CHAPTER
FIFTY-SEVEN
HEDGE FUND FIXED INCOME STRATEGIES

ELLEN RACHLIN

Managing Director
Mariner Investment Group, LLC

CHRIS P. DIALYNAS

Managing Director
PIMCO

VINEER BHANSALI, PH.D.

Managing Director
PIMCO

In this chapter, we discuss many of the most popular hedge fund fixed income investment strategies including macro, asset-backed credit, capital structure arbitrage, long/short credit, distressed, basis trading, index arbitrage and correlation trading, and volatility trading. We believe that a solid understanding of macroeconomic conditions, the economic environment, and the influence of policymakers and participants is critical for any robust investment strategy, including fixed income hedge fund investment strategies. Therefore, we begin with a discussion of macro investing fixed income strategies, focused on interest rates and currencies, and then move into further discussion of other strategies that are relative value, arbitrage strategies, as well as long biased ones. The performance of all of these strategies is dependent upon the portfolio manager’s ability to take advantage of deviations of asset prices from their fair values. This process requires having analytical tools and a historical context within which to gauge asset price deviations and their potential for corrections. Relative value, asset-backed and arbitrage strategies require more sophisticated valuation tools for the computation of the expected value of security cash flows.1

MACRO INVESTING

All elements of fixed income investing require an understanding of the macroeconomic framework and the macro-political economic environment. The macro initial condition will dictate a growth and price stability bias. The macro policy bias will determine the set of policy choices appropriate to achieve the policy bias objective. The philosophical bias of policymakers, as shown in Exhibit 57–1, will influence the analytical framework with which the initial condition is diagnosed given the existing institutional architecture of the macro economy.

EXHIBIT 57–1
Sizing Things Up as of January 2011

images

The complex dynamics of the interaction of these considerations will result in a directional bias for many (if not all) of the risk parameters that concern portfolio managers. The interest-rate direction, yield-curve shape, volatility of interest rates, risk spreads, and currency valuation depicted in Exhibit 57–2, along with the corresponding second derivatives of each, are dominated by the dynamics of the macro system.

EXHIBIT 57–2
Expected Changes in Market Variables Relative to Changes in Economic Growth

images

Many attributes define the macro-political economic environment. The institutional architecture is certainly very important. The institutional architecture is defined by the political, banking, and legal systems. While these bodies may be easily understood conceptually, they morph over time as the political/philosophical bias of the people in charge change as well as changes in the attitude of the general population occur, which can happen much more slowly.

Understanding the philosophical economic bias of each region is vital to anticipating policy and changes in policy. The primary objectives are simple and straightforward. In the United States, the stated objectives are a stable rate of inflation and full employment. The Europeans concern themselves most with price stability. The Chinese seem concerned with internal industrial development via a mercantilist export policy. Each country will have a particular objective at any particular time, and over time the importance of any particular objective will change as conditions change. Moreover, the philosophical bias evolves as a country evolves. In his Republic, Plato describes a very plausible evolution of political rule. Among those considered are: democracy, aristocracy, oligarchy, philosopher kings, monarchy, socialism, totalitarianism, and dictatorship. The implications of each are quite important to investment decisions, as are the migration of regime one to another. Exhibit 57–1 characterizes the institutional composition of a few of the many important financial economies. Note the differences among the market participants.

In his The Role of Monetary Policy (American Economic Association, 1968), Milton Friedman elaborates on public policy priorities, potential policy choices, and the difficulty of effective implementation.

To state the general conclusion still differently, the monetary authority controls nominal quantities—directly, the quantity of its own liabilities. In principle, it can use this control to peg a nominal quantity—an exchange-rate, the price level, the nominal level of national income, the quantity of money by one or another definition—or to peg the rate of change in a nominal quantity—the rate of inflation or deflation, the rate of growth or decline in nominal national income, the rate of growth of the quantity of money. It cannot use its control over nominal quantities to peg a real quantity—the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real national income, or the rate of growth of the real quantity of money.2

Understanding the Components of the Statistics

The investor should analyze the data in Exhibit 57–3 with an eye to dissecting the aggregated statistics. Understanding the trend of any particular statistic is insufficient. Understanding the distribution of components of the statistic is vital. In this regard it is most important to distinguish between the distribution of debt formation, both public and private, directed to consumption and that associated with investments. It is important to understand the distribution of prices associated with inflation. It is important to understand the components of trade, both exports and imports, associated with consumption and investments. The implications of the distributions are vitally important to predictions of the future and to an inferential understanding of the motivations of policymakers and the public at large. Also vital to the process is an understanding of when policy end points are near and the implications thereof. A microscopic understanding of the data will enable the investor to decide what coefficients to assign to each statistic and to change the coefficients when appropriate.

