Bond security selection involves a thorough analysis of a bond's intrinsic
value and its purchase or sale on this basis.
 Short-Term Trading and
Bond "Swaps"
Short-term trading techniques use technical and quantitative analysis to
establish overvalued and undervalued bonds.
- Traditional bond trading and "swapping" seeks to find
undervalued securities through examination of historical relationships and
patterns. If supply considerations, such as a new issue, have caused yields to
be high relative to historical norms for a particular retail company compared to
comparable credits, a bond manager would sell the more expensive retail bond and
buy the cheaper one compared to the historical relationship between them. This
can apply to government bonds as well. A manager might look at the historical
price and yield differentials or "yield spread" and "price spread"
between two similar Treasury Bonds and sell the one that is relatively expensive
and buy the cheaper one. Bond managers call this "taking out" dollars
of price spread or "picking up yield". The economics of "stripping"
or separating bonds into coupon and principal payments allows an evaluation of
the appropriateness of the spreads or pricing relationship between bonds and "zero
coupon" securities and trades can be executed between these very different
types of bonds.
- "Rich/Cheap" analysis references bonds to a peer group of
bonds. For example, a plot of all bonds against a theoretical (usually zero
coupon) yield curve show "rich" (overvalued) bonds with lower yields
than bonds of similar credit and term, or "cheap" (undervalued) bonds
with higher yields than bonds of similar credit and term.
- Option-Adjusted Spreads (OAS) techniques value a bond's cashflows
using a theoretical yield curve, attaching probabilities to future interest rate
movements. This gives a probability based value to a bond, usually quite
different than traditional "yield-to-maturity" and industry "rule-of
thumb" formulas. This technique is especially useful for callable and
extendible/retractable bonds, whose cashflows depend on future interest rates,
or are said to be "path dependent".
 Long-Term Credit
Analysis
Credit analysis is longer-term security selection, focusing on the
fundamentals of a bond. These include a credit assessment of the bond issuer
and the specific features of the security or issue. Where a trader might make a
short-term "swap" based on a higher yield for a bond than its peers,
the credit analyst focuses on longer-term issues. For example, although the
current ratings of a bond might be appropriate, the credit analyst might have an
insight into the prospects of the issuer that suggests that credit fundamentals
are improving. This could be based on a few things:
- the issuer's business conditions and operations are in an improving trend;
- the economy and other macroeconomic factors are likely to benefit the
issuer; and
- the underlying security or cashflows of the specific issue are stronger
than the market perceives, i.e. the shopping centre which forms the security for
the issue is worth far more than the outstanding bonds.
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