69
CHAPTER 13
RELATIVEVALUE
METHODOLOGIES FOR
GLOBAL CREDIT BOND
PORTFOLIO MANAGEMENT
PROBLEMS
1. What is meant by relative value in the credit market?
2. A. What is the dominant type of structure in the investment-grade credit market?
B. What are the strategic portfolio implications of the dominant structure answer in
Part(A)?
C. What is the dominant structure in the high-yield corporate bond market and why is
it not the same structure as discussed in Part (A)?
3. e following quote is from Lev Dynkin, Peter Ferket, Jay Hyman, Erik van Leeuwen,
and Wei Wu, “Value of Security Selection versus Asset Allocation in Credit Markets,”
Fixed Income Research, Lehman Brothers, March 1999, p. 3:
Most fixed income investors in the United States have historically remained
in a single-currency world. eir efforts to outperform their benchmarks have
focused on yield curve placement, sector and quality allocations, and security
selection. e style of market participants is expressed in the amount of risk as-
sumed along each of these dimensions (as measured by the deviation from their
benchmarks), and their research efforts are directed accordingly.
A. What is meant by “yield curve placement, sector and quality allocations, and security
selection”?
70 Part I: Learning Objectives, Summary Overview, and Problems
B. What is meant by the statement: “e style of market participants is expressed in the
amount of risk assumed along each of these dimensions (as measured by the deviation
from their benchmarks)”?
4. e following two passages are from Peter J. Carril, “Relative Value Concepts within the
Eurobond Market,” Chapter 29 in Frank J. Fabozzi (ed.), e Handbook of Corporate Debt
Instruments (New Hope, PA: Frank J. Fabozzi Associates, 1998), p. 552.
A. In discussing Eurobond issuers, Carril wrote: “Many first time issuers produce tighter
spreads than one may anticipate because of their so called scarcity value.” What is
meant by scarcity value?
B. In describing putable bonds Carril wrote: “Much analytical work has been devoted
to the valuation of the put’s option value, especially in the more mature US
investment-grade market.” However, he states that in the high-yield market the over-
riding concern for a putable issue is one of credit concern. Specifically, he wrote:
“traditional analysis used to quantify the option value which the issuer has granted
the investor is overridden by the investor’s specific view of the credit-worthiness of the
issuer at the time of first put.” Explain why.
5. In describing the approaches to investing in emerging markets credits, Christopher Taylor
wrote the following in “Challenges in the Credit Analysis of Emerging Market Corporate
Bonds,” Chapter 16 in Frank J. Fabozzi (ed.), e Handbook of Corporate Debt Instruments
(New Hope, PA: Frank J. Fabozzi Associates, 1998), p. 311:
ere traditionally have been two approaches to investing in emerging market
corporate bonds: top-down and bottom-up. . . . e top-down approach
essentially treats investing in corporates as “sovereign-plus.” e bottom-up
approach sometimes has a tendency to treat emerging market corporate as “US
credits-plus.”
What do you think Mr. Taylor means by “sovereign-plus” and “US credits-plus”?
6. Chris Dialynas in “e Active Decisions in the Selection of Passive Management and
Performance Bogeys” (in Frank J. Fabozzi (ed.), Perspectives on Fixed Income Portfolio
Management, Volume 2) wrote:
Active bond managers each employ their own methods for relative value analy-
sis. Common elements among most managers are historical relations, liquidity
considerations, and market segmentation. Market segmentation allegedly creates
opportunities, and historical analysis provides the timing cure.
A. What is meant by “historical relations, liquidity considerations, and market segmen-
tation” that Chris Dialynas refers to in this passage?
B. What is meant by: “Market segmentation allegedly creates opportunities, and histori-
cal analysis provides the timing cure?”
7. e following passages are from Leland Crabbe “Corporate Spread Curve Strategies,”
Chapter 28 in Frank J. Fabozzi (ed.), e Handbook of CorporateDebt Instruments (New
Hope, PA: Frank J. Fabozzi Associates, 1998).
In the corporate bond market, spread curves often differ considerably across
issuers...
Most fixed income investors understand the relation between the term struc-
ture of interest rates and implied forward rates. But some investors overlook
Chapter 13 Relative-Value Methodologies for Global Credit Bond Portfolio Management 71
the fact that a similar relation holds between the term structure of corporate
spreads and forward corporate spreads. Specifically, when the spread curve is
steep, the forward spreads imply that spreads will widen over time. By contrast,
a at spread curve gives rise to forwards that imply stability in corporate spreads.
Essentially the forward spread can be viewed as a breakeven spread...