EXHIBIT 57–3
Components of the Statistics: January 2011

images

images

Armed with the data, although estimates differ somewhat among sources, the philosophical economic political persuasion and institutional architecture, the portfolio manager’s challenge is to forecast the various risk parameters, knowing that there is more to economic behavior than statistics. The portfolio manager must also account for regulatory changes, sociological conditions, political risk, and the psychology of the participants. One looks to the markets for inferential valuations that presumably synthesize all of these criteria. After all, money-making is a bet against forward prices. So, forward rates, yield-curves and currency values are all requisite inputs to the portfolio manager’s decisions after an assessment of all of the statistics and after an evaluation of all of the political/economic/philosophical judgments.

Big Changes Are Very Important

The price of an asset is simply the intersection of supply and demand. Activist policy institutions like the U.S. Federal Reserve Bank, the European Central Bank (ECB), the Bank of England, and the Bank of Japan have decided to change their status from referee to both player and referee and to engage directly in the markets in such a way that they become price setters. This is a most important fundamental change to capitalism. Direct government interference in capital markets means that prices are less subject to the fundamental macro valuations described herein and more a function of “social” desire of policymakers. This is a gigantic change and during such a change the portfolio manager must consider placing the political, sociological, and philosophical forecasts ahead of the traditional economic forecasts associated with a “capitalist” system.

The Yield Curve

The yield curve is a mapping of interest rates for various lending periods for a particular issuer. The yield-curve shape can vary substantially and changes in the shape of the yield-curve can be an important source of return to the investor. Longer maturities typically yield more because there is more pro-inflation risk and credit risk embedded within them and they are less liquid than shorter maturities. Absent credit risk considerations, longer maturity securities’ yields are lowered because of their higher convexity, which takes on greater value when interest rates become more volatile. In Exhibit 57–4 there is displayed two examples of changes in risk from credit to interest-rate (inflation) risk and vice versa. In addition, we observe the proinflation tendency of policy in the United States in Exhibit 57–5.

EXHIBIT 57–4
Evolution of Interest-Rate Risk

images

EXHIBIT 57–5
U.S. Inflation Policy

images

Creditors generally cannot foreclose on a sovereign issuer. Defaults on sovereign issuers result in “restructuring,” in which creditors receive a fraction of their principal back. So, in anticipation of a potential restructuring, rates increase on the sovereign to reflect the increased credit risk. The increase in rates further impairs the sovereign’s credit, thereby increasing default probabilities because the interest-rate itself is higher than the rate of sovereign growth; growth that itself is reduced by the higher interest-rate. Moreover, over very long periods, demographic trends become an increasingly important variable if there is a large outstanding debt. Reductions in population growth translate into fewer workers to contribute to debt servicing and increases in the forward population relieve the debt burden.

The sovereign credit default swap (CDS) market is yet another check on the creditworthiness of the sovereign and the change in the credit status. The CDS market is one in which investors can buy and sell insurance on sovereign credit.

A policy is triggered and the insurance collected if and only if a default occurs or a restructuring, if CDS contract so specifies. The CDS spread is relative to a standardized LIBOR term and should map closely to the yield spread on that sovereign’s bond to the same term rate. Technical contract specifications and potential for regulatory interference cause the two spreads to be unequal. However, the direction of the spreads should be consistent most of the time.

Economic inferences and dynamics, forecasts for interest rates and currencies are, as discussed, much more complex in a highly globalized world economy. Traditionally, currency forecasting was a function of interest-rate differentials, growth and inflation, trade and capital flows, differentials and purchasing-power parity. Post the 2008 financial crisis, there has been an increasing focus on the growth in relative factor productivity and net trade flows. The military strength of a nation is always a very important consideration.

Many financial economists and investors believe the output gap is an important determinant of inflation. The output gap and inflation are inversely related as the output gap measures the degree of abundance of resources in the economy. The output gap theory relies on empirical Phillips curve analysis, which measures the historical relationship between a most important resource—labor and inflation—as depicted in Exhibit 57–6 for both the United States and the United Kingdom.

