BondSquawk

A very good article in the WSJ that links the current riots in the Middle East to the policies adopted by the Federal Reserve to contain inflation. A must read by George Melloan:

In accounts of the political unrest sweeping through the Middle East, one factor, inflation, deserves more attention. Nothing can be more demoralizing to people at the low end of the income scale—where great masses in that region reside—than increases in the cost of basic necessities like food and fuel. It brings them out into the streets to protest government policies, especially in places where mass protests are the only means available to shake the existing power structure.

The consumer-price index in Egypt rose to more than 18% annually in 2009 from 5% in 2006, a more normal year. In Iran, the rate went to 25% in 2009 from 13% in 2006. In both cases the rate subsided in 2010 but remained in double digits.

Egyptians were able to overthrow the dictatorial Hosni Mubarak. Their efforts to fashion a more responsive regime may or may not succeed. Iranians are taking far greater risks in tackling the vicious Revolutionary Guards to try to unseat the ruling ayatollahs.

Probably few of the protesters in the streets connect their economic travail to Washington. But central bankers do. They complain, most recently at last week’s G-20 meeting in Paris, that the U.S. is exporting inflation.

China and India blame the U.S. Federal Reserve for their difficulties in maintaining stable prices. The International Monetary Fund and the United Nations, always responsive to the complaints of developing nations, are suggesting alternatives to the dollar as the pre-eminent international currency. The IMF managing director, Dominique Strauss-Kahn, has proposed replacement of the dollar with IMF special drawing rights, or SDRs, a unit of account fashioned from a basket of currencies that is made available to the foreign currency reserves of central banks.

About the only one failing to acknowledge a problem seems to be the man most responsible, Federal Reserve Chairman Ben Bernanke. In a recent question-and-answer session at the National Press Club in Washington, the chairman said it was “unfair” to accuse the Fed of exporting inflation. Other nations, he said, have the same tools the Fed has for controlling inflation.

Well, not quite. Consider, for example, that much of world trade, particularly in basic commodities like food grains and oil, is denominated in U.S. dollars. When the Fed floods the world with dollars, the dollar price of commodities goes up, and this affects market prices generally, particularly in poor countries that are heavily import-dependent. Export-dependent nations like China try to maintain exchange-rate stability by inflating their own currencies to buy up dollars.

Mr. Bernanke has made it clear that his policy is to inflate the money supply. His second round of quantitative easing—the controversial QE2 policy to systematically purchase $600 billion in Treasury securities with newly created money—serves that aim. But even for the U.S. it is uncertain that Mr. Bernanke can hold to his 2% inflation target. Oil is going up. Foodstuffs are going up. And when the Fed sneezes money, the weak economies of the world, and the poor masses who are highly vulnerable to price rises in the necessities of life, catch pneumonia.

The turmoil in Iran is reminiscent of another period when the Fed was on an inflationary binge, the late 1970s. The Iranian oil boom had brought many thousands of peasants out of the villages into the cash economy in population centers like Tehran. On top of the disorientation resulting from that change itself, Iranians were then victims of an outbreak of inflation and a sharp decline in the purchasing power of the rials in their pay envelopes. Confused and angry, they supported the clerical revolution that unseated the shah and has been a thorn in America’s side ever since.

Today’s Iranian revolt has similar causes and, if successful, could be the flip side of 1979, a nation again friendlier toward the U.S. But there is no guarantee of that, or that states now friendly, like Bahrain, will remain so after an Egyptian-style upheaval.

Indeed, it is unlikely that Americans themselves will escape the inflationary consequences of current Fed policy. Aside from the rise in oil and foodstuffs, higher prices of manufactured goods are in the offing. China’s inflation rate is hovering at 5%. MKM Partners, a research and trading firm, last November reported that an internal study at Wal-Mart, a big importer from China, showed that the huge retail chain’s prices are edging up at an annual rate of 4% a year. That recent trend showed up in last week’s consumer-price index report.

The Fed is financing a vast and rising federal deficit, following a practice that has been a surefire prescription for domestic inflation from time immemorial. Meanwhile, its policies are stoking a rise in prices that is contributing to political unrest that in some cases might be beneficial but in others might turn out as badly as the overthrow of the shah in 1979. Does any of this suggest that there might be some urgency to bringing the Fed under closer scrutiny?

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of “The Great Money Binge: Spending Our Way to Socialism” (Simon & Schuster, 2009).

February 16, 2011

The producer price index rose by 0.8% m/m in January, once again driven by high energy prices. Energy prices jumped 1.8% m/m after the 2.8% jump in the previous month. Gasoline surged 6.9% m/m. Surprisingly, food prices were not such significant driver in January, as they increased by relatively subdued 0.3% m/m. Core prices (ex food and energy) posted a 0.5% m/m increase, which was the biggest monthly increase since 2008. Core pipeline pressures picked up lately with core crude prices and core intermediate prices increasing for the sixth consecutive month. However, while producer pricing power is improving, retailers will likely still have difficulties passing higher prices onto consumer. Core PPI is best correlated with the core goods component in CPI. Core goods have been on a constant downward trend as of late, but there is a limit to how much further it could fall.

