PART I – ANALYSIS AND VALUATION OF BONDS

Fixed Income Markets and Products 1. Bonds and Money-Market Instruments

2. Bond Prices and Yields
3. Term Structure of Interest Rates
4. Hedging Interest Rate Risk
Raquel M. Gaspar Sérgio F. Silva 5. Investment Strategies

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5.1 Passive Strategies

5 . Bond Investment Strategies • Look to have a performance equal to the market

• Passive investors act like that if the market were efficient

• If the market is fully effective, no active strategy is able to beat the

market

→ Straightforward (direct) Replication

→ Replication by Stratified Sampling
→ Tracking-Error Minimization
→ Factor Based Replication

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Direct Replication
Stratified Sampling

• Tries to replicate the different components/features of the index with a

• Exact index replication
smaller number of assets
- Holding all assets in the exact proportions the show in the index
• Different components/features:
• Once the index is replicated, trades are made only to keep track of the
• Sectors (treasury, corporate, …)
index changes
• Rating Classes (AAA, AA, A, BBB, …)

• Although widely used in the case of stock indices, it is not so common in • Duration
the case of bonds indices • Maturities
- High number of emissions
•…
- The composition of the index changes regularly

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Minimize the Tracking Error
The problem of optimization is:

- create a portfolio of N bonds
• Risk models allow you to replicate an index creating portfolios with a minimal
- choosing weights(wi, i =1, 2…N) in order to replicate as closely as
tracking error
possible the return of the bond index(RB)
• These models are based on the historical volatilities and correlations
between the returns of different asset classes or different risk factors

• It is expected that such portfolios have at least a correlation of 0.95 with the - portfolio return
index they are trying to track
- variance of portfolio returns
• The technique involves two steps:
-covariance between the return of bond i and the return of bond j (element
- Estimation of variances and covariances of returns obligations
ij of the variance-covariance matrix)
- Use this matrix to minimize the tracking error
- covariance between the return of bond i and the return of the index

- variance of the index return

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Sample variance-covariance matrix

The key aspect of the problem is the variance – covariance matrix of the bonds’
returns

T – sample size (number of periods of time);

N – number of bonds;
Rt – vector (Nx1) of bond returns in period t
Different approaches:
– vector (Nx1) of average returns of bonds

Historical estimation of variance-covariance matrix
Exponentially weighted variance-covariance matrix

Exponentially weighted variance-covariance matrix (gives more importance to the most recent observations)

Factor models based variance-covariance matrix

λ - decreasing factor (is common to use λ = 0,94)

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Factor Model based variance-covariance matrix Example - replicate the index JP Morgan Treasury-Bond using the following
treasuries
• Reduce the number of estimates through the use of a model of factors 6.25% 31-Jan-2002
4.75% 15-Feb-2004
• We know the term structure dynamics is driven by a limited set of factors (2 5.875% 15-Nov-2005
or 3) 6.125% 15-Aug-2007
6.5% 15-Feb-2010
5% 15-Aug-2011
- Fjt is the factor j at date t(j = 1, 2, ..,k) 6.25% 15-May-2030
- eit is specific return of asset i 5.375% 15-Feb-2031
- βij is the measure of sensitivity of Ri to the factor j
- Sample: daily observations for the period 2/08/2001-30/01/2002
• Using estimates of βij and to get estimates of Cov(Ri,Rj) considering 2
- Obtaining the tracking error for a portfolio:
factors :
- arbitrary with equal weights
- variance
- optimal with no restrictions on short selling
- covariance
- optimal when short selling is not allowed
- These expressions simplify it even more if we assume that Cov(F1,F2) = 0
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 Example – the case of sample variance-covariance matrix Example – the case of sample variance-covariance matrix
Portfolio with equal weights (Traking error = 0,14%) Optimal portfolio without short sales (Traking error = 0,07%)

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Example: Results (see excel file)

