Weekly Relative Value

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1 Back to Basics Identifying Value in Fixed Income Markets As managers of fixed income portfolios, one of our key responsibilities is to identify cheap sectors and securities for purchase while avoiding (or selling) the rich ones. There are many attributes of a fixed income security that must be assessed in order to determine what is rich or cheap or what the best relative value is. These attributes include credit risk, liquidity, convexity, embedded options and structural/cash flow uncertainty to name a few In this Back to Basics article, we will introduce some of the quantitative metrics used to help make these determinations. With that said, it is not our intention in this article to list all of the quantitative metrics available, nor to review the math underlying the calculations. Rather, our goal is to provide a brief overview of some valuation models and terminology as a way to help underscore the value finding process. Beyond Yield Yield, in and of itself, is woefully inadequate in assessing a security s relative value. Rather than focusing on price and yield, most fixed income traders, analysts and portfolio managers use relative yield spreads to determine the best relative value in the fixed income market. By looking at spreads in a historical context (i.e. maximum, minimum, average), one can better determine if the sector or security offers good relative value and compensates for the embedded risks. I am old enough to remember a time when the primary measure of value for all fixed-rate bonds was yield-spread to a benchmark Treasury security. While market participants had differing opinions as to how much spread was sufficient compensation for all the elements of risk embedded in a security, everybody was confident that this framework would lead to the correct relative value decision. Well things have changed. The world of fixed income is a great deal more complicated today, and no single spread valuation metric is adequate across every sector. Knowing Your Risk-Premia A risk premium or risk-premia is the minimum amount of money that the expected return off a risky asset must exceed in order to encourage an individual to hold that risky asset, rather than the risk-free asset. When risk-premia are compressed, risky assets are not expected to provide much in additional return compared to a risk-free asset. This is noticeable, for example, in the low yield spread between junk bonds and U.S. Treasuries (i.e. the risk premium). Conversely, when risk-premia is high, risky assets are expected to provide excess return.

2 The key to identifying and quantifying a sector or security s risk-premia or relative worth is applying the appropriate spread valuation metrics. The following are some of the Treasury/ LIBOR-spread measures in common use, along with simplified definitions. Fortunately, Bondedge Fixed Income Analytics and other analytic platforms provide an analytical platform to help with these complex calculations; it s up to us, however, to make the required assumptions and interpret the results. Nominal Yield Spread This is defined as the difference in the yield to maturity of a bond and the yield to maturity of its benchmark (interpolated Treasury (G) Curve or LIBOR (I) curve). This measurement is appropriate for comparing bullet non-amortizing securities. For example, nominal yield spreads are commonly used to determine the relative value between non-callable agency and corporate securities. Below we show the historical (G) and (I) spreads of the various Agency bullets and bank notes relative to comparable duration Treasury benchmarks. Currently, Agency to Treasury yield spreads (risk-premia) remain at relatively narrow levels. For example one-year Agency bullets are trading equal to the yield on Treasuries. Why take the added liquidity and credit risk of an agency security when there is no yield advantage? In fact, we have advised credit unions to sell short agency and purchase Treasury securities, or better still, higher yielding fully insured CDs or high quality bank notes. As one can glean from the table above bank notes offer much more generous yields and spreads than do Agency offerings. For credit unions that have the wherewithal we believe that select, short duration high quality bank notes offer an attractive risk/return trade-off. Other Types of Securities Many investors also calculate nominal spreads of a mortgage backed security (MBS) by comparing the cash flow yield and the average life to the yield on a comparable Treasury, the interpolated yield curve or swap rate. Unfortunately, while simplistic this is improper for an amortizing security. The cash flows of amortizing securities, including MBS, collateralized mortgage obligations (CMO) and asset-backed securities (ABS), should be

3 discounted at the unique interest rate (the spot curve) where cash flows are received. Static Spread or Zero Volatility Spread (Z spread) When this constant spread is added to the yield at each point on the spot-rate Treasury curve where a bond's cash flow is received will make the price of a security equal to the present value of its cash flows. The magnitude of the difference between the nominal yield spread and the Z spread is highly dependent on the slope of the yield curve. The steeper the slope of the curve, the greater the difference between the two values. In today s environment, in which yield curves are positively sloped, it is very important to quantify and compare Z spreads to nominal spreads to determine whether or not you are being adequately compensated for the embedded risk. In a relatively flat yield curve environment, the difference will be small because all cash flows are being discounted at essentially the same rate. Below, we show the Z spread for 20 year conventional MBS. As with Agency bullets, Z spreads on 20-year MBS widened dramatically during the financial crisis. And since reaching record wide levels in 2008, spreads have steadily tightened reaching an all-time low in late Currently, Z spreads point to an overall MBS sector that remains fully priced. Option Adjusted Spread (OAS) OAS evaluates bonds with an embedded option (such as a callable bond, puttable bond or a MBS) and attempts to capture the potential compensation after adjusting for call or prepayment risk. When this constant spread is added to the yield at each point on a spot rate curve (usually the U.S. Treasury spot-rate curve) where a bond's cash flow is received, will make the price of the bond equal to the present value of its cash flows. However, and unlike the Z spread, to calculate the OAS, the spot rate curve is given multiple interest rate paths. And for each interest rate path, a refinancing rate is also calculated. In other words, many different spot-rate curves and refinancing rates are calculated. The average of all of these interest rate paths (typically up to a 1,000 pathdependent scenarios) results in a single path used to calculate OAS.

