165
CHAPTER 13
RELATIVE-VALUE
METHODOLOGIES FOR
GLOBAL CREDIT BOND
PORTFOLIO MANAGEMENT
SOLUTIONS
Note: Many of the questions are conceptual in nature. e solutions o ered are one interpre-
tation, and there may be other valid views.
1 . Relative value refers to ranking credit sectors, bond structures, issuers, and issues in terms
2 . A . e dominant structure in the investment-grade credit market is the bullet structure
B . ere are three strategic portfolio implications of the bullet structure with an interme-
diate maturity:
i . e dominance of bullet structures creates a scarcity value for structures with
ii . Because long-dated maturities have declined as a percentage of outstanding credit
iii . ere will be increased use of credit derivatives, whether on a stand-alone basis or
C . High-yield issuers will continue to issue callable bond structures in order to have the
3 . A . Yield curve placement is simply the positioning of a portfolio with respect to duration
166 Part II: Solutions
B . For a manager who is evaluated relative to some bond index, the deviation of the port-
4 . A . Scarcity value means that an issue will trade at a premium price due to a lack of supply
B . Analytical models for valuing bonds with embedded put options assume the issuer
will ful ll the obligation to repurchase an issue if the bondholder exercises the put
5 . In general, the top-down approach involves beginning with a macroeconomic outlook
and making allocation decisions to sectors based on that outlook. With respect to credit
6 . A . Historical relations help a portfolio manager identify opportunities when current
spreads are out of line and relative-value opportunities may be available. Liquidity
B . Market segmentation may create relative value opportunities when spreads get out
of line due to obstructions that prevent or impede investors from allocating funds
7 . A . Spread curves show the relationship between spreads and maturity. ey di er by
B . Forward rates are derived from spot rates using arbitrage arguments. A forward spread,
A forward spread can be interpreted in the same way. For example, a 2-year
Chapter 13 Relative-Value Methodologies for Global Credit Bond Portfolio Management 167
e forward spread is a breakeven spread because it is the spread that would
C . Because a forward spread is one that will make an investor indi erent between two
8 . Yield measures are poor indicators of total return realized by holding a security to matu-
An example of this would be if at the beginning of the month, a portfolio manager
sold the 5-year Ford issue at a spread of 140 basis points and purchased the 5-year General
9 . e reason suggested as to why heavy supply of new investment-grade credit issues will
1 0 . A . e crossover sector refers to the sector with issuers whose ratings are between Ba2/BB
B . A manager can purchase a below-investment grade issue that he believes will be up-
11 . A portfolio manager would consider implementing a credit-defense trade when the man-
1 3 . A . e European credit market has been consistently homogeneous, having mostly high
quality (rated Aa3/AA– and above) and intermediate maturity issues. So swap spreads
B . US managers have embraced swap spreads for the MBS, CMBS, agency, and ABS
168 Part II: Solutions
C . Individual investors understand the traditional nominal spread framework as a market
convention. Moreover despite its limitations, this framework can be used across the
14 . A . By buying ABC Corporation issue and entering into a 5-year swap to pay xed and
receive oating, the spread over Libor until the rst reset date for the swap is:
points) until the rst reset date.
1 5 . A . e manager is relying on primary market analysis. e manager believes that one of
e assumption is that the attractive level of the corporate spread for single-A
rated issuers is driven principally by new issuance and not any structural issue or other
B . e keys to this strategy are 1) that the cash ows will in fact remain strong, 2) that
1 6 . e motivation for this strategy is that while investment-grade issues may decline due
to stronger-than-anticipated economic growth, a good amount of spread reduction has
1 7 . is relative value strategy has two elements to it. First, there appears to be an allocation
to single-A rated corporates versus lower-quality corporates. Hence, it appears to be a
Chapter 13 Relative-Value Methodologies for Global Credit Bond Portfolio Management 169
18 . A . One can use mean-reversion analysis in this question as follows. For each issue, the
number of standard deviations that the current spread is above the historical average
(the mean spread for the past six months) is computed as:
Issue Number of Standard Deviations Above Mean
A(110 − 85)/25 = 1.0
Issue B has the largest deviation above the mean and is therefore the one more likely
B . e assumptions are that 1) the spreads will revert back to their historic means and
19 . Ms. Xu should rst explain that callable bonds exhibit negative convexity when interest
rates decline, while noncallable bonds exhibit positive convexity. is means that when
All mortgage pass-through securities exhibit negative convexity. However, low-coupon
20 . Ms. Smith could sell retail issues and use the proceeds to purchase US dollar-denominated
Ms. Smith should use credit analysis to select which issues to buy or sell within each
returns. Key rate duration attempts to pro t from non-parallel shifts in the yield curve.
it is closest to the Yield Curve Plus Fund.
Hanover-Green’s liabilities and re ects the corporate bonds that form the bulk of their assets.
have come to dominate the credit market.