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Advanced Fixed-Income Trading

2. Content. Thai Bond MarketReturn vs RiskRisk MeasurementPortfolio Management

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Advanced Fixed-Income Trading

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    1. 1 Advanced Fixed-Income Trading 26 November 2005 by Sansanee Hutanuwatr

    2. 2 Content Thai Bond Market Return vs Risk Risk Measurement Portfolio Management & Strategy Active Trading Strategies

    3. 3 Thai Bond Market

    4. 4 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 Registered Bonds in TBMA

    5. 5 Registered Bonds by Value

    6. 6 Trading Volume

    7. 7 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 Corporate Bonds in Focus

    8. 8 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 Bond Symbol

    9. 9 Return vs Risk

    10. 10

    11. 11

    12. 12 Current Spread

    13. 13 Return Return from fixed-income investment: Coupon Coupon Reinvestment Capital Gain (Loss) Assumptions of Yield-to-Maturity (YTM) Reinvestment rate = YTM Hold-to-Maturity

    14. 14 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

    15. 15 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) ˝ - 1 = 9.09% Step 6: Bond equivalent yield = (1.0909)2 – 1 =19.01%

    16. 16 Horizon Return Horizon Return > YTM when - Reinvestment rate > YTM - Bond price at end of horizon > Par (Selling YTM < Invested YTM) Coupon reinvestment income has greater effect for long time horizon Capital gain has greater effect for short time horizon

    17. 17 TBDC Index TBMA Government Bond Index (Total Return Index, Clean Price Index, Gross Price Index) Sub group 1 : 1 < TTM < = 3 Years Sub group 2 : 3 < TTM < = 7 Years Sub group 3 : 7 < TTM < = 10 Years Sub group 4 : TTM > 10 Years TBMA Corporate Bond Index (Total Return Index, Clean Price Index, Gross Price Index)

    18. 18 Yield Curve Movement : 4 Jan – 31 Oct 05

    19. 19

    20. 20 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

    21. 21 Risk Measurement

    22. 22 Price-Yield Relationship

    23. 23 Price Volatility Measurement %Price Change ~

    24. 24 Duration Macaulay Duration: Weighted average of times until each payment is made

    25. 25 Modified Duration Price Volatility & Measurement

    26. 26 Factors Affecting Duration (All other things held constant) Maturity : Long => Coupon : High Coupon => Zero coupon Floating rate Amortising : More principle prepayment => YTM : High YTM =>

    27. 27 Rearrange from highest to lowest duration

    28. 28 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 Price Volatility & Measurement

    29. 29 Price Volatility Measurement Example : We invest THB 10,825,000 in LB08DA @ 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%?

    30. 30 Price Volatility Measurement

    31. 31 Price Volatility Measurement

    32. 32 Credit Risk Measurement Credit Scoring Model In-House Model Market Model Altman Z-Score Springate Model Logit Model

    33. 33 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 < 1.81, reject the loan

    34. 34 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 < 0.862, Fail

    35. 35 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/(1+eY)

    36. 36 Portfolio Management & Strategy

    37. 37 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

    38. 38 Core Portfolio Setup Forecast yield curve movement Calculate Horizon Return of each bond Optimization SHARPE = (Expected Return-Rf)/sp

    39. 39 Portfolio Structuring

    40. 40 Anticipation 1. Changing Interest Rate Level 2. Changing Yield Curve Shape 3. Changing Spread - Between bond sector - Between individual bond 4. None Active Portfolio Management

    41. 41 Expect interest rate Duration Expect interest rate Duration Changing Interest Rate Level

    42. 42 Factors Affecting Yield Curve Interest Rate Inflation Economic Growth Demand Supply

    43. 43 Factors Affecting Yield Curve

    44. 44 Factors Affecting Yield Curve

    45. 45 Factors Affecting Yield Curve

    46. 46 Parallel Shifts (Upward / Downward) Changing Yield Curve Shape

    47. 47 Twists (Flattening / Steepening) Changing Yield Curve Shape

    48. 48 Humps (Butterfly Shifts) Changing Yield Curve Shape

    49. 49 Yield Curve Strategy

    50. 50 Yield Curve Strategy

    51. 51 Yield Curve Strategy

    52. 52 Negative Butterfly: Sell Body, Buy Wings Positive Butterfly: Sell Wings, Buy Body Yield Curve Strategy

    53. 53 Trading Strategies

    54. 54 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

    55. 55 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)

    56. 56 Bond & IRS We can use IRS (Interest Rate Swap) with fixed-income portfolio - to hedge or - to enhance return

    57. 57 IRS Transaction

    58. 58 For Hedging If expect yield to increase Enter pay fix, receive float Duration of portfolio will reduce

    59. 59 IRS for Hedging

    60. 60 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

    61. 61 For Yield Enhancement If expect yield to drop Enter pay float, receive fixed You effectively increase portfolio duration

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