FOUNDATIONAL CONCEPTS FOR ACTIVE MANAGEMENT OF YIELD CURVE STRATEGIES Three basic movements in the yield curve: 1 ∆ in level 2 ∆in slope 3 ∆in curvature • If spread widensnarrows, the yi
Trang 1YC = yield curve
“YIELD CURVE STRATEGIES”
2 FOUNDATIONAL CONCEPTS FOR ACTIVE MANAGEMENT OF YIELD CURVE STRATEGIES
Three basic movements in the yield curve:
1) ∆ in level 2) ∆in slope 3) ∆in curvature
• If spread widens(narrows), the yield curve becomes steepen (flatten)
• Negative value of spread results in inverted yield curve
• Common measure of the yield curve curvature is the butterfly spread
Butterfly Spread = -(Short-term yield) + (2 x Medium-term yield) – Long-term yield
• These three changes in the yield curve are interrelated
Generally, for a(an):
↑ shift in level, the yield curve flattens and becomes less curved
↓ shift in level, the yield curve steepens and becomes more curved
2.1
A Review of Yield Curve Dynamics
2.2 Duration and Convexity
• For a zero-coupon bond:
there is a linear relation b/w Macaulay duration and maturity
Convexity ≈[duration]2
• Coupon-paying bonds have higher convexity as compared to zero-coupon bonds
• Convexity (+ve or -ve) is an important factor in a bond portfolio’s return
1 INTRODUCTION
Active yield curve strategies are the primary tool for developing and implementing active fixed-income strategies
Trang 23 MAJOR TYPES OF YIELD CURVE STRATEGIES
• An active portfolio manager can shift the portfolio to be more laddered (securities distributed equally around various maturities), bullet (securities concentrated around single point on YC) or barbell (securities
concentrated at longer and shorter points)
• Bullet and barbell structures are the most common approaches to benefit from non-parallel shifts in the YC
• A bulleted portfolio will have little exposure away from the target segment of the curve
• A barbell portfolio exhibits higher convexity than a bullet portfolio
• Bullet (Barbell) structure is usually used to take advantage of a steepening (flattening) YC
3.1.3 Sell Convexity
3.1.2 Riding the Yield Curve
• An aggressive version of buy &
hold strategy
• The strategy works
if the YC is ↑ sloping & is likely
to remain static
• This strategy is based on the concept of “roll down”
• is valuable when i-rates are expected to be volatile
• helps managers earning additional return, without altering the portfolio duration
• using options to enhance portfolio convexity is an alternative for managers who find it difficult to ∆ the portfolio structure easily
3.2.2 Buy Convexity
3.1 Strategies under Assumptions of
a Stable Yield Curve
3.2 Strategies for Changes in Market Level, Slope, or Curvature
Active strategies have been categorized into the following two groups
1.Active strategies under assumption of a stable yield curve 1) Buy & hold 2) Roll Down/Ride the Yield Curve 3) Sell Convexity 4) The Carry Trade
2.Active strategies for yield curve movement of level, slope, and curvature 1) Duration Management 2) Buy Convexity 3) Bullet & Barbell Structures
Managers ↓ (↑) portfolio duration
in anticipation of ↑ (↓) i-rates
3.2.1 Duration Management
Portfolio duration can be altered using futures contract, leverage and interest rate swaps
• Futures contracts are sensitive to changes
in the price of the underlying bonds and no cash outlay is required except posting and maintaining margin
• To increase the portfolio duration, add desired PVBP by purchasing bonds of any duration through leverage
• Interest rate swaps can be created for every maturity; however, they are less liquid than futures and less flexible than using leverage To lengthen(shorten) duration add a receive-fixed (pay-fixed) swap
3.2.1.1 Using Derivatives to Alter Portfolio Duration
3.2.3 Bullet & Barbell Structures
3.1.1 Buy & Hold
3.1.4 Carry Trade
• constructing a portfolio whose features deviate from the benchmark, & the portfolio is held constant for certain time period
• This is not a passive strategy as it may appear due to low portfolio turnover
