Bond Pricing: Spread Quoting

This is a series of short posts examining the bond markets and some of the key pricing, risk and quoting concepts (with EXAMPLES!) –
        The Yield Curve
        Duration/Convexity and DV01
        Spread Quoting
        Roll PnL

Corporate bonds give a higher yield than govvies, reflecting their increased credit risk – the chance that the company defaults before the investor receives – their payment on the bond. The difference between these two is called the ‘Credit Spread’ – and typically the lower the credit rating of the company, the higher the yield investors will demand to purchase the bonds, so this spread will be larger. Because of this, corporate bonds are sensitive to two risk factors – interest rates in the bond’s currency, and the credit risk of the issuer.

If govvie yields (and hence interest rates) in a given currency increase, existing fixed rate bonds will be less valuable and the price will fall in order to increase yields to reflect the new govvie yield. Similarly, if the credit rating of the issuer declines, bonds it has issued see price declines as the spread to govvie bonds increases to reflect the new, increased credit riskiness of the bonds.

Investors seeking exposure to interest rates will typically buy govvies – and some will go long corporate bonds to gain an additional yield pickup over the risk-free govvies. On the other hand, specialist credit investors often seek exposure only to the credit riskiness of corporate bonds, and for these investors the sensitivity to interest rate risk is unwanted. To hedge this risk out, they will often trade bond ‘switches’, going long a corporate bond and simultaneously short the govvie benchmark bond with the closest maturity to the corporate bond in question, to neutralise the interest rate risk.

An example corp curve showing the spread over govvies, which typically increases with maturity, and is steeper for lower-rated bonds

Because switches are traded so often, for most highly-rated investment grade bond, dealers will quote them not by price or by yield, but instead by the spread between a bond and its govvie benchmark. The investor typically transacts both legs of the switch simultaneously with the dealer. A practical advantage of this way of quoting is that even if there are interest rate movements between the time of quoting and the time the trade is transacted, the spread between the two bonds is highly insensitive to them and rarely needs requoting (interest rates typically move much more frequently than credit spreads).

An example corp curve is shown above with the corresponding govvie curve in the diagram. Note that no interpolation is performed – a govvie with a nearby maturity is chosen as a benchmark, which can lead to small maturity mismatch.

Once a deal is agreed, the investor and the dealer must still agree on the Spread-to-Price conversion. This is done in two steps – the spread between the corporate bond and the govvie bond, plus the yield of the govvie, gives the equivalent YtM r_y for the corporate bond. This is then converted into a price by discounting all of the bonds payments using r_y as a risky discount factor.

Example: an AAA-rated corporate bond with three remaining annual coupon payments of 4%, which also returns notional of $100 at maturity (assume the most recent coupon was paid recently and the price already reflects this), is quoted bid-offer at 65-60 bps spread to the govvie benchmark which is quoted at 2.2% YtM, expires in 2.75 years, and pays biannual coupons at 1.8%. What is the approximate cash price to buy the corporate bond?

The only relevant quantities here are the corp spread to govvie, the govvie YtM, and the payments remaining on the corp. Since the govvie has a YtM of 2.2%, and the corp ask-quote is 60 bps (we’re buying the bond*, so the ask price is the relevant spread), we pay a price that implies a YtM of 2.8%

    \[\text{Price} = \frac{\$4}{(1 + 0.028)} + \frac{\$4}{(1 + 0.028)^2} + \frac{\$104}{(1 + 0.028)^3}\]

Performing the calculation this way round doesn’t require a solver – plugging in the r_y value from the quotes, we get a price of $103.41.

Note that the govvie here has a YtM higher than its coupon payments so is trading below par – despite its credit riskiness, the corp bond is more valuable due to its higher coupon payments. In yield terms the relative price relationship is much clearer.

*An interesting point to note from this example is that we typically think of dealer bid prices being lower than offer prices. This is of course true with spread-priced bonds, but as a lower price corresponds to a larger yield/spread, the larger spread is actually the bid price (ie. the YtM/spread that the trader would receive if she buys the bond from you)

Bond Pricing: Duration/Convexity and DV01

This is a series of short posts examining the bond markets and some of the key pricing, risk and quoting concepts (with EXAMPLES!) –
        The Yield Curve
        Duration/Convexity and DV01
        Spread Quoting
        Roll PnL

For dealers who buy and sell bonds, the change of a value of a portfolio as market rates change will be extremely important. As we discussed in the previous post, yields of bonds will typically rise and fall along with market-implied yields coming from risk-free treasuries, and having some quantities that capture the first-order magnitude of this change is useful – such first order measures are especially easy to handle as they sum linearly across a portfolio.

If market yields fall, the price of already-issued bonds will typically rise. To measure this, we define the ‘Duration’ of a bond to be the percentage decrease in a bond’s price as yields rise by 1%. From before, the value of a bond expressed in terms of YtM is

(1)   \begin{align*} C(t) &= \sum_{i=1}^N CF(t_i) \cdot \frac{1}{(1 + r_y)^{t_i}} \nonumber \\ \text{Duration} = \frac{1}{V} \frac{\delta C(t)}{\delta r_y} &= \frac{1}{V} \sum_{i=1}^N CF(t_i) \cdot \frac{\delta}{\delta r_y} \Bigl( \frac{1}{(1 + r_y)^{t_i}} \Bigr) \nonumber \\ & = \frac{1}{V \cdot (1 + r_y)} \sum_{i=1}^N \frac{CF(t_i) \cdot t_i}{(1 + r_y)^{t_i}} \nonumber \end{align*}

This last term looks complicated, but all it is is the duration-weighted sum of cash-flows, discounted by the YtM (and divided by 1+r_y, but this is likely to be very close to 1), so we see why ‘Duration’ is a sensible name for this risk measure!

