Bond Security Selection

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.

Bond Security Selection