EXHIBIT 57–6
Phillips Curve

images

images

Currency debasement, inflation, and taxation are all substitute expropriating vehicles in addition to regulatory tools such as capital controls the sovereign has at its disposal. The choice of vehicles is employed in combination with the prevailing conditions shown in Exhibit 57–7 make a big difference to an investor in sovereign bonds and to choice of currency—as always relative to forward values. Exhibit 57–7 is a crude mapping of currency and bond strategy given a particular policy circumstance.

EXHIBIT 57–7
Implications of Policy Choices

images

Exhibit 57–8 shows the valuation of a few currencies in both the spot and forward markets. Conceptually, any difference between the interest rates implied by the forwards and the prevailing interest-rate differential between that country and the United States, interest rates (in this case) represents the speculative motive in that market or is indicative of high transaction costs.

EXHIBIT 57–8
Spot and Forward Currency Valuation

images

Political Self-Interest versus Interest of the Sovereign

Politicians and policymakers can be predisposed to do what is in their best interest as opposed to the national interest. The national interest is, as discussed in the beginning of this chapter, a function of one’s underlying political/philosophical/economic beliefs. To the extent that politicians get re-elected by providing benefits to the population through spending programs, we will observe an accumulation of debt and a generalized inflation over time. This has certainly been the case for the United States. Exhibit 57–9 provides inferential support for the thesis that politics in democratic nations are incentivized to increase debt for the purpose of providing greater benefits to its constituents with the hope of reelection.

EXHIBIT 57–9
Debt Creation and Inflation

images

images

images

Investors in bonds and currencies must consider the psychological impact on policymakers’ behavior when legacies are in the making. The period from the 2008 financial crisis through 2011 is a period when legacies are at risk and monumental global financial and social change is proceeding. It is a time for bond and currency investors to evaluate the efficiency of policies, the sustainability of policies, as well as, realistic alternatives to prevailing policies and the implications thereof. Investors should heed the council of notable economists of the past. Specifically, Keynes’ policy prescription to a financial crisis might result in, “Euthanasia of the rentier,”3 and Robert Triffin’s concern about the responsibility of the custodians of the reserve currency. “We should be as averse as foreign countries—or more so—to incurring again the awesome political responsibilities and inflationary temptations inseparable from the exorbitant privilege of having our national currency used as the main international currency of the world.”4

Macro fixed income hedge fund investment is one significant hedge fund style of investing. The rest of this chapter is devoted to other styles including: asset-backed credit, capital structure arbitrage, long/short credit, distressed, basis trading, and index arbitrage and correlation trading.

ASSET-BACKED CREDIT STRATEGY

The asset-based credit strategy is a long/short style of portfolio management that focuses on investing in securitized debt obligations, which may encompass a wide variety of types of debt from residential and commercial mortgages to leases and credit cards. The portfolio manager will seek to identify asset-backed securities that they believe are mispriced relative to the value of the supporting loan collateral for long or short investments. This strategy is focused, generally, on higher yielding securities backed by loans to riskier, non-prime borrowers, but not exclusively so.

The best opportunities to purchase mispriced asset-backed securities generally occur during significant dislocations in the credit markets. Practitioners of this strategy will often develop complex proprietary models to value the individual collateral referencing a given security with the goal of ascertaining whether that security may or may not have a greater liquidation value and principal and interest payment stream than is built into the current pricing. These valuation models will include current information such as payment delinquencies as well as payment projections over the expected life of the security. These models will have the ability to analyze loan level data. Hedging or shorting in this strategy may tend to focus on hedging macro risk factors such as general market declines as well as use derivatives on specific vintage or year and seniority in the payment of a securitized obligation.

The types of asset-backed credit collateral considered as a potential investment set for the credit strategy includes agency and non-GSE issued residential mortgage securities, primarily, consumer credit asset-backed securities, commercial mortgage securities, and commercial nonmortgage asset-backed securities, among others. The largest asset-backed credit group, residential mortgages, consists of securities backed by differing mortgage loan types, among them Alt-a, option adjustable-rate mortgages, other subprime loans, as well as others.

These loans are not only securitized into pooled obligations securities, but are further divided into tranches tiered by payment priority loss. The lower the payment priority, the higher the default risk, but also the higher the current yield. Part of this investment strategy is for the portfolio manager to not only identify misvalued securities but misvalued tranches. At times the cheapest security may be the first loss and in other instances it may be the top of the structure. The portfolio manager may also choose to allow their impression of the market environment determine where they are most comfortable in the tranche structure with the view that defaults have a cyclical component.