In January housing starts surged by 14.6% m/m above expectations, entirely driven by a 77.7% m/m increase in multifamily starts. Single family starts continued to decline posting a 1.0% decline in January, which followed an 8.4% m/m drop in the month prior. The strength in multifamily starts likely points to some pick up in demand for rental properties, as owners’ market continues to struggle from falling prices and surging foreclosures. Meanwhile, housing permits, the indicator of future activity, dropped 10.4%m/m, driven by a 23.8% decline in multifamily starts. Such a decline in permits likely points to a drop in starts in February. Unusually high volatility in housing starts and permits around the turn of the year also reflects builders’ attempts to get approval before the end of the year in anticipation of changes in building codes. Starts remain depressed by historical standards and confirms expectations of a prolonged and painful housing recovery.

Bond Ladders

One very popular and effective way to create a bond portfolio is to create a bond ladder.  A bond ladder consists of several different bonds with differing maturity dates. For example, if one had $200,000 to invest, they could buy $40,000 in bonds that mature in 2 years, 4 years, 6 years, 8 years, and 10 years.  This would result in a portfolio that has an average maturity of 6 years.  Another possibility is to purchase $20,000 in bonds that mature each year for the next ten years, which would create a portfolio with an average maturity of 5.5 years.

Each separate bond maturity is a “rung” in the ladder.  The bonds could be treasuries, agencies, municipals, or corporate bonds.  For bonds that are not treasuries, the ladder would most likely be invested in bonds from different issuers to diversify in order hedge againstdefault risk.

Creating a bond ladder provides investors with a number of advantages:

• Provides a steady and predictable stream of income.
• The regular maturity intervals provides ongoing liquidity.
• Because the periodic maturities allow the portfolio to purchase new bonds on a regular basis, the reinvestment risk is significantly reduced.  If interest rates rise, the maturing capital is reinvested at higher rates.  If interest rates fall, maturing capital is reinvested at lower rates, but the longer bonds in the portfolio continue to earn higher rates.
• Having the bonds mature at regular intervals also provides a hedge against interest rate risk.
• Because it is unlikely that all of the bonds in the portfolio are likely to be called at once, the ladder provides protection against early redemption or call risk.

If an investor knows that they will need access to funds in the future, a bond ladder can be created that matches their funding requirements.

Bond Swapping

A bond swap is the simultaneous sale of a bond for the portfolio and purchase of another bond from the sale proceeds.  An investor will execute a swap in order to take advantage of a market opportunity, or to adjust their portfolio for a change in investment objective or financial status.  Typical strategies for executing a swap include:

• Increasing Yield
• Increasing Quality
• Increasing Diversification
• Benefit from Changes in Interest Rates
• Call Protection
• Lower Taxes

Let’s take a look at how each objective is achieved.

Increasing Yield

Bond investors will often execute a swap to increase the yield that their portfolio is earning.   An increase in yield is often achieved by swapping to a bond with a longer maturity (assuming a positive sloping yield curve), a lower credit rating, or both.  It is important to remain cognizant of the fact that the added yield does not come for free- increasing the maturity also increases the portfolio’s interest rate risk, and decreasing the credit rating increases the credit risk.

Often the investor will enter into such a swap based on their perceptions of relative value.  It is not unusual for identical bonds with the same credit rating to trade at different yields due to the market’s current perception of differences in an industry or company’s business outlook.  For example, the prospect of high oil prices may cause investors to be concerned with the earnings impact this would have for heavy users of fuel, such as airlines; or a particular company may be considered to having a weaker product offering.  If an investor does not share the market’s view, or if they think the situation is only temporary, they may take advantage of the price discrepancy by buying the cheaper bond.

Bonds that carry credit risk will yield more than treasuries.  The difference in yield is known as the credit spread. Credit spreads change over time depending on the market’s perception of where the economy is in the business cycle. If investors feel that the economy is weakening, they will sell riskier assets and buy safer investments (this is known as a flight to quality).When this happens, credit spreads widen.  Conversely, when the investors are optimistic about the economy, they are more willing to purchase riskier assets in order to increase their return, and the credit spread will narrow.  An investor that believes the market has overreacted, and that the credit spread is exceedingly large, may take advantage of the situation by swapping into a bond with a lower credit rating.

Increasing Quality

A quality swap is a swap that is executed by selling a lower rated bond and purchasing a higher rated security.  It is essentially the opposite of a yield swap and is the result of the investor’s negative perception of the economic prospects for the issuer of a specific bond in their portfolio, the issuer’s industry, or the economy in general (they feel that the credit spread is too narrow).

Increasing Diversification

An investor may decide that their portfolio is too concentrated in a specific issuer, industry, or country.  The investor will sell some of the concentrated position and invest the proceeds in the bond of another issuer that provides greater diversification.  The concentrated position may result from a merger or other corporate restructuring, or some event may alter the investors comfort level with their exposure to the issuer, industry, or country.

