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The Search for Relative Value in Bonds.pdf
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The Search for Relative Value in Bonds.pdf
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1
The Search for Relative Value in Bonds
Asset swaps are a seductive, but incomplete, approach.
Robin Grieves
1077 30
th
St NW
Washington, DC 20007
1 (202) 378-6865
robin_grieves@yahoo.com
Steven V. Mann*
Professor of Finance
The Moore School of Business
University of South Carolina
Columbia, SC USA 29208
1 (803) 777-4929
1 (803) 777-6876 (fax)
svmann@moore.sc.edu
May 2006
*Corresponding author
2
Abstract
Asset swap spreads are a widely used metric for identifying relative value in
bonds. We document that this approach breaks down because different benchmark credit
curves have different slopes and spread volatilities. If credit default swaps augment the
relative value analysis, portfolios return to their original spread duration exposures.
Apparently disparate portfolios are returned to an approximately equal footing.
3
The Search for Relative Value in Bonds
1. Introduction
Fixed-income investors have long sought a one-dimensional measure of bond
attractiveness. With such a measure, security valuation is reduced to a single test. The
highest scoring portfolio in today‟s metric is likely to have the highest (risk adjusted)
total rate of return over the coming periods. Yield to maturity is perhaps the most
prominent example. Despite flaws that have been well known and well understood for
more than 30 years, yield to maturity is still commonly employed in fixed income
investors‟ investment selections and their predictions for holding period returns [see, e.g.,
Homer and Leibowitz (1972) and Schaefer (1977)]. Potential errors from this approach
can be large, especially when a mixture of coupon paying bonds and zero-coupon bonds
is under consideration because the alternatives „roll down‟ different yield curves. Bonds
with embedded options realize holding period returns equal to their yields (either to
maturity or to first call) only by numerical accident.
The search for single measure of bond attractiveness continues unabated today.
One tool that has gained broad currency recently is to asset swap every bond in the
portfolio – or at least every bond that can be swapped – and determine which portfolio
maximizes the spread over a reference curve, typically Libor. The portfolio that swaps
out best is deemed to be optimal.
The mechanics of an asset swap are straightforward. For simplicity, assume that
an investor buys a bond that is a standard coupon paying issue that returns the principal at
maturity. Assume further the bond sells at or near par such that the coupon rate should be
near its yield to maturity. The investor simultaneously enters a pay-fixed swap with a
4
tenor equal to the bond‟s remaining term to maturity. The reference rate for the floating
rate cashflows is 6-month Libor. On each coupon date, the investor receives a coupon,
pays some portion of that coupon to the receive-fixed counterparty and receives the
floating rate cashflow from same. The remainder of the bond‟s coupon payment
represents the expected return pick-up over 6-month Libor on average. Subsequent
changes in the bond‟s market value in response to changes in yields are offset by nearly
equal changes in market value of the pay-fixed swap position. For example, a bond with
a 6% coupon-rate and 6% yield when pay-fixed swap rates are 5% for the same term to
maturity „swaps out‟ at 100bp over Libor. This number (100 basis points over 6-
monthLibor) is the asset swap spread and is used as the measure of relative value
regardless of whether the cashflows are actually swapped.
If portfolio managers followed this rule literally and their security selection were
otherwise unconstrained, they would be induced to buy bonds with the highest credit risk
and longest maturity. Clearly, beneficiaries and plan sponsors impose constraints to
avoid such an outcome.
The purpose of this paper is to show that maximizing the asset swap spread is a
decision rule nearly certain to fail.
2. How do fixed-income portfolio managers add value?
The performance of an actively managed fixed-income portfolio is measured
against a designated benchmark (e.g., an index or liability structure). Portfolio managers
employ four basic strategies to add value relative to the benchmark. First, bond portfolio
managers may seek to outperform by extending duration before a rally and shortening
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