A portfolio manager may also choose to purchase securities that are “seasoned” meaning that they are older. Borrowers that have been current on their payments, historically, tend to continue to pay. However, seasoned securities tend to be more fully priced and are less likely to be cheap. Short strategies tend to be hedges designed to protect from systematic risks such as against general deterioration in all asset prices, both stocks and bonds and less security level specific, other than derivatives due to the limited ability to short or borrow the cash securities in the asset type.

Some of the underlying collateral that is monitored by the portfolio manager include home and commercial property price appreciation, cumulative default rates, delinquency trends, cumulative loss rates, loss severity from sale, loan to value rates, loan modification levels, liquidation rates, geographic, REO levels, commercial sector demand, and unemployment rates, among others. Because default rates are the primary risk factor in this asset class, the asset-backed credit portfolio manager will monitor the performance of the underlying loans behind the asset-backed securities held and the ones under consideration for possible inclusion in their portfolio. Some details include the number of reference loans that are delinquent, length of time delinquent, nonperforming, in foreclosure and liquidated, as well as restructured and re-performing.

Hedging techniques and possibilities have greatly expanded in scope and potential for this hedge fund strategy over time. At one time, one could only primarily think in terms of hedging systematic or cyclical risk. One would choose broad-based credit, interest-rate or even equity indices to provide downside protection. However, during the beginning stages of the housing debt market crisis a proliferation of derivative products that referenced asset-backed securities and tranches of asset-backed securities by type were developed that offered ways to more directly hedge or short sell residential and later, commercial asset-backed securities. Some of these products include: Markit ABX-HE, Markit CMBX, Markit TRX.NA, and Markit iBoxx European ABS, as well as credit default swaps on home equity asset-backed securities. These derivatives are tranched, allowing for a more specific type of asset-backed hedge or short sale instrument.

CAPITAL STRUCTURE ARBITRAGE

Capital structure arbitrage is an investment strategy that is typically focused on stressed or distressed companies. Typically, these are ones with high balance sheet leverage. A capital structure arbitrage portfolio manager considers all securities of a company (debt and equity) for possible mispricing or relative mispricing. They view the securities by payment priority against current cash and future earnings potential. They assess value by ascertaining probabilistic ability to pay debt obligations as well as potential realized equity valuation. Capital structure arbitrage is an investment strategy that is flexible and broad enough in scope to accommodate opportunities that arise throughout the credit cycle. For example, the portfolio manager may be more constructive on holding equity that appears cheap versus a senior debt short hedge during an economic recovery and shorting equity while holding senior secured debt during economic contraction. Other times, the financial merit of a company’s outstanding securities may hold a case independent of economic times. The portfolio manager will likely identify a specific catalyst event that will correct the senior versus junior security relative value mispricing. This catalyst could be an upcoming refinancing or a business specific event. This strategy tends to use low levels of leverage as the companies invested in have high levels of balance sheet leverage.

The layers of securities within a company can be quite varied from senior secured bank debt with strong covenants to the most junior security or equity-based ones. Each of these securities can be expected to have unique volatility characteristics. The more junior a security, the more likely it will be relatively more volatile. The portfolio manager must consider this volatility when positioning long and short as this will affect the overall P&L volatility exposure to their portfolio.

The portfolio manager must evaluate the covenants of outstanding debt and ascertain payment priority, which can be complicated. The most difficult layer of complication comes from companies with multiple subsidiaries. Subsidiaries and holding companies may have cross-liabilities and not be entirely self-reliant. The portfolio manager must also factor in debt maturity schedules as an important element of valuation against their prediction of future ability to make interest and principal payments. Often the clarification of payment priority and asset rights are resolved in a court of law. The portfolio manager must have a thoughtful way of assessing the likely bankruptcy proceeding outcomes in regard to the various debt instruments outstanding. This process can be fairly long and the outcomes uncertain. However, these securities are usually ones that can be sold or traded long before final legal decisions are reached.

A capital structure arbitrage portfolio is likely to contain multiple positions in various securities within the capital structures of many companies. Each of these companies is likely to be or anticipated to be experiencing some form of structural change as a result of meaningful current or prospective corporate events. The events may not only include a changing capital structure specific to one company, but may represent changing financial fortunes inflicted by the larger macroeconomic environment on many sectors of the economy. Often the capital structure arbitrage portfolio can be concentrated by sector as industry dynamics can affect multiple companies at once in a way that creates opportunity uniquely to that sector. The portfolio manager thinks in terms of various scenarios with probabilistic outcomes. The long and short security weightings will reflect their probabilistic assessments. Longs may hold a larger weight if stronger economic fortunes are expected ahead, for example. Events have varying time frames and the portfolio manager is also likely to assess the attractiveness of an opportunity based on the present value of the expected price change of the securities positioned.