Very often, rather than the relative change in the bond price due to the yield change, we will be interested in the absolute, dollar-value of the change (ie. the PnL of the portfolio). The measure often used here is DV01 – the dollar value of a 1bp (ie \frac{1}{100} of 1%) move in YtM

(2)   \begin{align*} \text{DV01} &= V \cdot \text{Duration} \cdot \frac{1}{10000} \nonumber \\ & = \frac{1}{10000 \cdot (1 + r_y)} \sum_{i=1}^N \frac{CF(t_i) \cdot t_i}{(1 + r_y)^{t_i}}\nonumber \end{align*}

which is very close to the discounted duration-weighted present value of the cashflows.

If a portfolio is constructed with DV01 close to 0, it will be fairly insensitive to YtM changes. However, note that we haven’t specified where the yield change came from – it could be coming from a change in the yield curve coming from govvie prices changing, or from a widening credit spread for corporate bonds. Changes in just the credit spread, for example, will affect the yields of some bonds more than others and a crudely hedged portfolio might suddenly show PnL.

Example: a portfolio is constructed made up of positions on two bonds A and B, both United States Treasuries paying bi-annual coupons. A has 3.5 years left to run, pays 2.5% annually and is priced at $99 on the market; B has 2 years left to run, pays 3% annually and is priced at $101 on the market. The portfolio is made up of $1MM face value of bond A. How large a short position should the portfolio manager hold in position B for the portfolio to be DV01-flat? What risk remains in the portfolio? (as usual, assume bonds have recently paid a coupon and that’s already reflected in the pricing)

First, we calculate the yield for each bond as described in the previous post (not forgetting that as coupons are bi-annual, they are each half of the annual total). A trades at YtM of 2.82%, and B trades at YtM of 2.5%.

Next we use these YtMs to calculate the unit DV01 of the bonds fromthe equation above. A has a DV01 of 0.00325 $/bp, while bond B has a DV01 of 0.00193. Since the ratio of these is 1.68, a short position of $1.68MM face value of bond B is required to flatten the DV01 of the portfolio.

Because we have used DV01 with bonds of different maturity to flatten the risk, we are immune to parallel shifts in the yield curve – ie. those that increase or decrease the yield of both bonds by the same amount. However, if the yield moves to become steeper or shallower, this will increase/decrease the yield of one bond more than the other, and our simple hedge will not be sufficient to prevent PnL.

Bond Pricing: The Yield Curve

This is a series of short posts examining the bond markets and some of the key pricing, risk and quoting concepts (with EXAMPLES!) –
        The Yield Curve
        Duration/Convexity and DV01
        Spread Quoting
        Roll PnL

As discussed in a previous post, bonds give investors a way to lock up their capital in return for a stream of coupon payments, with the full initial payment returned at maturity. Mathematically, the undiscounted payoff is very straightforward:

    \[\text{Payoff} = \sum_{i=1}^N CF(t_i)\]

where the cashflows CF(t_i) are typically annual or bi-annual, fixed percentages of the notional – and include the return of the notional at expiry.

After issuance, bond markets set the prices of bonds at each maturity. Typically government bonds – ‘govvies’ – in each currency set the overall ‘Yield Curve’ for the currency, which is the relationship between the rate of return against the length of investment (govvies are usually thought to be ‘risk free’ if denominated in the local currency as the government can print money to make repayments). Corporate bonds in each currency will trade at higher prices than govvies, with the ‘spread’ between a bond and a govvie determined by the market’s view of its credit-riskyness.

Bonds with higher coupons will typically be worth more to investors as they result in larger payments. However, if markets are efficient we expect that regardless of the coupons, $100 invested in two bonds from the same issuer that mature at the same time should yield the same return (otherwise, investors would pile out of one and into the other). The ‘Yield-to-Maturity’ (YtM) is a concept that captures this – it is the annually compounded rate of return expected from buying a given bond:

    \[C(t) = \sum_{i=1}^N CF(t_i) \cdot \frac{1}{(1 + r_y)^{t_i}}\]

Where C(t) is the market price of the bond, and r_y is the YtM of the bond, calibrated to satisfy the equality. Note that if the price of a bond traded on the market goes up, its calibrated YtM will fall, and vice versa.

Example: a United States Treasury (UST) has 2 years remaining until maturity, pays bi-annual 3% coupons and returns $100 at maturity. It is currently trading at $102.50. What is its YtM (assume it has already paid out its most recent coupon)?

This bond generates four payments of $1.5 in 6m, 12m 18m and 24m, and additionally returns $100 notional at 24m. The YtM is chosen to satisfy this equality:

    \[\$101.50 = \frac{\$1.50}{(1 + r_y)^{0.5}} + \frac{\$1.50}{(1 + r_y)} + \frac{\$1.50}{(1 + r_y)^{1.5}} + \frac{\$101.50}{(1 + r_y)^2}\]

Plugging this in to a root solver (eg. via excel) we find that this price implies a r_y of 1.731%. Note that, if this bond was trading at par (ie. $100) its YtM would equal its coupon rate of 3%. As the price is above par, the calculated YtM is below this.

When trading govvies, rather than quoting the price of a particular bond, dealers will usually quote the price in terms of its YtM, so that the return expected from a bond is more easily compared to other securities. Typically bonds with longer maturities will trade with a higher YtM, and for each currency we can use the liquidly-traded govvies to create a yield curve for this currency.

Because of this relationship, one way a portfolio manager can increase the yield of her portfolio is to increase its maturity profile by trading shorter-dated bonds for longer-dated bonds which will have a higher yield (although as we will see later, this also increases the interest rate risk of the portfolio).

An example Yield Curve is shown below for USD as of 22nd December 2017 from the US Treasury website:

Yield curves for USTs in early and late December 2017, built from US Treasury data