Investors may also execute diversification swaps because they feel general economic or market conditions warrant increased diversification to mitigate market risk.

Changes in Interest Rates

Investors may execute swaps based on their belief that the level of overall interest rates are likely to change.  If the investor believes that rates are likely to rise, they can swap intofloating-rate, shorter term, and/or premium bonds to reduce their portfolio’s exposure tointerest rate risk. If the investor believes that rates are likely to fall, they can swap into zero coupon, longer term, and/or discount bonds to try to maximize their exposure to the expected rate change.

It is important to note that interest rate swaps are speculative in nature as the anticipated rate change may not occur, or rates may change in the opposite direction.  Also, changes in rates do not impact all maturities equally, so the swaps may not provide the desired effect.

Call Protection

An investor may choose to execute a bond swap to increase the call protection in their portfolio.  Call protection swaps generally occur in a falling rate environment when it is more likely that bonds may be called.  In this case, the investor will swap out of bonds with little or no call protection to bonds that are not callable in the near future, or into bullets.

Lower Taxes

Tax swapping is the most common form of bond swapping.  Investors will often swap out of a bond that is trading below par (or the price the investor paid for it) in order to offset a capital gain realized in the sale of another asset.

It is important to note that the IRS does not recognize a tax loss resulting from the sale and repurchase of the same or “substantially identical” security within 30 days before or after the sale date (known as a wash sale). The IRS has not explicitly defined “substantially identical,” but it is generally believed that the securities would not be considered substantially identical if the securities have different issuers, or there are substantial differences in the coupon rate or maturity.

Investors that experience an increase in their tax rate will often swap from taxable bonds to tax-free municipal bonds.  Some municipal bonds are subject to the Alternative Minimum Tax (AMT), while others are not.  Bonds that are subject to AMT will generally yield more than an equivalent non-AMT bond, therefore investors that are not subject to AMT can often improve their yield by swapping into AMT bonds.  Investors subject to AMT can save taxes by swapping into non-AMT bonds if the tax savings more than offsets the lower yield.

Tax laws change frequently and the treatment of capital gains is particularly complicated, so investors should always consult with a competent tax advisor before engaging in tax swaps.

Constructing an effective investment portfolio requires much more than just assembling a selection of investments- it requires careful planning, research, and discipline.

Preliminary Steps

Before any investment decisions are made, it is important to give careful consideration to the following items:

Investment Objectives

As in most endeavors, setting goals is an important part of the process of creating an investment portfolio.  After all, it’s very difficult to get somewhere if you have no idea where you are going.  Investment objectives are the goals that every investor should consider when creating a portfolio.  Investment objectives should not only be identified, but prioritized as some goals may conflict with others.

Current Income

It stands to reason that anyone considering the creation of a bond portfolio would have current income high on their list of objectives, if not the primary goal.  The maximization of current income becomes a risk/reward decision as higher yielding bonds present greater risks.

Capital Appreciation

Capital appreciation is when an investment or portfolio increases in value.  Many people do not think about bonds when it comes to capital appreciation, but the reality is that bonds do fluctuate in value, and can be used to meet this investment objective, though they should probably not be the only asset class in the portfolio.  Longer maturity and discount bonds provide the most price movement when interest rates change, but this also increases the portfolio’s price risk.

Capital Preservation

Capital preservation is when a portfolio’s principal maintains its value.  Investors that are seeking the preservation of capital are looking to minimize price risk. Investors looking for capital preservation would usually want to purchase bonds with shorter maturity with high credit ratings.

Tax Minimization

This is usually considered a secondary objective, but investors seeking to minimize taxes may want to consider municipal bonds.

Risk Profile

Once you have identified your investment objectives, the next thing that you need to determine is your risk profile- the level of risk that you can comfortably assume to meet your investment objectives.  In order to do this, you need to ask yourself some questions:

1. How would you describe yourself as a risk taker?
   1. I avoid risk;
   2. I am cautious;
   3. I am willing to take a calculated risk; or
   4. I am a gambler;
2. You have been saving and planning a big vacation.  A few weeks before leaving, you lose your job, so you:
   1. Cancel the vacation;
   2. Make plans for a modest vacation;
   3. Go as scheduled; or
   4. Extend your vacation since you now have plenty of time.
3. When do you plan to retire?
   1. Over 20 years;
   2. 10 to 20 years;
   3. 5 to 10 years; or
   4. Less than 5 years
4. Do you see any large expenditure in the next few years that would require liquidating part of your portfolio?
5. How would you react to a 5% drop in value of an investment, even if it may be temporary?
   1. I lose sleep;
   2. I worry;
   3. I am disappointed;
   4. I am confident that it will work out well in the long run.
6. How would you react to a 10% drop in value of an investment, even if it may be temporary?
   1. I lose sleep;
   2. I worry;
   3. I am disappointed;
   4. I am confident that it will work out well in the long run.
7. How would you react to a 20% drop in value of an investment, even if it may be temporary?
   1. I lose sleep;
   2. I worry;
   3. I am disappointed;
   4. I am confident that it will work out well in the long run.