Hedging in this strategy tends to be company specific, whether on a junior or senior security basis. However, it is usual to see industry level hedges or even index based ones in this strategy. Capital structure arbitrage portfolios can have a tendency to be net long for the company specific positions. Other more generalized hedging techniques may often make sense to deploy in order to mitigate overall market beta exposures.

LONG/SHORT CREDIT STRATEGY

The long/short credit strategy is also referred to as a relative value strategy or a fixed income arbitrage strategy. Within any of these descriptions are multiple substrategies or investment approaches practiced. Some of these substrategies may have very specific tightly hedged arbitrages while others have more systemic or generalized hedging approaches. Long/short credit strategies can include debt securities within the entire credit spectrum from investment-grade to high-yield and distressed. All approaches depend upon a bottom-up analysis of a given company’s ability to pay its debt obligations based on its business model and its revenue prospects. Similarly, portfolio managers are focused on economic and leverage cycles, which affect companies’ abilities to meet their debt obligations. A long/short credit portfolio can consist simply of diverse bond positions both long and short of companies that the portfolio manager feels are worthy of taking a positive or negative view on based on current default probability versus current price. A portfolio manager can be expected to hold overall exposure ranging from net long to closer to market neutral. Practically speaking, it is unusual for a portfolio to be consistently net short.

Cash corporate debt (loans, bonds, and preferreds) and derivatives, both single company reference as well as index and tranches of indices are the main instruments used, in addition to sovereign debt instruments. However, interest-rate and equity instruments are used to hedge or emphasize certain desired exposures. Specifically, cash corporate debt obligations are ones that have some claim or payment priority in the event of corporate default. Derivative instruments, credit default swaps, are generally bi-lateral payment agreements between two contractual parties based upon the financial fortunes of a referenced entity. These instruments represent no direct obligation of the referenced company in the event of default. These instruments will be assessed based on a given entities’ prospective cash flows, asset quality, covenant protection, possible catalysts that may alter an entity’s future earnings capabilities, industry trends, overall default rates, credit conditions, industry, and broad economic factors, among others.

The long/short credit portfolio manager may take several different approaches toward building their portfolio. They may construct a credit long book and a credit short book with the net and gross exposures reflecting some macro point of view regarding underlying market volatility and near term direction. In general, the gross market value of the aggregated positions versus assets under management can be expected to be larger for higher rated, lower spread debt than lower rated, wider spread debt. Such construction reflects a risk attitude that the latter is likely more volatile in price.

Directional longs may include the debt or credit derivatives of out of favor, stressed, distressed companies, debt whose prices seem to be below their fair price as assessed by the portfolio manager, or of companies undergoing positive changes. Directional shorts may include the debt of or credit derivatives of companies that are experiencing a cyclical decline, whose prices seem to be above their fair price given future earnings potential as assessed by the portfolio manager, or provide opportunity to profit from the part of the leverage cycle in which all corporate bond spreads are widening. The portfolio manager can be expected to use leverage but hold some reasonable portion of unencumbered or excess cash over their margin requirements. The amount of unencumbered cash held will rise and fall depending on the overall conditions of the markets, both by cyclicality and opportunity. Depending on the risk appetite of the portfolio manager, their portfolio may be highly diversified with hundreds of positions or be more concentrated. Generally, over time the more concentrated a portfolio, the more volatile that portfolio’s valuation can be expected to be. Concentration can refer to position size, ownership percentage of a particular debt issue, geography, industry, and credit quality, among others.

Of a given debt issue, the higher its investment rating, the lower the probability of its default; however, the return distribution of such a debt issue will be negatively asymmetrically skewed with more downside potential than upside. This is what makes hedging interesting in this strategy. Hedging can be company specific in such a way that overlaps with capital structure arbitrage and involve other debt in the same company as well as reference credit default swaps. Hedging or shorting can be used to express a negative view on a company or a sector as well as to maintain a net short position during times of market turmoil. Hedging can also be as broad in nature to include generalized equity, credit, and interest-rate hedges. The more tightly hedged, market neutral or investment-grade focused a given portfolio is, the greater likelihood leverage will be higher than otherwise. Concentrated or net long portfolios can be expected to be commensurately less leveraged, as this type of portfolio will be more volatile than a market neutral one.