• Another strategy to position a portfolio in anticipation of stable yield curve
• In a carry trade, manager purchases ↑ yield security, which is financed at a rate ↓ than the yield on that security, and earns the spread between the two rates This strategy frequently involves ↑ leverage
• Cross-currency carry trade implies borrowing in a currency of a ↓ i-rate country and investing proceeds in a currency of a ↑ i- rate country
In anticipation of lower future volatility or stable yield curve, portfolio returns can be enhanced
by reducing/selling the portfolio convexity i.e
receiving option premiums by selling the calls and puts on the bonds
Trang 34.1 Duration Positioning in
Anticipation of a
Parallel Upward
Shift in the Yield
Curve
Manager can improve the portfolio returns under such scenario by ↑ the portfolio convexity i.e if rates ↑ the portfolio will bear ↓ losses and if rates ↓, the gains will
be ↑
4 FORMULATING A PORTFOLIO POSITIONING STRATEGY GIVEN
A MARKET VIEW
• Adding convexity using options can be performed by selling some bonds and purchasing call options on those bonds in a way that the portfolio’s effective duration and market value remains unchanged
• Par value of the options = Par value of the bonds sold
×ᇲ ᇲ
• The post trade portfolio outperforms the pre-trade portfolio when interest rate change as long as the rate change is greater than certain basis points
• Convexity can be ↓ by selling options or buying MBS
Buying MBS is equivalent to selling call options as MBS exhibits -ve convexity
• If the YC is expected to remain stable sell the treasury bonds and purchase MBS
• Compared to treasury bonds, MBS are more sensitive to ↑
in rates and less sensitive to ↓
in rates
4.4 Using Options
4.4.1 Changing Convexity Using Securities with embedded Options
4.3.1 Bullets and Barbells
4.3.2 Butterflies
• a long-short combination of bullet and barbell portfolio structures
• The butterfly structure is created by taking position in three securities; short-term, intermediate term and long-term
• Two types of butterfly structures include:
Long barbell, short bullet – ↑ convexity position, benefit from a flattening of the YC
Long bullet, short barbell – ↓ convexity position, beneficial amid stable interest rate prediction or steepening of the YC
• Some common ways to select the weights of the butterfly wings are:
Duration neutral
50/50
Regression weighting
Consider two duration-matched portfolios of equal market value, a barbell portfolio containing 5-year bonds and a bullet portfolio containing two bonds of zero maturity and 10-year maturity respectively
If there is an instant ↓ parallel shift in the YC, barbell portfolio will outperform bullet portfolio
If the YC flattens in a way that short-term rates ↑ and long-short-term rates
o remain unchanged, the barbell portfolio will outperform the bullet portfolio
o ↓, the barbell portfolio will outperform the bullet portfolio
If the YC steepens, the bullet portfolio will outperform the barbell portfolio
4.2 Portfolio Positioning in Anticipation of a Change
in Interest Rates, Direction Uncertain
4.3 Performance of Duration-Neutral Bullets, Barbells, and Butterflies Given a Change in the Yield Curve
Trang 4Relative performance of Bullet and Barbell under different yield curve scenarios
performs
Under- performs Level ∆ Parallel Shift Barbell Bullet
Steepening Bullet Barbell
Rate Volatility ∆ Decreased Bullet Barbell
Increased Barbell Bullet
5 COMPARING THE PERFORMANCE OF VARIOUS DURATION-NEUTRAL PORTFOLIOS IN MULTIPLE CURVE ENVIRONMENTS
Expected return can be decomposed into five sub-components
This decomposition can help understanding the relative contribution of each component in the performance of the strategy
E(R) ≈ Yield income + Rolldown return + E(∆ in price based on investor’s views on yields and yield spread) − E(Credit losses) + E(currency gains & losses)
6 A FRAMEWORK FOR EVALUATING YIELD CURVE TRADES