Sometimes, investors may disagree with the expectations implied by forward
rates, and consequently they may want to implement trading strategies to profit
from reshapings of the spread curve.
A. What is meant by “spread curves” and in what ways do they differ across issuers?
B. Consider the relationship between the term structure of interest rates and implied
forward rates (or simply forward rates). What is a “forward spread” that Mr. Crabbe
refers to and why can it be viewed as a breakeven spread?
C. How can implied forward spreads be used in relative-value analysis?
8. What is the limitation of a yield-pickup trade?
9. Increases in investment-grade credit securities new issuance have been observed with con–
tracting yield spreads and strong relative bond returns. In contrast, spread expansion and a
major decline in both relative and absolute returns usually accompanies a sharp decline in
the supply of new credit issues. ese outcomes are in stark contrast to the conventional
wisdom held by many portfolio managers that supply hurts credit spreads. What reason can
be offered for the observed relationship between new supply and changes in credit spreads?
10. A. What is meant by the “crossover sector of the bond market”?
B. How do portfolio managers take advantage of potential credit upgrades in the cross-
over sector?
11. When would a portfolio manager consider implementing a credit-defense trade?
12. What is the motivation for portfolio managers to trade into more current and larger sized
“on-the-run” issues?
13. A. Why has the swap spread framework become a popular valuation yardstick in Europe
for credit securities?
B. Why might US managers embrace the swap spread framework for the credit asset class?
C. Compare the advantages/disadvantage of the nominal spread framework to the swap
spread framework.
14. An ABC Corporate issue trades at a bid price of 120 bps over the 5-year US Treasury
yield of 6.00% at a time when Libor is 5.70%. At the same time, 5-year Libor-based swap
spreads equal 100 bps (to the 5-year US Treasury).
A. If a manager purchased the ABC Corporate issue and entered into a swap to pay fixed
and receive oating, what spread over Libor is realized until the first swap reset date?
B. Why would a total return manager buy the issue and then enter into a swap to pay
fixed and receive oating?
15. e following was reported in the “Strategies” section of the January 3, 2000 issue of
BondWeek (“Chicago Trust to Move Up in Credit Quality,” p. 10):
e Chicago Trust Co. plans to buy single-A corporate bonds with intermediate
maturities starting this quarter, as the firm swaps out of lower-rated, triple B
rated paper to take advantage of attractive spreads from an anticipated ood of
single-A supply. . . .
72 Part I: Learning Objectives, Summary Overview, and Problems
e portfolio manager gave the following reasoning for the trade:
… he says a lack of single-A corporate offerings during the fourth quarter has
made the paper rich, and he expects it will result in a surge of issuance by sin-
gle-A rated companies this quarter, blowing out spreads and creating buying
opportunities. Once the issuance subsides by the end of the quarter, he expects
spreads on the single-A paper will tighten.
A. What type of relative value analysis is the portfolio manager relying on in making this
swap decision and what are the underlying assumptions? (Note: When answering this
question, keep the following in mind. e manager made the statement at either the
last few days of December 1999 or the first two days in January 2000. So, reference to
the fourth quarter means the last quarter in 1999. When the statement refers to the
end of the quarter or to “this quarter” it is meant the first quarter of 2000.)
B. Further in the article, it was stated that the portfolio manager felt that on an historical
basis the corporate market as a whole was cheap. e portfolio manager used new cash
to purchase healthcare credits, doubling the portfolio’s allocation to the healthcare
sector. e portfolio manager felt that the issuers in the healthcare sector he pur-
chased for the portfolio had fallen out of favor with investors as a result of concerns
with healthcare reform. He thought that the cash ows for the issuers purchased were
strong and the concerns regarding reform were “overblown.” Discuss the key elements
to this strategy.
16. e following was reported in the “Strategies” section of the January 3, 2000 issue of
BondWeek (“. . . Even as Wright Moves Down.” p. 10):
Wright Investors Services plans to buy triple B-rated corporate paper in
the industrial sector and sell higher rated corporate paper on the view that
stronger-than-anticipated economic growth will allay corporate bond investor fears.
In the article, the following was noted about the portfolio manager’s view:
spreads on higher rated investment grade paper already have come in some from
last summer’s wides, but he believes concerns over year-end and rising rates have
kept investors from buying lower rated corporate paper, keeping spreads rela-
tively wide.
Discuss the motivation for this strategy and the underlying assumptions.