Interpreting the Results

For questions 1 and 2, answer “a” indicates real risk aversion, “b” indicates some aversion, “c” indicates little risk aversion, and “d” indicates a willingness to assume risk.  For question 3, answer “a” indicates you can take considerable risk if you wish, “b” indicates you can take moderate risk if you wish, “c” indicates you can take a small amount risk if you wish, “d” indicates you should take minimal to no risk.  If you answer yes to question 4, you should consider setting aside a portion of your portfolio in low risk, liquid investments in the amount of the expected expenditure.  Questions 5 through 7 should give you an idea of how much price risk you would feel comfortable with.  For example, answering “a” to question 5 indicates you should take little to no price risk, while answering “d” to question 7 indicates you are willing to take on considerable risk.

If you have not done so already, you should read the lesson on Bond Risk.

Portfolio Management Style

Now that you have determined your objectives and risk profile it is time to decide whether you wish to pursue a passive, enhanced indexing, structured, or active management style.

Passive Portfolio Management

Passive portfolio management is essentially a buy-and-hold approach.  Passive portfolio management provides the least amount of risk, but also the lowest potential returns.

Passive portfolio management is also known as indexing, because it involves choosing an index that you wish to match the return of, and recreating it in the portfolio.  Matching an index by replicating every security in it is not practical, as many indexes contain hundreds or thousands of securities.  Professional portfolio managers will index by creating a portfolio of securities that match various characteristics of the index such as coupon, maturity, duration, and credit rating.  The duration component is probably the most important determinant of portfolio performance, followed closely by the credit rating.

Most retail bond investors pursue a passive strategy by simply buying a number of bonds that they are comfortable with, and holding them until maturity.  It is a good idea, however, to monitor the weighted average duration and credit rating of the portfolio.  This will give you a good idea of the level of risk in the portfolio.  While not absolutely necessary, matching these weighted averages against an index will provide you with a benchmark for monitoring the portfolio’s performance.

Enhanced Indexing

Enhanced indexing is a hybrid of passive and active portfolio management.  The objective is to outperform the targeted index, but it also presents the risk of underperforming the index.

One strategy involves deviating from the characteristics of the portfolio.  For example, a manager may create a portfolio with a slightly longer average duration or lower average credit rating.  Another strategy involves creating an indexed portfolio with most of the assets, and actively managing a smaller portion of the assets.

Asset-Liability Management

Asset-liability management (ALM) is a portfolio management strategy that involves matching the cash flows of the portfolio assets with liabilities.  In other words, the portfolio is constructed so the interest payments and maturities of the bonds in the portfolio are matched against the future payment obligations. While this is popular with large institutional investors, such as insurance companies, it is less common with retail investors.  However, it can be an effective strategy for investors that are retired or are approaching retirement.  The advantage is that it lowers the price risk because the investor is less likely to have to sell an investment at a loss.

Active Portfolio Management

Active portfolio managers are attempting to outperform the benchmark.  This is often very difficult to achieve, especially considering the higher transaction fees that result from increased trade activity.  It is the strategy that presents the highest potential return, but the risk is also higher.  Active managers do not believe in the efficient market hypothesis, or they believe that markets are not significantly efficient.

Relative Value Strategies

Relative value (RV) strategies attempt to take advantage of temporary price anomalies between different bonds.  In other words, the spread between the two bonds is exceedingly large, and the manager expects the spread to return to normal.  The anomaly may be in a credit spread, a yield spread, or a maturity spread.

Aggressive managers will usually go long the cheap security and short the expensive bond.  These trades are usually made market neutral by weighting the long and short position by the price sensitivity of each bond (see How Traders Establish Strategic Curve Trades section in Bond Trading 201).

An investor can also take advantage of relative value anomalies by swapping out of an expensive security in their portfolio into a cheap on (see the Bond Swapping section in Fixed Income Portfolio Management 102).

Market Timing Strategies

Market timing involves attempts to correctly anticipate changes in interest rates.  Traders use a number of methods to try to forecast interest rates and structure trades to profit from their forecasts (see Bond Trading 102).

Reactive Strategies

While market timing strategies involve anticipated changes in market prices, reactive strategies respond to changes in market prices.  Momentum strategies follow trends by getting into markets that are in a trend, and exiting when the trend changes.  Traders use statistical methods to identify trends.  These methods will be explored in future lessons.

With duration-based mean reversion strategies the manager will extend the average duration of the portfolio (by selling short-duration securities and buying long duration securities) as interest rates rise, and shorten the average duration as interest rates decline.