Example – the case of sample variance-covariance matrix
Sample Covariance Matrix Bond 1 Bond 2 Bond 3 Bond 4 Bond 5 Bond 6 Bond 7 Bond 8 TE
Optimal portfolio with short sales (Traking error = 0,04%) with short-sales contraints 12,93% 14,19% 0,00% 0,00% 0,00% 62,41% 8,33% 2,13% 0,07%
without short-sales contraints 1,99% 39,92% -1,43% 20,93% -62,38% 83,59% 3,44% 13,93% 0,04%
Equal
0,14%
weight

Exponentially-Weighted
Estimator Bond 1 Bond 2 Bond 3 Bond 4 Bond 5 Bond 6 Bond 7 Bond 8 TE
with short-sales contraints 0,37% 34,44% 0,27% 4,02% 0,00% 44,79% 0,00% 16,10% 0,02%
without short-sales contraints 0,20% 29,00% 5,21% 18,80% -23,80% 54,74% -4,97% 20,82% 0,01%
Equal
0,12%
weight

Single-Index Covariance
Matrix* Bond 1 Bond 2 Bond 3 Bond 4 Bond 5 Bond 6 Bond 7 Bond 8 TE
beta 0,021 0,361 0,695 0,821 1,071 1,216 1,930 1,963
with short-sales contraints 8,20% 10,84% 8,29% 7,81% 7,85% 48,73% 4,74% 3,53% 0,08%
without short-sales contraints 8,20% 10,84% 8,29% 7,81% 7,85% 48,73% 4,74% 3,53% 0,08%
Equal
0,10%
*Considers as a factor the index itself weight

TE – tracking error =
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Factor-Based Replication
5.2 Active Strategies
• Consists of choosing weights so that the exposure of the portfolio and the
index to the different factors are the same
• Investors who don't accept the hypothesis of market efficiency would
In case of 3 factors:
rather active investment strategies
(i = 1,2,…N)
• 2 types of strategies

→ Market Timing
(to trade based upon expectations on the future evolution of interest rates)
→ Bond Picking
Minimizing tracking error considering additional restrictions:
(to trade to explore possible market inefficiencies)

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Riding the yield curve

5.2.1 Market Timming
• Technique traditionally used by managers to increase the returns when:
• The portfolio managers do "bets" on the future changes of the yield curve
• the yield curve is increasing;
- "Bets" based on the assumption the yield curve will not change (riding the yield
curve) • and it is expected it will remain unchanged
- "Bets" based on their opinions on what will be the changes in the level of interest
rates (naive strategies or roll-over)
- "Bets" based on their opinions on what will be the level, slope and/or curvature of
the yield curve (butterflies) • Allows the investor to obtain a higher rate of return by:

• Managers need scenario analysis tools both to estimate returns and to assess • buying bonds with maturities exceeding the intended investment
the risk of the strategies implemented time horizon

- Evaluation of the break-even point • selling them when the yields are reduced as the maturity decreases
by the simple passage of time
- Risk assessment in case their expectation is not verified

• It can be implemented considering different classes of bonds or assets

(treasury vs corporate bonds vs. equities;)

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Example
Example (cont.)
Consider the following zero-coupon curve (column 2) and 5 bonds with a - Option 1: investing in the bond with a maturity of 1 year
coupon rate of 6% - Option 2: riding the yield curve
In column 3 contains the current (t=0) prices of the bonds (for a nominal - option 2.1: buy a 2-year bond and sell it in 1 year
value of 100 $) and in column 4 the prices in 1 year (t=1) assuming the zero- - option 2.2: buy a 3-year bond and sell it in 1 year
coupon curve remained unchanged - option2.3: buy a 4-year bond and sell it in 1 year
Maturity Zero-coupon Price at t=0 Price at t=1 - option2.4: buy a 5-year bond and sell it in 1 year
rate Returns: Option 1 -
1y 3.90% $102.021 $102.021
2y 4.50% $102.842 $102.842 Option 2.1 -
3y 4.90% $103.098 $103.098
4y 5.25% $102.848 $102.848 Option 2.2 -
5y 5.60% $102.077
Option 2.3 -
Assume the portfolio manager has funds available to invest with a 1-year
time horizon
Option 2.4 -
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Example (cont.)
Expectations about the level of interest rate

