What are some proven strategies of bond trading? Can someone break down/share links for this:
Buy bonds and finance it by making reverse Repos.
Buy low, sell high.
^ Decent strategy but I knew a fend hudge manager who made monnes of toney doing the exact opposite.
Fixed income is pretty interesting, and you’ll learn more about how those strategies work on CFA L3.
Bond trading is tricky because yields tend to be lower than stock returns, so there’s less variation and less opportunity to overcome the transaction costs enough to justify a trade. You can lever up to do it, but leverage can bite you in the rear, particularly since fixed income can spike (yeilds spike up, prices spike down) in ways that make typical stock panics look tame.
One use of fixed income is to immunize known future expenses through duration matching. When you do that, it’s not so much about returns but instead about capturing the time value of money to make sure future expenses are funded at rates that will grow into what’s needed. You can depart from that allocation to try to get a little more, but you’re usually talking about a few basis points, not great gains. When you do trading in these portfolios, better returns is not generally the motive, rather, you are readjusting the portfolio’s duration to match the duration of whatever it is you are trying to immunize (because bond portfolio durations change over time as 5 year bonds turn into 4 year bonds, etc.).
The other thing that you can do is play the yeild curve. So you have bullet bond portfolios, where all the bonds have the same duration, you have barbell bonds, where bonds are divided between a low duration number (like 1-2) and a high duration number (like 10 or 15). These portfolios will then react to steepening or flatteningof the yield curve. This is a big thing to do in macro - steepeners and flatteners. Finally, there are laddered portfolios, where bonds are approximately evenly distributed in maturities… this is often the default benchmark for bond portfolios that don’t need to be matched to liabilities.
Ultimately, bond investing is still about risk vs return, just like stocks. What’s different about bonds is that you typically know what the return is supposed to be (because of known scheduled interest and principal payments), whereas with stocks you have to try to estimate it from expected earnings and such. So since the return is known (as long as nothing goes wrong) a lot has to do with evaluating whether the bond is riskier than its yield would suggest that it is, or vice versa.
Generally, you need a very large capital allocation before an active bond strategy starts to make sense. Since you are often outperforming by a basis points, it means that you need to have a large AUM (or a lot of leverage) before active management beyond rebalancing can produce enough to make it worth doing. That’s why smaller investors tend to stick to stocks, and put their fixed income allocations into bond mutual funds or simple ladders.
High Yield Bonds are different, in many ways they trade more like equity, because the performance of equity has a greater impact on their valuation, because poorly performing equity translates into a higher risk of default. It’s not that normal bonds aren’t also influenced by the performance of equity, but the high yield bonds are simply much more sensitive to equity performance.
That was really insightful, thanks for sharing bchad!
@krokodilizm…I believe you meant buy a bond and finance it using repo(not rev repo). Multiple strategies: Bond Laddering; Rolling down the yield curve; Steepner vs flattener trades; duration matching etc.- explaining each is a tedious task
I saw it in a very old Schweser item set.
"Bill Woods, CFA, is a portfolio manager for Matrix Securities Fund, a closed-end bond fund that invests in U.S. Treasuries, mortgage-backed securities (MBS), asset-backed securities (ABS), and MBS derivatives. The fund …
…pays a $.12 monthly dividend that is paid from current income. The basic operating strategy of Matrix is to leverage its capital by investing in fixed income securities, and then financing those assets through reverse repurchase agreements. Matrix then earns the spread between the net coupon of the underlying assets and the cost to finance the asset. Therefore, when evaluating a security for investment, it is critical that Matrix can be reasonably assured that it will earn a positive spread"
Right. The steps are:
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You receive cash from investors.
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You buy treasuries with that cash. Usually short term, but I think you can repo long term treasuries too. Markets have changed since the crisis, so maybe the long term stuff is harder to repo. Anyway, step 2 is just acquire treasuries, because treasuries pretty much have a guaranteed payer (as long as Congress isn’t playing budget chicken and threatening not to fund the government).
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When you find what you want to invest in, you raise cash by handing the treasury over to a bank (or possibly hedge fund) who takes it as collateral for a short term loan (often only 1 day, but then gets strung together day after day after day). You promise to repurchase the treasury at a given price. Effectively, the difference between what the bank buys the treasury for and what you repurchase it at represents the cost of the cash you are raising. The one-day loan term basically allows the lender to call the loan back (by refusing to relend) and change the interest rate they are charging on a daily basis.
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Once you have the cash, go and invest in whatever other asset (such as a credit bond that pays more, or anything else your heard desires) and hope it works out well.
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You win if your investment earns more than your treasury + the repo rate (which is the difference in buy and repurchase price converted into an interest rate)
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Tell your clients that your assets are basically treasuries (to make your clients feel safe) that have been magically repoed into high performing investments (to make your clients feel smart), when in reality it is just to make sure that your cash sits in treasuries rather than idle when it’s not being used.
why not skip step 3 and just hold treasuries until you ready to invest, they are pretty liquid
Thanks for the inputs. What is dodgy for me is this: Are you essentially betting on an interest rate movement or is this some kind of arbitrage since all rates/costs seem to be fixed beforehand?
I saw this one the CFA website:
Not sure if this pdf will work for you but give it a shot:
http://www.cfapubs.org/doi/pdf/10.2469/onll.v2011.n1.1
It’s on my to-do list.
What bchad said is financing a bond with repo. You get cash in a repo which you use to finance the bond. Cash goes out in a reverse repo and a bond comes into your hands (as a collateral posted by the counterparty).
Pretty much all [active] fixed income I’ve seen is a bet in some fashion on interest rates or credit spreads or individual probabilities of default. I suppose things like lending club can be bets on one’s ability to extract high repayment rates, but that’s still basically a rates bet.
There presumably is some arbitrage happening to keep the yield curve consistent with current rates and perhaps when currencies get into the picture. There is also capital structure arbitrage, but that tends to be company specific. Most straight fixed income is still a bet on interest rate/credit spread movements, or the impact of liquidity demands (which feed back into rates).
There may also be some arbitrage stuff happening in convertible bonds, but that market is thinner and I suspect transaction costs can be higher there.