4 An OAS accounts for interest rate volatility and the probability of the prepayment of the principal of the bond under multiple scenarios. The reasoning: An environment of no interest rate changes, the investor earns the Z spread. However, in the case of MBS (when future rates are uncertain) the spread is less, due to the homeowner s option to prepay or refinance. The OAS accounts for this optionality. Therefore, the option cost is the difference in spread between what the investor would earn in a static environment (Z spread) and what the investor would earn after adjusting for the refinancing option. Summary: Each of the above spread measurements has its strengths and weaknesses. All share some limitations. None of these spreads should be used in isolation. Also, market participants know that fixed income investing is part art and part science. A whole host of additional, more subjective considerations (the art part) also must enter the relative value equation. These are too numerous to mention here, but they are at least as important as the quantitative aspects. Spread analysis, within a well-defined risk control framework, in effect produces a relative valuation framework of a sector s or a security s worth. When relative values (spreads) diverge and become rich or cheap investors can swap sectors/securities to optimize returns or minimize losses. A disciplined and systematic analysis of inter-market sector and security spread relationships, coupled with the appropriate management response, can add incremental value and reduced risk to a credit union s fixed income portfolio. Running Scenario What-if Analysis In addition to looking at various spread metrics, another valuable risk management tool (arguably the most useful) is scenario analysis.

5 Pre-trade what-if scenario analysis is the process of calculating and projecting the value, income and total return (principal and income and reinvestment) of a fixed income investment or portfolio, under hypothetical probable and improbable scenarios. The number of assumptions used in scenario analysis is virtually limitless. Through scenario analysis, an investor can determine if the incremental yield (risk-premia) compensates for the added risk. There are a number of reasons you might consider using scenario analysis. Here are some of the motivations: Sector swaps Treasury bonds, CDs, corporate bonds and municipal bonds are different sectors within the fixed-income markets, each with unique characteristics and yields. Scenario analysis can assist quantifying the relative merits and determine if the riskpremia validates a change in sector allocations. Yield (maturity) swaps If you are seeking to raise your overall yield, you might sell bonds with shorter maturities (even cash) and purchase longer-term bonds. Scenario analysis will quantify the risk of the potential change on an absolute trade only basis as well as on how the change could impact the overall risk profile of the total portfolio. Portfolio structure swaps Altering the number of callable bonds or swapping bonds with varying levels of a call protection. For example, during periods of declining interest rates, you might minimize reinvestment risk by swapping out of callable bonds (including MBS) and buying non-callable bonds. The opposite is true during periods of rising rates. Managing Yield Curve Risk The traditional scenario analysis shows how a bond will perform if interest rates move up/down along the yield curve in unison. This is referred to as a parallel shift. In reality, this is not typically the case. Over the past 12 years, the slope of the Treasury curve, measured as the difference between the yield of the 10-year Treasury and the yield of the sixmonth T-bill, ranged from -80 basis points to more than 330 basis points. Clearly, not all yield curve shifts are parallel moves. In fact, none are! Due to ever changing slopes of yield curves, it is critical to look at how securities will perform if the yield curve steepens or flattens. Analysis To enhance the investment decision making process when purchasing securities Balance Sheet Solutions provides a Analysis. Please click here for this analysis, which is updated weekly and included in every edition of the.

6 This analysis highlights: Relative yields and key current spread relationships on various sectors, including Agency bullets, bank notes, MBS, CMOs and CMBS. Total returns are projected over one, two and three years Total returns are projected under parallel and non-parallel shifts. Our hope is that this report will be a useful tool in guiding clients in assisting credit unions in identifying sectors /securities that are most suitable for their investment portfolios and avoiding those sectors/securities that do not offer a favorable risk /return profile. As always, our goal and commitment is to help our clients add incremental value to their investment portfolio and overall balance sheet. Please contact your Fixed Income Account Representative for additional information pertaining to this new resource. More Information Author Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI, has more than 30 years of fixed income portfolio management experience, and has developed and successfully managed various high profile domestic and global fixed income mutual funds. He has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments. At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the ultimate goal of optimizing investment portfolio performance at the credit union level. He can be reached at tom.slefinger@balancesheetsolutions.org or , ext Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or particular needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding future prospects might not be realized. Please contact Balance Sheet Solutions to discuss your specific situation and objectives.