How Traders Exploit Changes in the Shape of the Yield Curve

In bond trading 102, we discussed how professional bond traders trade on expectations of changes in interest rates (referred to as “outrights”).   Bond traders also trade based on expected changes in the yield curve.  Changes in the shape of the yield curve will change the relative price of bonds represented by the curve.  For example, suppose you have a steeply upward sloping yield curve Like the one below:

On this curve the 2-year is yielding 0.86% and the 30-year is yielding 4.50%- a spread of 3.64%.  This may lead a trader to feel that the 30-year was cheap, relative to the 2-year.  If that trader expected the yield curve would flatten, he could simultaneously go long (buy) the 30-year and sell short the 2-year.  Why would the trader execute two simultaneous trades rather than simply buying the 30-year or selling short the 2-year?  Because if the yield curve flattens, reducing the spread between the 2-year and the 30-year, it could be the result of the price of the 2-year falling (increasing the yield), or the price of the 30-year increasing (decreasing the yield), or a combination of the two.  For the trader to profit from just going long the 30-year, they would be betting that the flattening of the curve will be the result of the price of the 30-year going up.  Similarly, if the short the 2-year they are betting that the price of the 2-year will decline.  If they take both positions, they do not have to know in what way interest rates will move in order to make a profit.  Such trades are “market neutral” in the sense that they are not dependent on the market going up or down in order to make a profit.

In this and in subsequent lessons, we will explore ways that professional bond traders anticipate changes in the shape of the yield curve and trade on these expectations.

So what is the driving force that determines the shape of the yield curve?  As it turns out, Federal Reserve monetary policy in response to the economic business cycle determines the shape of the yield curve as well as the general level of interest rates.  Some traders will use economic indicators to follow the business cycle and try to anticipate fed policy, but the business cycle is very difficult to follow, while the Fed is very transparent about their policy decisions, so most traders follow the Fed.  Think back to our discussion in Bond Trading 102: Forecasting Interest Rates.  There we stated that when the Fed sets the level of the fed funds rate, it directly influences short-term rates, but has less of an impact the further out you go on the yield curve.  Because of this, changes to the fed fund rates have a tendency to change the shape of the yield curve.  When the Fed increases the fed funds rate short-term rates tend to increase more than long-term rates, thus flattening the yield curve.  A flattening curve means the spreads between short-term treasuries and long-term treasuries are narrowing.  In this environment, traders will buy longer term treasuries, and short shorter term treasuries.  An inverted yield curve is the result of the Fed pushing short-term rates to very high levels, but investors are expected that these high rates will soon be lowered.  An inverted yield curve is often an indication that the economy is heading into a recession.

When the Fed lowers the fed funds rate, the yield curve tends to steepen, and traders will tend to buy the short end and short the long end of the curve.  A steep positively sloped curve results from the Fed maintaining low short-term rates, but investors are expecting rates to rise.  This usually occurs towards the end of a recession and is often an indication that the economy is about to turn around.

How Traders Establish Strategic Curve Trades

Professional bond traders structure their strategic yield curve trades to be market neutral[1](also referred to as duration neutral) as they only want to capture changes in relative rates along the curve and not changes in the general level of interest rates.  Because longer maturity bonds are more price-sensitive than shorter term bonds, traders do not go long and short equal amounts of short-term bonds and long-term bonds, they weight the positions based on the relative level of price sensitivity of the two treasuries.  This weighting of the positions is known as the hedge ratio.  As was pointed out in Debt Instruments 102 in the discussion of duration and convexity, the price sensitivity of bonds changes with the level of interest rates.  Bond traders, therefore will not keep the hedge ratio constant over the life of the trade, but will dynamically adjust the hedge ratio as the yields of the bonds change.

While there are different ways to measure the price sensitivity of a bond, most traders use the measure DV01, which measures the price change that a bond will experience with a 1 basis point change in interest rates.  For example, if the DV01 of a 2-year bond is $0.0217, and the DV01 of a 30-year is $0.1563, the hedge ratio would be 0.1563/0.0217, or 7.2028 to 1.  For every $1,000,000 position the trader takes in the 30-year, he would take an opposing position of $7,203,000 in the 2-year.  As interest rates change, the trader would recalculate the DV01 of each bond and adjust the positions accordingly.

Flat or inverted yield curves provide bond traders with unique strategic curve trade opportunities, since they are not encountered very often and generally do not last very long.  They usually occur near business cycle peaks when the Fed is holding the fed funds rate at significantly high levels.  When fed funds rates are unusually high, investors at the longer end of the curve do not expect these high rates to prevail over the long term, so yields at the long end do not rise as much.  Traders will exploit this by shorting longer maturities and going long shorter maturities.

Another opportunity that does not present itself very often occurs during times of extreme economic turmoil when financial markets experience significant sell-offs.  During these periods, investors will sell their equity and lower rated debt investments and buy short-term treasuries.  This phenomenon is referred to as a flight-to-quality.  Short term treasury prices shoot up, causing a steepening of the yield curve, particularly prominent in the very short end of the curve.  Traders will often sell short the short-term treasuries while buyer treasuries further out on the curve.  The risk with this trade is that it is hard to judge how long it will take for yield spreads to adjust back to more normal levels.