DISTRESSED

The distressed investing strategy is one that focuses on investing in the securities of companies experiencing financial stress. They may be or may not be in default. The investment situations may be ones that are meant to focus on improving corporate balance sheets, others may be liquidation investments in which a company’s securities may represent a claim on valuable assets, including cash, some liquidity investments in which refinancing will provide the necessary time for a company to recover, or litigation investments in which the portfolio manager may participate on creditor committees and the value of certain securities will be determined in a court of law. As well, some positions may be short ones on deteriorating companies that are losing market share or are cyclical in nature. All positions will generally be constructed with an identifiable catalyst or some event, usually corporate specific, that will unlock the value potential of securities held in the portfolio.

The securities held in the portfolio of a distressed strategy can include all parts of the capital structure of a company, holding company or subsidiary as well as aggregated debt securities as described in the asset-backed security strategy section. Securities range from senior secured debt (such as bank loans) to subordinated debt (such as second lien debt) down to more junior secured securities (such as busted convertibles trading well below the convertible price and equities). Other types of debt securities exist only with companies experiencing financial distress such as debtor in possession (DIP) or rescue financing. The lower the debt in the capital structure or payment priority, the lower the dollar price can expected to be.

The distressed portfolio manager may take several approaches to building their portfolio. This strategy is primarily long-biased and the characteristics of the securities held in a sensibly constructed portfolio will include ones that are the debt or equity of companies that are industry leaders or have strategic importance, ones that are cheap relative to not only current valuation but have a cushion to protect during a downturn or market volatility, and well priced for the industry and region in which the company does business. The portfolio manager may use other companies’ valuations in a similar industry to ascertain value of a target company as a way of affirming the total valuation of the securities they are holding. It is worth noting that one aspect of this strategy overlaps with the asset-backed credit strategy in that impaired structured credit such as collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs), which are bundled multiple corporate debt obligations are often part of a distressed portfolio manager’s investment set. These securities can be disaggregated to the loan or bond level and valued against current market pricing for the debt obligations of the underlying companies. The portfolio manager will value the sum of the collateralized obligation against the parts and attempt to profit if there is a suitable mismatch. Overall, the distressed portfolio will be likely constructed of multiple positions in multiple companies, but can be concentrated as when the securities of the top 10 companies represent a majority of the invested assets under management.

Hedging for this strategy will span from other parts of the capital structure in which strategic long positions exist to index or interest-rate hedges. Hedges may also include the debt and equity of other companies within the same or similar industries as strategic long positions. This strategy may also encompass short positions for companies whose fortunes are declining given industry trends and economic outlook. However, in this situation, which can be fairly cyclical by nature, portfolio managers may tend to restrict capital inflows, or even return money to investors if opportunities are scarce. Tactically, portfolio managers can move “up or down” in the capital structure, buying senior secured positions during the weaker part of the economic or industry cycle and taking more junior security positions, unsecured or equity, during growth phases of the cycle. While not necessarily a hedging technique, it is a risk mitigation one.

BASIS TRADING

Basis trading involves the simultaneous purchase and sale of two closely related securities to take advantage of relative mispricing.

In the classic futures basis trade, an investor can buy a cash Treasury security and sell a futures contract. In the credit basis trade, an investor purchases or sells a cash corporate bond and hedges the credit risk by the purchase or sale of credit default swaps. Other versions, such as the LIBOR-fed funds, or its longer maturity counterpart, the swap-spread trade, as well as the cross-currency basis swap, which involves funding in one currency and swapping via the currency forward exchange-rate market are also popular.

The hallmark of all basis trades is the isolation of a factor that is not present in one leg of the trade but is present in the other leg. In the futures basis trade, the important factor is the presence of a delivery option. The gross basis of each bond in the delivery basket is computed by computing the difference in its forward price versus the converted price of the futures contract (the delivery price, which equals the futures price times a conversion factor specified by the exchange). To obtain the net basis the gross basis is adjusted by the net carry, which is the coupon income and re-investment income minus the funding cost or repo rate of the bond. When the net basis is positive, a long cash/short futures basis trade has a negative expected loss equal to the basis. For example, if the net basis is 2/32nds, the long-cash, short futures position is expected to lose 2/32nds if held to the futures expiration date. The reason for negative expected return is that the person who is short the futures contract has an option to deliver one of the bonds in the basket, and the price of the option is equal to the value of the net basis. The short effectively pays the long futures holder for this option. Since all option values are positively correlated to a rise in volatility, the value of the option can rise if interest-rate volatility rises. In the case of the futures basis trade, the probability of another bond switching to become the cheapest to deliver rises as the volatility rises. Thus a person with the short futures position will have the value of the delivery option rise in an environment of rising volatility. Thus futures basis trading is really an option trading enterprise.