• Strategies based on the changes of the level of interest rates are simple
- Best option: 2.4 (return of 6.633%)
• Assumes that the yield curve depends on just one factor
- The longer the maturity of the bond, the greater the return
• the focus is in the YTM
But, • only considers parallel movements
• Two possible moves: an increase in interest rates (upward movement) or a
- What if zero-coupon rates would have increased reduction in interest rates (downward movement)
- the return would have been less than 6.633%; • If there is an expectation of a reduction of the interest rate level, then
one should buy bonds with high duration
- and it could even be less than 3.90%
• on the other hand, if there is an expectation of an increase of the level of
interest rates, then we should reduce the $ duration or modified duration
of the portfolio of bonds or sell uncovered bonds (or futures contracts) or
alternatively hold short-term instruments and at roll over them at maturity.

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Expectations of a decrease in interest rates
Example – expectation of a decrease in the interest rate level

Consider on date t, a flat curve at the 5% level and 5 bonds with the following
Recall that: characteristics
- The higher the maturity T and the higher coupon rate C, the higher the $ Bond Maturity Coupon YTM Price
duration of a bond rate
-The higher the maturity T and the lower coupon rate C, the greater the 1 2 anos 5% 5% $100
modified duration 2 10 anos 5% 5% $100
3 30 anos 5% 5% $100
4 30 anos 7,5% 5% $138,43
5 30 anos 10% 5% $176,86

Strategies: - A portfolio manager has the expectation that the YTM curve will decrease to
the 4.5% level
- Investing in bonds with high T and high C, to optimize the absolute gain
- Investing in bonds with high T and low C, to optimize the relative gain - What bonds must he negotiate if you want to:
- maximize the absolute gain

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- maximize the relative gain
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Example (cont.)– expectation of a decrease in the interest rate level
Example – expectation of an increasse in the level

Bond Modified $ Duration Relative Absolute Consider a flat curve at the 5% level
duration gain gain - the investment time horizon is 5 years
1 1,859 -185,9 0,936% $0,936 - you expect an increase in interest rates by 1% in 1 year
2 7,722 -772,2 3,956% $3,956
• Option 1
3 15,372 -1 537,2 8,144% $8,144
- Buy a 5 years’ maturity bond
4 14,269 -1 975,3 7,538% $10,436
- Hold the bond
5 13,646 -2 413,4 7,196% $12,727
until maturity
• Option 2
- If the focus is the relative gain: the 30 years’ bond with a coupon rate of 5%
(bond number 3) - Buy a 1-year obligation (T-bill)

- If the focus is the absolute gain: the 30 years’ bond with a coupon rate of 10% - Hold the 1-year T-bill until maturity
(bond number 5) - A year from now buy a 4-year maturity bond
- Hold the 4-year bond until maturity

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Example (cont.) – expectation of an increase in level

Expectations on the level, slope and curvature of the yield curve
Assume your expectations were realized
• Option 1
• The yield curve is potentially affected by other movements beyond parallel
Date t=0 t=1 t=2 t=3 t=4 t=5 movements (level) – there are also movements in the slope and curvature
Cash Flow -100 5 5 5 5 105 • In general it is quite complex to know under what market conditions a
concrete strategy will generate a positive or negative results when all possible
Annual rate of return: moves of the yield curve are taken into account.
• We will see:
• Option 2 • Simple strategies bullet , barbell e Ladders
Date t=0 t=1 t=2 t=3 t=4 t=5 • More complex butterfly strategies
Cash Flow -100 105-100 6 6 6 106 • Other strategies that can be understood as contingent hedging strategies

Annual rate of return:

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Bullets
- Definition: a bullet portfolio is built concentrating all the investment on a particular
Butterfly
maturity – we put a “bullet” on a particular point of the yield curve - It is one of the most commonly used strategies
- Example: portfolio 100% invested in 5 years bonds
- Results from the combination of a barbell with a bullet