17. e following appeared in the “Strategies” section of the September 27, 1999 issue of
BondWeek (“Firm Sticks to Corps, Agencies,” p. 6):
e firm, which is already overweight in corporates, expects to invest cash in
single A corporate paper in non-cyclical consumer non-durable sectors, which
should outperform lower-quality, cyclicals as the economy begins to slow.
Discuss this strategy and its assumptions.
18. A. Suppose that a manager believes that credit spreads are mean reverting. Below are
three issues along with the current spread, the mean (average) spread over the past
Chapter 13 Relative-Value Methodologies for Global Credit Bond Portfolio Management 73
are normally distributed, which issue is the most likely to be purchased based on
mean-reversion analysis?
Issue Current Spread
Mean Spread for
Past 6 Months
Standard Deviation
of Spread
A 110 bps 85 bps 25 bps
B 124 100 10
C 130 110 15
B. What are the underlying assumptions in using mean-reversion analysis?
19. Ms. Xu is the senior portfolio manager for the Solid Income Mutual Fund. e fund
invests primarily in investment-grade credit and agency mortgage-backed securities. For
each quarterly meeting of the board of directors of the mutual fund, Ms. Xu provides
information on the characteristics of the portfolio and changes in the composition of
the portfolio since the previous board meeting. One of the board members notices two
changes in the composition of the portfolio. First, he notices that while the percentage of
the portfolio invested in credit was unchanged, there was a sizeable reduction in callable
credit relative to noncallable credit bonds. Second, while the portfolio had the same per-
centage of mortgage passthrough securities, there was a greater percentage of low-coupon
securities relative to high-coupon securities.
When Ms. Xu was asked why she changed the structural characteristics of the securities
in the portfolio, she responded that it was because the management team expects a signif-
icant drop in interest rates in the next quarter and the new structures would benefit more
from declining interest rates than the structures held in the previous quarter. One of the
directors asked why. How should Ms. Xu respond?
20. Ms. Smith is the portfolio manager of the Good Corporate Bond Fund, which invests primari–
ly in investment-grade corporate bonds. e fund currently has an overweight within the retail
industrial sector bonds of retailers. Ms. Smith is concerned that increased competition from
internet retailers will negatively affect the earnings and cash ow of the traditional retailers.
e fund is also currently underweighted in the US dollar-denominated bonds of European
issuers placed in the United States, which she believes should benefit from increased opportu–
nities afforded by European Union. She believes that many of these companies may come to
market with new US dollar issues to fund some of their expansion throughout Europe.
Formulate and support a strategy for Ms. Smith that will capitalize on her views about
the retail and European corporate sectors of her portfolio. What factors might negatively
impact this strategy?
e following information relates to Questions 21–26 and is based on “Fixed-Income
Portfolio Management—Part I” and this chapter
Coughlin Fixed Income Funds is a family of mutual funds with assets totaling $4 billion,
comprised primarily of US corporate bonds. Hanover-Green Life Insurance Company has just
under $1 billion in total assets primarily invested in US corporate bonds. e two companies
are considering combining their research and analysis units into one entity. ey are also look-
ing at possible synergies from consolidating their trading desks and/or back-oce operations.
Over a longer horizon, the companies also are open to the possibility of merger.
74 Part I: Learning Objectives, Summary Overview, and Problems
Gaven Warren is a senior portfolio manager with Hanover-Green. He has been asked to
review the prospectuses for the various Coughlin funds and make recommendations regarding
how the two companies might combine operations. Specifically, Warren is reviewing three
of Coughlin’s funds—e Select High-Performance Fund, the Yield Curve Plus Fund, and
the Index Match Fund. Highlights of the investment objectives of the three funds are shown
below:
e Select High-Performance Fund relies on the superior skills of its analyst team to
discover hidden values among a wide range of corporate fixed-income securities. e
fund will be approximately 95 percent invested in US dollar denominated corporate
bonds with medium-term to long-term maturities and Standard & Poors ratings of
B or higher. e fund may use options, futures, and other derivative products to
enhance returns. e primary goal of the fund is to maximize total return. e fund’s
annual total return target is to exceed the Lehman Brothers US Corporate Bond
Index total return by 200 basis points.
e Yield Curve Plus Fund uses selected investments at key points along the
yield curve to enhance portfolio returns. e fund will be approximately 95 per–
cent invested in US dollar denominated corporate bonds with medium-term to
long-term maturities and Standard & Poors ratings of BBB or higher. e fund
may use options, futures, and other derivative products to enhance returns. e
primary goal of the fund is to outperform the Lehman Brothers US Corporate
Bond Index by analyzing the yield curve appropriate to pricing corporate bonds,
identifying key rate durations for the bonds held in the portfolio, and position–
ing the portfolio to benefit from anticipated shifts in the slope and shape of the
yield curve.
e Index Match Fund seeks to match the return on the Lehman Brothers US Cor–
porate Bond Index. e fund will be approximately 98 percent invested in US dollar
denominated corporate bonds with medium-term to long-term maturities and Standard
& Poors ratings of BBB or higher. e fund may use options, futures, and other deriva–
tive products to match the Lehman Brothers US Corporate Bond Index returns.