In a cash-CDS basis trades, an investor prefers to purchase a cash corporate bond and buy protection against it using credit default swaps contracts. If cash bond yields are higher than the price of protection, then the investor can take out risk-free profits. Following the history of the cash-CDS trade (here depicted at an aggregate level), illustrates some important insights into the fundamental driving factors. Before the crisis of 2008, the cash-CDS basis traded within a small range around zero. However, the crisis created a substantial widening of the spread, and the basis went negative, that is, cash bonds traded substantially wider than the CDS. In other words, at the height of the crisis an investor who had cash could purchase a cash corporate bond and buy protection on the credit risk and still be ahead by hundreds of basis points from those who did not have the cash and were forced to liquidate the cash bonds. In other words, the cash-CDS corporate basis trade is driven by the important risk-factor of liquidity. When liquidity is ample (as illustrated by the convergence of the basis trade after the infusion of liquidity from the Fed) the spread between cash and CDS quickly falls, as shown in Exhibit 57–10.

EXHIBIT 57–10
Spread between Cash and CDS

images

INDEX ARBITRAGE AND CORRELATION TRADING

Broadly speaking, index arbitrage and correlation trading take advantage of mispricing between the valuation of an index and its tranches (the “composite” securities), and the weighted valuation of its constituents. Since most indices have a large number of constituents, assumptions have to be made about the correlations between the constituents in order to reduce computational complexity. Thus index arbitrage is also known as “correlation” arbitrage.

The investment-grade credit default swap index (CDX) consists of 125 names of investment-grade credits that are selected by a consortium to represent the universe of investment-grade credits. There are similar indices in high-yield, Europe (ITRAXX), emerging markets, and others that make correlation trading possible. For the purpose of the discussion here, we will look at the CDX (investment-grade) indices.

The CDX index tranche market takes the losses on the 125 names and tranches them. The first tranche is the 0% to 3% or the equity tranche, which takes the first 3% of losses. The next three (mezzanine) tranches are the 3% to 7%, 7% to 10%, and the 10% to 15% tranches, which take the losses from 3% to 7%, 7% to 10%, and 10% to 15%, respectively. Finally the senior and the super senior tranches are defined by the attachment and detachment levels of 15% to 30% and 30% to 100%, respectively. These tranches are thus akin to put spreads on losses on the underlying index.

Correlation trading starts with the observation that if all correlations rise, the likelihood of large losses goes up, since many underlying entities become likely to default. Thus, if correlations rise, the premium that one receives for selling protection on super senior tranches should go up. Similarly, as correlations go up, the equity tranche premia fall, since the possibility of no or low losses also increases. The case for the tranches in the middle (the mezzanine tranches) is much more complicated and typically requires a model. In correlation trading, a portfolio manager takes a view on the correlation, and combines different tranches from the capital structure stack to express their view, while keeping the exposure to the underlying index flat or delta-hedged. Similar to trading equity options by using implied volatility, tranche trading with reference to implied correlations is a popular strategy (with similar shortcomings). For equity options trading, the correlations are implied by fitting a Black-Scholes distribution to the option prices and extracting the value of the implied volatility parameter. For tranche trading, the popular approach is to use a Gaussian copula approach to model the joint behavior of defaults, and take views on the implied correlations.

Correlation trading done with simple models such as these ran into trouble in May 2005, when equity tranches hedged with mezzanine tranches diverged greatly from the model implied numbers. This can be traced to the downgrade of companies in the index that created a steep correlation skew (akin to a volatility put skew that occurs when there is a market crash) to account for higher systemic risk.

VOLATILITY TRADING

Volatility trading focuses on the purchase and sale of implied volatility in the market. In its most direct form, volatility trading attempts to benefit from opportunities and perceived mispricing in the fixed income options markets. Since options prices are primarily determined by the implied volatility of the underlying reference security, a portfolio manager can analyze the opportunity from many different angles.

