Relative Value Methodologies

Relative value refers to the ranking of fixed income investments by sectors, structures, issues and issuers in terms of their expected performance during some future period of time.

Relative value analysis refers to the methodologies used to generate such rankings of expected returns.

There is a positive relationship between liquidity and bond prices, i.e. As liquidity decreases, the investors are willing to pay less (implying increasing yields) and as liquidity increases, the investors are willing to pay more (decreasing yields).

Rationale for secondary bond trades

i. credit upside trades- occur most often at the juncture of the highest speculative rating and the lowest investment rating.

ii. Credit-defense trades- managers reduce exposure to sectors where they expect a credit downgrade.

iii. New issues swaps- Managers tend to prefer new issues especially on the run Treasuries since they are perceived to have superior liquidity.

iv. Sector-rotation trades- Allows movement from sectors that are expected to underperform and into one that is expected to outperform on a total return basis.

v. Yield curve adjustment trades- attempts to align the portfolios duration with anticipated changes/shifts in the yield curve.

vi. Structure trades- swap into structures that will have strong performance given an expected movement in volatility and yield curve shape.

vii. Cashflow reinvestment trades-if the interest rates are expected to rise, buy short duration bonds and sell long duration bonds. If interest rates are expected to fall, buy long-duration bonds and sell short duration bonds.

Assessing Relative Value Methodologies

a) Nominal spread- is the yield difference between corporate and government bonds of similar maturity. It is currently the basic unit of both price and relative value analysis for most of the global corporate bond market.

b) Option-adjusted spread- is the effective spread for the class after removing any embedded options.