Barbells - The weights of the components are adjusted so that the combination
- Definition: a barbell portfolio is built concentrating investments in short and long presents a null $duration and is a self-financed transaction (cash-neutral)
segments of the yield curve
- To presenting a null $duration, it guarantees an almost perfect immunity
- Example: portfolio in which 50% is invested in 6-month Treasury bills and the other to minor parallel changes of the yield curve
50% in 30 years bonds
- Usually the butterfly strategy is structured to present a positive convexity

Ladders which generates a positive gain for parallel yield curve shifts

- Definition: a ladder portfolio is built by investing equal proportions in various bonds - There are different types of butterflies that are structured to generate a
of different maturities positive pay-off in the event a particular yield curve movement.
- Example: portfolio in which 20% is invested in 1 year OTs, 20% in 2 year OTs, 20% in 3
years OTs, 20% in 4 years OTs and the last 20% in 5 years OTs

OBS: Bullets, Barbells e Ladders constitute the basis for building more complex
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Butterfly – Cash and $Duration Neutral Example I (cont.)
- Ensures a positive pay-off if the yield curve movement shifts in a parallel
- For a given value of α, for example1000, find out qs and ql that guarantee:
way ( no matter if a positive or negative shoft)
Example (excel):
$Duration = 0:
Maturity Coupon rate YTM Price $ $Duration Quantity
cash neutral:
2 5% 5% 100 -185,9 qs
5 5% 5% 100 -432,9 α
10 5% 5% 100 -772,2 ql

Designing the butterfly:

- Sell 5 year bonds (in quantity α) qs = 578,65
⇔
- buy 2 years and 10 years bonds (in quantity qs e ql respectively) ql = 421,35

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Example I (cont.) Example (see Buterfly excel file):

Consider the following bonds:

Maturity Coupon rate YTM Price $ $duration

2 5% 4,5% 100,936 -186,851
5 5% 5,5% 97,865 - 421,173
10 5% 6% 92,64 -701,139

Structure a butterfly Cash and $Duration Neutral, considering you sell 10

000 5 year bonds:

⇒
The butterfly has a positive convexity; whatever the changes that occur in
the YTM, this strategy generates always gain … but the yield curve can
suffer non-parallel movements in which case looking to the YTM is not
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 • Butterfly – weighted 50/50 • Butterfly – regression weighted

- Since short-term rates are more volatile than long term rates one expects
- Adjust the weights so that the $duration of the portfolio is null and that the larger variations in the yield curve short segment than long segment
$duration of the “wing" (short and long segments) are the same
- Do the regression that explains the variation of the spread between the
long segment and intermediate segment (∆S1) based upon the variation of
- The aim is to make the strategy neutral to small movements, increases or
the spread between the intermediate segment and the short segment
decreases, off the slope (steepening and flattening respectively), such as:
(∆S2): ∆S1 = a + b∆S2 + e
- Steepening scenario: “-30/0/30”
- Adjust the positions so that the portfolio presents a null $duration and
- Flattening Scenario: “30/0/-30” that the short segment position $duration (weighted by the factor b)
equals the $duration of the position in the long segment
Using the data in the previous example:
Example: if b =0.5, the strategy is almost neutral to a steepening scenario of
the type "-30/0/15" or a flattening scenario of the type "30/0/-3". Using the
⇒ previous example data we would have:

⇒
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• Butterfly – maturity weighted • Results (one day) for different scenarios

- Similar to the previous case, but instead of considering the weight as a

regression coefficient, it is defined using the maturities of the bonds: Net profit (in $) assuming a 4% financing rate

Type of
equal +20 pb -20 pb -30/0/30 30/0/-30 -30/0/15 30/0/-15
Butterfly

Cash-neutral -9 11 11 -6 214 6 495 -1 569 1 646

In the Example, we would have:

