.0
5.5
Port
Swap Dealer
THBFIX
Port pay fixed _at_0.5, receive float _at_THBFIX Net
receive THBFIX 0.5
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Pair Trade using IRS

• Monitoring IRS spread. If spread reduces
  significantly
• You believe government bond is cheap, swap is
  rich
• Enter pay fixed, receive float
• Unwind when spread turn back to normal
• Effectively you long government bond and short
  fixed rate swap

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For Yield Enhancement

• If expect yield to drop
• Enter pay float, receive fixed
• You effectively increase portfolio duration