The first approach is to buy or sell options when the implied volatility is rich or cheap compared with some metric of long-term levels. To do so, portfolio managers use various estimation techniques to measure and forecast realized volatilities. If implied volatilities are higher than the forecast of realized volatilities, options are sold and the risk to the underlying is delta-hedged based on some model. Typically, option prices reflect a risk-premium, since sellers of options require compensation over and above the actuarially fair value of the options in order to sell them. Over long periods of time the average return from selling fixed income options, and holding them to maturity, in particular, has been positive since yields are naturally mean-reverting (high rates slow the economy down and hence cause yields to fall). Many portfolio managers follow the ratio of implied to realized volatilities to wait to initiate these trades. For those who do not want to hedge the risk to the underlying by delta hedging, instruments such as variance and volatility swaps are available where a direct bet on the level of volatility levels can be made in relation to a volatility strike. Of course, this strategy is very directional in both the level of volatility and in the level of rates, since the profit or loss is driven by both movements in the level of uncertainty as well as the demand for options from hedgers.

Another approach to trading volatility is to look at the volatility surface and find opportunities from mispricing of particular strikes, expiries, and maturities. The swaption volatility “cube” is specified in terms of swaption expirations, as well as, the swap “tails” that these swaptions exercise into the different strikes given the option expirations and underlying forward swaps. For instance, with low rates and the short-end of the yield-curve pegged to zero rates, a portfolio manager might take the view that the implied volatility for a payer swaptions (one that gives the right to pay fixed) at a higher strike than current forward is pricing in too much volatility. They can sell that swaption and pick both the volatility premium and the payer skew (currently payer swaption volatilities are higher than receiver swaptions due to inflation hedging demand for high strike payer swaptions).

Many portfolio managers also look at implied optionality across various fixed income securities. For instance, a mortgage backed agency pass-through is sensitive to the change in volatilities since rising volatilities increase prepayment probabilities. A mortgage pass-through buyer is naturally short the prepayment option to the homeowner, and is compensated for the option in terms of extra spread. If the level of swaptions volatilities is low compared with the option volatility implicit in the mortgage security, a portfolio manager can position a volatility arbitrage by buying the MBS and buying the swaption.

A further extension of volatility trading is to execute the trades across markets. One might take the view that option volatility in the United States is higher than European fixed income, and sell options in one versus purchase in another. Or that the volatility expressed in the fixed income options market is higher or lower than the volatility expressed in the longer dated currency options markets. The two are related because currency forwards are driven by both the spot exchange-rate and interest-rate differentials, and for longer dated forwards the volatility and correlation of the longer rates becomes a dominant relative value factor.

KEY POINTS

• All elements of fixed income investing require an understanding of the macroeconomic framework and the macro-political economic environment at any point in time; present and future for any country or region within which the investment is derived. The complex dynamics of the interaction of these considerations will result in a directional bias for many (if not all) of the risk parameters that concern portfolio managers. The interest-rate direction, yield-curve shape, volatility of interest rates, risk spreads and currency valuation, and the second derivatives of each are all dominated by the dynamics of the macro system.

• The asset-based credit strategy is a long/short style of portfolio management that focuses on investing in securitized debt obligations, which may encompass a wide variety of types of debt from residential and commercial mortgages to leases and credit cards.

• Capital structure arbitrage is an investment strategy that is typically focused on stressed or distressed companies. Typically, these are ones with high balance sheet leverage.

• The long/short credit strategy is also referred to as a relative value strategy or a fixed income arbitrage strategy. Within any of these descriptions are multiple substrategies or investment approaches practiced. Some of these substrategies may have very specific tightly hedged arbitrages while others have more systemic or generalized hedging approaches. A long/short credit portfolio can consist simply of diverse bond positions both long and short of companies that the portfolio manager feels are worthy of taking a positive or negative view on based on current default probability versus current price.

• The distressed investing strategy is one that focuses on investing in the securities of companies experiencing financial stress. They may be or may not be in default. The investment situations may be ones that are meant to focus on improving corporate balance sheets; others may be liquidation investments in which a company’s securities may represent a claim on valuable assets including cash, some liquidity investments where refinancing will provide the necessary time for a company to recover or litigations investments where the portfolio manager may participate on creditor committees and the value of certain securities will be determined in a court of law.

• Basis trading involves the simultaneous purchase and sale of two closely related securities to take advantage of relative mispricing. In the classic futures basis trade, an investor can buy a cash treasury security and sell a futures contract. In the credit basis trade, an investor purchases or sells a cash corporate bond and hedges the credit risk by the purchase of sale of credit default swaps.

• Index arbitrage and correlation trading take advantage of mispricing between the valuation of an index and its tranches (the “composite” securities), and the weighted valuation of its constituents.

• Volatility trading focuses on the purchase and sale of implied volatility in the market. In its most direct form, volatility trading attempts to benefit from opportunities and perceived mispricing in the fixed income options markets.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
34.229.110.49