Fixed Income -- Readings 28, 29 and 30

Any FI experts out there? Reading 28, p. 377 says “sharp supply declines are accompanied frequently by spread expansion…” I would have thought – if no one is issuing new debt then those that do don’t have to pay as much interest as there is lots of money chasing few FI opportunities – therefore spreads decline. Reading 29, pgs. 18 through top of 23 – not marked as optional, but doesn’t seem to be covered by any LOS’s – anybody else notice that? Reading 29, eg. 13, pg. 25 “the max possible loss for this party is limitless”. I don’t agree – default puts a cap on the loss, doesn’t it? Reading 30 – pg. 60, top – says to dynamically hedge when expect volatility to decline, and purchase options when expect volatility to rise – how do you reach this conclusion? Reading 30 – pg. 70 – “mortgage securities are market directional” – is this because the error is + in the one scenario and - in the other, or is it because the loss is bigger than the gain?

I am no FI expert by any measure. Let me give a try. #1. In the reading, the underlying assumption is about the issuance of bond “create” the validity of the quality of the bond. When supply decrease, such validity goes away, therefore cause investor to get nervous about their bond holdings==>sell bond, cause spread to increase. #2. Not sure! #3. Not sure! #4. Most model that are used to calcuate OAS are build on the assumption of a small movement of interest rate. Very similar to how duration is only “accruate” for small change in bond yield, and option delta is only “accurate” given a small change in stock price. If the expected volatility is to decline, the change of interest rate will be small, the dynmaic hedge can work well because it is based on the assumption of small rate change. However, if volatility is to increase, the model for dynamic hedge won’t be valid anymore, therefore option works better, since option price is also positive related to volatility. #5. In the text, it is talking about directional with the inerest rate change…meaning when rate go down, MBS value goes down (I know this is not entirely true), and when rate goes up, MBS value goes up.

Hey TooOldfThis, For # 2 - You are right, LOS’s don’t touch upon these concepts in the context of fixed-income (maybe they touch on them in later study sessons…I am not there yet). I just read over but am not going to put too much empahsis on them…kust enough effort to regurgitate some info if it is on the test. >>>>>I have a question though, when you say “not marked as optional”, do you mean Schweser marks as optional or are concpets marked as “optional” by CFAI in their texts? Any color here would be great. For #3 - I see your point. I also sorta get the CFAI’s point. I guess CFAI is assuming spread could go to infinity (which obviously would never happen) but I guess theoretically it could. So if you are on the short side of the credit forward and the spread increases 1 million percent, i guess you are screwed, but that ain’t gonna happpen.

For 1, the issuance of new debt helps in price discovery in the secondary markets. That is, it reassures traders in the secondary market that they are not way off the mark in their pricing of similar instruments. Lacking this information, they just increase their spreads to protect themselves.

ChiTown, In the CFAI texts, you’ll see “Optional” clearly marked in the margins (but it doesn’t happen alot). Once in awhile Schweser will tell you not to bother with something – but that’s their opinion more than anything, I don’t take for granted that Schweser is right. ws, I don’t agree with what you said re: #5, they specifically talk about MBS being market-directional, as opposed to all bonds, and they talk about it in the context of hedging. There’s something more there, I just don’t know what it is!

TooOld4This - Regarding #5, I think you are on to the crux of the market-directional concpet in your first posting about the error being positive when hedging in an increasing interest rate scenario and the error being negative when hedging in a decreasing interest rate enviroment. I think this goes back to how duration increases when interest rates rise for a mbs with negative convexity as the value of the pre-payment option drops in value. Still a little foggy on this market-directoinal stuff but I think it just means they outperform when interest rates rise (which I guess could occur during a market expansion) and underperform when interest rates are decreasing (which I guess could occur in a market contraction). The links are weak but hope that sorta helps. Also, I don;t know your thoughts but the CFAI has 7 pgs of that 2 bond hedging crap just to spell out the concept that the interest rate sensitivy measurement is superior to duration management. Seems like complete overkill to me.

#1 ws is right. The premise is that by issuing a bond, market participants/issuers implicitly agree or believe that the interest rate environment is reasonable and that the yield on these new issues are a yardstick for bonds currently traded. This “act” (increased supply) gives investors confidence and confirmation thus leading to decreased yields and vice-versa. #4 Hedging removes any upside potential, thus use only when you expect volatility to decline. However, options you can continue to maintain the upside potential while covering the downside.