Factors that influence the P & L of Strategic Curve Trades

Changes to the relative yields of the bonds in a strategic curve trade are not the only determining factor to a trades profit or loss.  The trader will receive the coupon interest in the bond that they are long, but will have to pay the coupon interest on the bond that they borrowed to sell short.  If the interest income received from the long position is greater than the income paid on the short position, the profit is enhanced, if the interest paid exceeds that which is received the profit is reduced, or the loss is increased.

When a trader goes long the short end of the curve and shorts the long end, the proceeds of the short is not sufficient to cover the long position, so the trader will have to borrow funds to purchase the long position.  In this case, the cost of carry must be factored into the P&L of the trade.  These trades that require borrowing to finance cash shortfall between the purchase and short sale are said to have negative carry, while trades that have short sell proceeds that exceed the purchase amount are said to have positive carry.  Positive carry adds to the P&L because the excess cash can earn interest.

Advanced Strategic Curve Trades

Professional bond traders also have strategies to deal with perceived anomalies of the yield curve shape.  If a trader sees an unusual convex hump in a section of the curve there is a strategy to make a bet that the hump will flatten out.  For example, if there is a hump between the 2-year and the 10-year, the trader will take a duration neutral short position in the 3-year and 10-year and buys a treasury in the middle of the range of the same duration.  In this example the 7-year would do.  If the anomaly was a concave dip in the curve, the trader could buy the short and long-term bond, and sell short the intermediate; however this trade would entail negative carry, so the trader would have to have a strong belief that the anomaly would be corrected and that the correction would cause a considerable change in relative prices.

By Maulik Mody – Bondsquawk.com

February 8, 2011

The momentum that bond yields gained last week has continued into this week as yields continue to rise across the curve. As opposed to the beginning of the year, the yield curve is higher by around 20 bp on average (a graph comparing yield curves at the beginning of the year and today is shown). Many economists fear that inflation expectations are rising and that the Fed might not be able to act ahead of the inflation curve. But it is interesting to note that inflation expectations have not risen as much as nominal rates, indicating that real interest rates are rising.

Treasuries are selling off, mainly due to indications that the recovery might be gaining speed and as investors gain their appetites for riskier investments. A Fed Reserve official noted that the Fed should reconsider its repurchasing program since the economy looks stronger. The Richmond Fed President said that the jobs market is improving as seen in January’s unemployment rate and that he expects the economy to grow by 4% this year, reported The Wall Street Journal.

There is more to January’s unemployment report than meets the eye. Although the recovery is speeding, consumer spending will be boosted only when more jobs are created and wages increase. The sluggish housing market stands as a deterrent to a complete recovery. Manufacturing activities are increasing but it alone cannot drive the country out of the crisis. The recent rally in yields to me is just a relief rally at best, with a lot of factors such as slightly improved data, lined up Treasury sales and the Egypt crisis driving it.

The demand for this week’s auctions will shed more light on whether this rally will last and if the higher yields can be sustained for long. Treasuries might continue to sell of this month but all it might take is next months’ corrected employment reports for investors to push yields lower again. And for economists who are concerned about the Fed’s disregard of inflationary pressures, there are other things that demand the Fed’s attention and inflation, as of now, is not one of them.

How Bond Prices Fluctuate

A bond’s market price, like the price of any financial asset, represents the present value of the stream of future cash flows to the bondholder.

A dollar in your hand today is worth more than a dollar that you receive a year from now due to several factors:

You can deposit that money at a bank

Purchase an investment that will yield you a return for the next year.  The present value is discounted by the rate of return you could earn on that dollar over the next year (the discount rate).  Our example represents a one-time future payment, but the concept is the same for bonds that represent a stream of future payments.  The discount rate for a bond is its yield.

The price of a bond is a function of the coupon of the bond relative to the market yield of equivalent bonds.  For example, a bond with a coupon rate of 5% will be priced at par if the market yield is also 5%, if the market yield is below 5%, the bond will trade at a premium, and if the market yield is above 5% the bond will trade at a discount.  Since bond prices fluctuate with changes in market yields or the general level of interest rates, in order to determine the factors that influence bond prices we need to understand what factors influence the general level of interest rates.

What Determines the Level of Interest Rates?

Because treasuries have no default risk, they represent the risk-free rate of return (though treasury bonds are subject to other risks such as interest rate and reinvestment risk).  Treasury yields have three components:

The risk-free real yield

The inflation premium that reflects the expected rate of inflation

The volatility premium that represents the risk associated with the price sensitivity of longer maturity bonds to changes in interest rates

Non-treasury bonds have a fourth component, the credit risk premium, which we will cover in another lesson.   Because treasury TIPS are indexed to inflation, their yield gives an indication of the risk-free yield.

There are a few factors that affect the price of treasuries including supply and demand, general economic activity, and budget and trade surpluses or deficits.  However, the single most important factor is the general level of interest rates, and the general level of interest rates is mainly determined by the expected level of inflation.