As is typical of life insurance companies, Hanover-Green has estimated its liabilities us–
ing standard actuarial methods. e weighted-average duration of Hanover-Green’s liabilities
is about 12 years. e long-term focus of Hanover-Green means they can tolerate low liquid–
ity in their portfolio. e primary management technique used by Hanover-Green has been
contingent immunization. Because Warren anticipates a discussion with Coughlin regarding
contingent immunization, he has prepared the following statements as part of a presentation.
Statement 1 “Contingent immunization requires the prevailing immunized rate of re-
turn to exceed the required rate of return.”
Statement 2 “When interest rates fall, contingent immunization switches to more active
management because the dollar safety margin is higher.”
Although the Lehman Brothers US Corporate Bond Index is the benchmark for the
Coughlin funds, Warren is not certain that the index is appropriate for Hanover-Green. He
compiled the data given in Exhibit 1 as a step toward deciding what index might be the best
benchmark for Hanover-Green.
Chapter 13 Relative-Value Methodologies for Global Credit Bond Portfolio Management 75
EXHIBIT 1 Selected Characteristics, Bond Indexes
Index
Effective
Duration YTM (%)
Average
Coupon
(%)
Number of
Securities Weighting
Long-Term US
Corporate Bond Index
8.65 5.75 5.25 558 Value
Global Government
Bond Index
5.15 6.30 5.85 520 Value
Selected Municipal
Bonds Index
4.65 4.87 4.75 20 Value
Equal-Weighted
Corporate Bond Index
4.70 5.19 5.75 96 Equal
Hanover-Green is considering a more active style for a small part of its portfolio. Warren is
investigating several relative value methodologies. Two approaches are of particular interest—
primary market analysis and spread analysis. Warren is worried that the primary market is
about to enter a period where the supply of new issues will increase causing spreads to tighten,
and furthermore, that most of the new issues will not be callable.
Regarding spread analysis, Hanover-Green is considering the addition of mortgage-backed se–
curities (MBS) to its portfolio. Warren has investigated the MBS market and found that MBS anal–
ysis emphasizes the option-adjusted spread (OAS). Warren is considering using OAS to measure
21. e strategy used by the Yield Curve Plus Fund most likely attempts to enhance portfolio
returns by taking advantage of:
A. changes in credit spreads.
B. changes in the level of interest rates.
C. nonparallel changes in the yield curve.
22. e contingent immunization technique that Hanover-Green currently uses in managing
their fixed-income portfolio is best described as:
A. a passive management strategy similar to that of the Index Match Fund.
B. an active management strategy similar to that of the Select High-Performance Fund.
C. a mix of active and passive management strategies similar to that of the Yield Curve
Plus Fund.
23. Are Warren’s statements regarding contingent immunization most likely correct or
incorrect?
Statement 1 Statement 2
A. Correct Correct
B. Correct Incorrect
C. Incorrect Correct
24. Based solely on the information in Exhibit 1, which index is the most appropriate bench-
mark for Hanover-Green’s portfolio?
A. Global Government Bond Index.
B. Long-Term US Corporate Bond Index.
C. Equal-Weighted Corporate Bond Index.
76 Part I: Learning Objectives, Summary Overview, and Problems
25. Consider Warren’s expectations regarding the supply of new issues in the primary market.
Given recent research into primary markets, is Warren most likely correct or incorrect
regarding the effect on spreads and the probability of the bonds being callable?
Effect on Spreads Bonds Being Callable
A. Correct Correct
B. Correct Incorrect
C. Incorrect Correct
26. Which of the following statements most accurately evaluates the use of the option-adjusted
spread (OAS) to analyze the bonds held in Hanover-Green’s portfolio?
A. OAS excludes default risk from its calculation; therefore OAS has limited applicability
to the analysis of speculative grade bonds.
B. OAS uses Monte Carlo simulation to factor out default risk from the spread; therefore
OAS is not well suited to the analysis of speculative grade bonds.
C. OAS is often used to evaluate bonds other than mortgage-backed securities. It is a
very useful tool, especially appropriate for high-risk positions such as speculative grade
bonds.