50/50 -9 -1 -5 100 116 3 192 -3 110

Regresão -9 7 6 -4 087 4 347 35 44

⇒ Maturidade -9 5 3 -3 040 3 289 824 -744

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5.2.2 Bond Picking
Pure arbitrage opportunities
- Comparison of bonds’ relative value – technique of detecting Exemplo:
undervalued and overvalued bonds
- In 14/09/2004
- There are two different types of investment opportunities:
- Prices of Strips with maturities 15/02/2005, 15/02/2006 and 15/02/2007
Pure arbitrage opportunities were 99,07%, 96,06% and 92,54%, respectively
- It compares the price of two products with identical cash flows - The (dirty) price of a bond maturing in 5/02/2007, paying an annual
- Typically an bond and a sum of STRIPs (zero coupon bonds) that replicate that coupon rate of 10%, was at that time 121,5%
bond
- Is there any arbitrage opportunity?
- If there is any price difference, then there exists an arbitrage opportunity
without risk
We have to compute the price of the portfolio of strips that replicate
Speculative arbitrage opportunities the bond:
- It detects expensive or cheap assets that historically have abnormal YTM For a face value of the bond equal to 100€, we have the replica:
- Taking as reference a theoretical zero coupon yield curve that should apply to 10 € face value on the Strip 15/02/2005
that concrete product.
10 € face value on the Strip 15/02/2006

41 42 110 € face value on the Strip 15/02/2007

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Speculative arbitrage opportunities (Rich-cheap analysis)

Example (cont.):
• Steps
Replica price:
1. Building a zero coupon yield curve using data on bonds that are
(121,307%) homogeneous and have similar characteristics to the bonds under analysis,
⇓ at least, in terms of liquidity and risk
Replica price (121,307%) < Bond price(121,5%)
2. Using that theoretical zero coupon yield curve, compute the theoretical
prices of the bonds under analysis
There is a pure arbitrage strategy:
3. Using the theoretical prices derive the implied YTM for each bond
- buy the replica
4. The spread (yield de mercado – yield teórica) allows you to identify the
- (short) sell the bond
bonds that are expensive (spread < 0) and the obligations that are cheap
Result for1 000 000€ traded nominal value: (spread > 0)
5. Using statistical analysis (Z-score analysis) on the historical spreads of each
bond in order to distinguish abnormal or current inefficiencies of yields

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Z-score Analysis (assuming normality)
• Steps (cont.)
•Calculate the mean m and standard deviation σ the spread based upon, for
6 . Combine long and short positions to create a portfolio almost insensitive example, the last 60 days
to interest rate risk •Assume that the spread, S, is normally distributed, defining the
7. Reverse the positions according to a criterion defined a priori standardized spread as U =(S-m)/kσ with k =2

- for instance, when the spread is back to "normal“ level •We the get Prob(-1<U<1) = 0,9544
•Thus, if the standardized spread value is higher (lower) than 1 (-1), the
bond can be seen as relatively cheap (expensive)
•We can change the confidence level using different k values

Example:
- The average value and standard deviation of the last 60 days spreads are:
m = 0,03% e σ = 0,04%
- The observed spread is S = -0,11%, taking k = 3 (confidence level equal to
99,73%), we know that U = -1,166, thius we consider the bond is expensive.
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5.3 Performance Analysis Example:

- initial investment50
• Measures of return - after 6 months, the investment value is 25
- value-weighted - new entrace of 25 (CF = -25)
- after more 6 month, the final investment value is 100 (CF=100)
- equivalent to an internal rate of return
- considers the various cash flows (inputs and outputs)

- value-weighted: ⇒ r = 40,69%

- time-weighted - time-weighted: - first 6 months:

- calculation of returns between exits/entrances
- second 6 months:
- calculation of the return of the period (geometric mean)
- total rate of return of the period:

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Return Measures - comments
Measures of risk-adjusted return

- value-weighted measures are better: - Sharpe ratio:

- when the manager has control over the entrances and exits of funds
- the manager should be rewarded when you take good decisions
- Sortino ratio:

- time-weighted: - MAR – Minimum Acceptable Return

- should be used in other situations (e.g. for Pension Fund Managers) - The calculation of risk only contemplates the observations to which Rt <
MAR (Tm)
- Penalizes managers by taking “negative” risk

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