It is obvious that if one was able to have a reliable indication of future changes in interest rates, then one could make considerable profits in the bond markets.  Fortunately, there are some very good ways to get an indication of where interest rates are going, and we will discuss these rate indicators in future lessons.

What Influences the Level of Credit Spreads?

All domestic bonds that are not treasury issues contain some amount of default or credit risk.  This risk means that these bonds must compensate the bondholder for assuming this risk by providing a yield greater than what a treasury security of the same maturity would pay.  This yield premium is known as the credit spread.  For example, if the 10-year treasury note is yielding 5% and a 10-year AAA rated corporate bond yields 5.75%, the credit spread is .75%.

The credit spread represents the market’s perceived creditworthiness of the bond issuer and will not only vary from one bond to another, but will fluctuate over time for the same bond.  The credit spread is calculated based on the current on-the-run treasury.

The primary determinant of a bond’s credit spread is the bond’s credit rating.  However, not all bonds of the same credit rating and maturity will trade with the same credit spread.  Factors that can cause an issue’s credit spread to be larger/smaller than the credit spread of other issues of the same credit rating include:

A negative/positive outlook for the issuer’s industry group

A competitive disadvantage/advantage for the issuer

Expectations of a ratings downgrade/upgrade

A deteriorating/improving business or financial trend for an industry or issuer

An issue with less/more relative liquidity

The Yield Curve

A yield curve is a graph of the yields of closely related bonds of different maturities. The vertical axis of the graph represents the yield, and the horizontal axis represents the time to maturity. The yield curve of treasury securities is the most commonly seen yield curve in the U.S.

There are four basic yield curve shapes:

“Yield Curves” The Upward Sloping Curve

“Yield Curves” The Inverted Yield Curve

“Yield Curves” The Humped Yield Curve

“Yield Curves” The Flat Yield Curve

The upward sloping curve is historically the norm given the normal relationship that the longer the time to maturity, the higher the yield.  An inverted yield curve occurs when interest rates are very high and expected to fall.  A flat yield curve indicates that the term to maturity has no impact on interest rates, and a humped yield curve initially rises, but then falls for longer maturities.  Inverted and flat yield curves are fairly rare.  In recent years institutional investors have had high demand for the 30-year long bond, which has raised its price to the point that it often yields less than the 20-year.  This has caused the humped curve to be the most common shape in recent years.

The shape of the yield curve changes with the business cycle and has been a good leading indicator of economic activity.  A steeply positive sloped yield curve is indicative of an economic recovery, and is often found at the end of recessions.  Its shape reflects market expectations of a significant increase in interest rates and the fact that the fed is keeping short-term rates low to aid a slumping economy recover.

Inverted curves often precede an economic downturn.  The Fed has been raising short-term rates to slow down the economy because of high inflation and the market is anticipating that interest rates will fall, so long-term rates are lower than the extremely high short-term rates.  Inverted curves have proceeded all of the last 7 recessions (although not all inverted curves have been followed by a recession).

A flat yield curve is often the result of the Fed raising short-term rates to cool an overheated economy.  Flat yield curves are rare and do not last very long when they appear.

Many bond traders use the shape of the yield curve to derive trading strategies.  Future lessons will delve into analyzing the yield curve and yield curve related trading strategies.

Repurchase Agreements (Repos) and Reverses

Repo, short for repurchase agreement (also known as RP), is a form of short-term borrowing for government securities dealers.

In a repo transaction, the dealer sells a treasury security to investors with an agreement to repurchase the security at a later date, usually the next day, and at a fixed rate of return to the investor (the repo rate).

Repos can also be done for a longer term, such as a week or a month (this is known as term repo) or a Repo can be done on open without a fixed repurchase rate.

The rate for an open repo is most often renegotiated on a daily basis.  It is effectively a short-term loan that is collateralized by a treasury security.  The investor (lender) in the transaction is entering into a reverse repurchase agreement or reverse.

Typically, the term repo is used for both repos and reverses since the terms only refer to which side of the transaction one is on.

Dealers use repos to finance their activities because treasury securities are subject to market risk (because the price fluctuates). Due to the changing price, the investor will not lend the full value of the security.  The difference between the value of the security and the amount that is borrowed is called a haircut.

The Carry Trade

The principal behind the carry trade is to borrow short to purchase a longer-term bond that will pay a higher rate than the rate of the short-term loan.

Dealers finance their treasury purchases by borrowing against their treasury holdings by doing repo transactions, which are essentially loans collateralized by treasuries.

The risk/reward is determined by the spread between the treasury yield and the repo rate the dealer pays.

Longer maturity bonds will trade at a greater spread because:

• They are more price-sensitive to changes in interest rates
• They have a longer time horizon that presents more uncertainty as to the level of interest rates.

If the Fed raises rates – a dealer could end up with a negative spread.

The two-year note is a particularly popular security for the carry trade because its yield is closely tied to the fed funds rate and it is extremely liquid.

February 7, 2011

January’s sloppy employment numbers, which showed a mere 36k rise in non-farm payrolls after a 121k increase, were mainly attributed to the bad weather. Absent the severe weather, economists expected the reading to follow the trend, but not improve significantly. The unexpected drop in unemployment rate however raises some fundamental questions about the economy.

The drop is mainly a result of downward adjustments to population and a decline in labor force participation. The average population growth has been around 1.2% for the past two decades, but has slowed to around 0.8% as a result of population aging and a reversal in immigration flows. Besides this, the decline in labor force participation has accelerated in the past six months, which is more of a structural change. The decline from 9.8% in November is the largest 2-month decline since 1958, which was mainly driven by a 0.5% decline in labor force participation. Although the aging of baby boomers is an on-going factor contributing to this decline, it is worth noting that the participation of men aged 45-54 has dropped 1.6% in the past five months. This could possible reflect early retirement of workers who will rely on pensions or in some cases, wealthy workers. This could also be a result of workers not being able to find jobs after the crisis and making different life choices. These factors make it debatable for analysts to determine whether such changes are cyclical or structural.

As an increasing number of workers stay out of the labor force, the labor force slack keeps reducing at a faster pace than estimated, and this reduces the downward pressure on wages. But this comes as a result of lesser workers and not acceleration in hiring. At the current rate, the economy needs to generate only 100k jobs a month to keep the unemployment rate steady. A further decline in participation reduces that number, which implies slower wage and salary growth and slower gains in consumer spending. This trend of slowing population growth and reduced participation indicates a reduced potential of the US GDP growth.

By Maulik Mody – Bondsquawk.com

February 4, 2011

Stocks gained slightly while Treasuries fell across the curve after the Labor Department reported lower unemployment in January, despite a fall in payroll. The dollar gained against most currencies, while commodity prices were mostly lower. This week saw a gain in stocks and a fall in Treasuries, as economic optimism boosted investor confidence about the recovery.

Economic Data

The unemployment rate in the U.S. for January unexpectedly fell to 9.0%, its lowest level since April 2009, when it was reported at 8.9%. This figure comes after a reading of 9.4% in December, much below economists’ expectations of 9.5%.  This reflected both a population benchmark that subtracted 185k from the labor force, as well as an ongoing decline in labor force participation which subtracted another 319k. The unemployment rate would have been unchanged absent these two factors. The ongoing savage decline in participation reflects both demographics as the baby boomers transition into retirement as well as a structural adjustment as people simply give up looking for jobs. This means less labor force slack, but also less economic growth as there are fewer paychecks in the economy.

The change in non-farm payrolls was also much less than expected, increasing by 36,000 in January. This is the smallest increase in 4 months, coming after a 121,000 increase in payrolls in December and missing expectations of 146,000. Private payrolls increased by 50K versus an expected 145K. Bad weather keeping employees at home and businesses temporarily closed caused January payroll numbers to be unusually low.

For more on today’s economic data, click here.

Interest Rate

Treasuries fell on today’s employment reports, pushing yields higher across the curve. The 10-yr note fell pushing its yield 9 bp higher to 3.64%. The yield on the 5-Yr also climbed 9 bp to 2.27%. The front end of the curve rose as the yield on the 2-Yr advanced 5 bp to 0.75%. The Long Bond fell as its yield gained 7 bp to 4.73%.

Inflation expectation, as seen as the yield differential between the 10-yr Treasury and inflation-indexed securities with similar maturity, widened 3 bp to 2.36%.

Yields were broadly lower across the Atlantic. Germany’s 5-yr bunds yields gained 8 bp to 2.46%. France’s 5-Yr bond fell as its yield gained 6 bp to 2.70%. 5-Yr U.K. Gilts fell pushing yield 9 bp higher to 2.26%.

Yields were higher among peripherals too. Italy and Greece 5-yr bonds fell as yield inched up a basis point to 3.64% and 11.76% respectively. Portugal’s 5-Yr bond gained as its yield fell by a basis point to 5.81%. The yield on Spain’s 5-yr fell 2 bp to 4.22%.

Across The Capital Markets

Stocks ended the week higher on good economic data and boosted confidence in the recovery. The S&P advanced 0.3% today to 1310.87. NASDAQ gained 0.6% to end the week at 2769.30. The VIX Volatility index fell to 15.93.

The dollar DXY index jumped to 78.023 from 77.748. Euro weakened 0.4% against the greenback to 1.3586. The GBP also fell against the dollar to 1.6108.

Gold spot price fell 0.4% to 1349.48. Crude spot price fell by $1.5 to 89.04.

February 4, 2011

Distressed municipal and corporate debt is providing various takeover opportunities to private equity investors these days, with what is popularly known as the loan-to-own strategies. This strategy involves financing a distressed business or project and in exchange, gain some form of ownership in the venture. An investor can buy secured debt and then influence a restructuring, or be a debtor-in-possession financer. Although similar to private equity investing, it has some different risks such as the risk of liquidation and litigation risk. Bloomberg reports some of the deals in the distressed municipal debt sectors.